Written and copyright © 2008-2014 by Thomas N. Bulkowski. All rights reserved.
Fundamental Analysis and Position Trading,
pictured on the left, has a complete chapter dedicated to cash flow, including, "Cooking the Books" and "Is Increasing Cash Flow Good?"
$ $ $
This page reviews the results from a study of the price to cash flow ratio.
Price to Cash Flow Summary
Cash flow is a biggie among some traders, investors, and analysts that use fundamental analysis. Cash flow is an indicator of the company’s ability to generate cash that it
can use to run its business. Peter Lynch writes in One Up on Wall Street that cash flow "is the amount of money a company takes in as a result of doing business." He says
that the critical difference between companies, is how much it costs them to generate the cash. It is far better to spend 40 cents to make a dollar than it is to spend 80 cents per dollar.
Lynch goes on to say that a 10 to 1 ratio is standard for price to cash flow.
Value Line defines cash flow per share as "net profit plus non cash charges (depreciation, depletion, and amortization), less preferred dividends (if any), divided by common shares
outstanding at year end."
A study of the price to cash flow ratio shows that stocks having a low ratio outperform those with a high price to cash flow ratio 78% of the time. A low ratio means that
the cash flow is high relative to the stock’s price.
A second test using almost 1,000 samples shows the same result, with stocks having price to cash flow ratios below the median beating the performance of those with ratios above the
median by over 60%.
Price to Cash Flow Methodology
I used the Value Line investment survey and typed in their cash flow per share numbers to build a database of 178 stocks with data ranging from 12/30/1991 to 7/11/2008.
After completing the database, I logged the close-to-close price change from 1 to 5 years out, looking
forward from the base year. The base year ranged from 1992 to 2006. Not all stocks covered the entire range.
Years with no numbers were excluded. The price change measured from the close on the last trading day of each year.
Years 2008 and later are not included since the year had not completed as of the time of this study.
Price to Cash Flow Results
The following table shows the results of price to cash flow ratio (PCF) versus performance over time.
|Base Year||PCF||Median PCF||1 year||2 years||3 years||4 years||5 years||Samples|
Let’s take an example using 2006. Stocks with a price to cash flow ratio above the median 11.96 had gains averaging 17.5% in 2007 compared
to a loss of 2.2% for stocks with a price to cash flow ratio at or below the median. No more results appear for that row because the years had not ended when the study was done.
There were 88 to 89 samples that qualified for the study.
If you count the yearly performance of each entry when the price to cash flow ratio was above or below the median, you will find that stocks with a low price to cash flow ratio outperformed
those with a high ratio 78% of the time (51/65).
I consider this result preliminary and intend to expand the database and then publish my findings.
In a second test, I compared stocks with price to cash flow ratios above and below the median of all stocks. The following table shows the results.
|Price/Cash Flow||1 Year Move||Samples|
|Below or equal to 10.34||14.7%||943|
Using almost 1,000 samples, I found that those stocks with price to cash flow ratios below or equal to the median outperformed those with ratios above the median from 1992 to 2007 on a 1 year
basis. In other words, I computed each stock’s price to cash flow ratio for 1992 and measured the price change from year end 1992 to year end 1993 and then
moved to 1993 and started a new calculation, and so on until I ran out of data. Sorting the price to cash flow ratios and averaging the performance gave the results shown in the table.
-- Thomas Bulkowski
Copyright © 2008-2014 by Thomas N. Bulkowski. All rights reserved. Q: What is the difference between a new husband and a new dog? A: After a year, the dog is still excited to see you.