Is the price to cash flow ratio more important than the price to earnings ratio?

Question

Earnings does not include money used for depreciation and amortization.
I think amortization and depreciation are payments for debts and interest.


From Yahoo Financial Glossary:
Amortization: The repayment of a loan by installments.

Depreciation: A non-cash expense that provides a source of free cash flow. Amount allocated during the period to amortize the cost of acquiring long-term assets over the useful life of the assets.

Cash flow: In investments, cash flow represents earnings before depreciation, amortization, and non-cash charges. Sometimes called cash earnings. Cash flow from operations (called funds from operations by real estate and other investment trusts) is important because it indicates the ability to pay dividends.

Answer 1

Dont be confused by the yahoo definitions. They arent that great. Here is the layman's definition of amortization and depreciation.

Depreciation: If Company A buys a t-shirt making machine in 2006 for $100, they can not expense the $100 cost of the machine entirely in 2006. They have to disperse the cost of the machine over the amount of time it can make t-shirts for them. Lets say they determine that the machine has a 10 year life. Then, they would take a $10 depreciation expense every year from 2006-2016. However, this is considered a non-cash expense since their cash account is not actually going down by that amount every year. In fact, it only goes down by $100 in 2006. However, that is the key difference between cash flow and an income statement.

Amortization: is the same thing, but usually for intangible items. Let's say pharmaceutical Company A buys a patent from Company B for $100. If they determine the life of the patent is 10 years, then they would expense $10 per year as amortization expense. But again, its a non-cash expense.

To answer your question, it really depends. The problem with p/e is that earnings can involve all types of accounting tricks that might not reflect the true nature of the business. On the other hand, cash does not lie. Cash flow is cash flow. However, it can be misleading if you look at it in a vacuum. Think of the t-shirt example above. In that first year, you would probably have negative cash flow since you spent alot of your money buying the machine. However, that says nothing about whether or not you would be on track to make up that investment over the next 10 years.

Hope that helps.

Answer 2

This is a good question. I would suggest that you pay more attention to P/E rather than cash flows. Even a EBITDA (Earnings before Interest, Taxes, Depreciation and Amort.) negative firm can show large cash flows. In other words, you can shuffle money like crazy and have no earnings. Now where you have to be careful is in how the earnings are measured. If you take EBITDA, you're going to get a larger number than if you factor your P/E ratio off net income which is what is left after all the bills are paid so to speak. Any detailed stock quote will provide a P/E ratio - you're wise to use it as a measure. The lower the P/E the better. Try to get stocks with P/E of less than 20 and that pay a dividend. This makes you an investor as opposed to a speculator. Owning a stock with no dividend is basing your future wealth on the hope that someone will come along and pay you more than you paid for the share. Dividends are a must. Merck (MRK) is a good stock, with a P/E of around 16 or so, and a dividend of $1.52/share. The price is a little high right now, so be careful, but those are the types of things you want to think about.

Hope that helps!

Answer 3

cash flow is just one piece of the puzzle to consider and it is not more important than earnings. They are both important as is also the balance sheet.

Sometimes companies in rapidly growing capital intensive industries such as integrated circuit fabrications might have a negaive cash flow because of investments in new plant and equipment to meet future demand. That could very likely also be the case in the biotechnology industry.

Let us say for example that a company developed a drug to cure lung cancer and received a patent and FDA approval to market it. But would require 3 years and 30 billion dollars to construct the manufacturing facilities and would not have a positive cash flow for 5 years. Do you think that would matter at all to potential investors??

Answer 4

No, cash can constantly flow but if there is no profit what's the point?

Answer 5

If you don't have any money you can't buy anything so forget it.

Answer 6

wow, you sound smart.