Forget P / E – these 2 metrics are far better

The price-to-earnings ratio (P / E) is probably the most commonly used metric to measure whether a stock is cheap. It is easily accessible and allows for a quick comparison of the valuation of two shares or the valuation of one share over time. The lower the P / E, the better. However, P / E has some disadvantages. Therefore, the following two measurements are in my opinion better suited to valuing stocks in most cases.

relationship between price and cash flow

The P / E ratio is the ratio between earnings per share and the share price. A major disadvantage is that this balance sheet result is easily distorted by special factors such as (special) depreciation, provisions, share-based payments and extraordinary income.

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A brief example of this: Based on the results of the last financial year Shopify (WKN: A14TJP) has a P / E of 14 (as of 07/05/22, applies to all information). This may seem cheap, but it is almost exclusively due to an unrealized gain on Shopify’s investments in companies such as confirm and Global-E Online. As the share prices of these companies rose in 2021, Shopify’s accounting profit also rose – its P / E fell. In the first quarter of 2022, this effect reversed – stock prices fell and Shopify’s result was markedly negative.

Free cash flow is a great way to hide these particular factors as much as possible. Unrealized gains from changes in the investment rate and many other special factors do not lead to changes in cash – the free cash flow remains unaffected. This shows how much money a business has actually made. If I put this free cash flow in relation to the price or market value of a company, I get the price-cash flow ratio. Shopify has a value of 89 – a much more realistic image than P / E. However, there is one drawback left. This static key figure refers to only one year and ignores the development. This is where the next metric comes into the picture.

Price for cash flow growth

To calculate this ratio, the price-to-cash ratio is compared with the growth in cash flow. Either the past growth trend is used, or the expected future growth is included. The logic behind this is that a high price-to-cash ratio is acceptable as long as growth is also high.

Let’s return to our Shopify example. The price-to-cash ratio is 89, free cash flow grew by 15% in 2021. Dividing 89 by 15 gives us a price-to-cash flow growth of 5.9. Similar to the PEG ratio, this metric should be below 1 to signal a cheap valuation. So even though the P / E ratio suggests Shopify’s cheap valuation, the other two less skewed measurements still show a high valuation.

When I analyze a company, I always calculate these two key figures. To me, these are always just a delicious accessory. More important to me are things that cannot be easily measured by numbers, such as future prospects, the quality of management, and the corporate moat.

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Hendrik Vanheiden owns shares in Shopify. The Motley Fool owns shares in and recommends Shopify and recommends the following options: long January 2023 $ 1,140 call on Shopify and short January 2023 $ 1,160 call on Shopify.

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