Market Capitalization to Cash Flow Ratio
The term market capitalization to cash flow ratio refers to a metric that allows the investor-analyst to understand the relative premium investors are willing to make in a company. The calculated rate uses EBITDA in the denominator, which eliminates the effects of both financing decisions as well as accounting practices.
Market Capitalization to Cash Flow Ratio = (Stock Price x Shares Outstanding) / EBITDA
- Stock price is the average price over the period examined.
- Shares outstanding is the average number of common shares outstanding over the period examined.
- EBITDA stands for earnings before interest expense, taxes, depreciation and amortization. It can be restated as operating profit plus depreciation and amortization.
Cash flow measures allow the investor-analyst to understand if the company is generating enough cash flow from ongoing operations to keep the company in a financially sound position over the long term. One of the ways to understand the relative premium investors are willing to pay for the common stock of a company is by determining their market capitalization to cash flow ratio.
By calculating a company's market capitalization to cash flow ratio, the investor-analyst can understand the relative premium investors are willing to pay for a share of common stock in a company relative to their peer group. Since there are a number of variables the price paid for a share of common stock (in addition to their ability to generate cash), this ratio can be used as a benchmark when examining the value of an organization.
A manager of a large mutual fund would like to understand the market's sentiment towards Company ABC's common stock. The company competes in an industry where the average market capitalization to cash flow ratio is 5.2. Company ABC had an average of 225,000,000 shares of common stock outstanding with average price of $26.32 last year. The company also generated EBITA of $1,287,000,000 in that same timeframe. Using this information the investor-analyst calculated Company ABC's market capitalization to cash flow ratio as:
= (225,000,000 x $26.32) / $1,287,000,000= $5,922,000,000 / $1,287,000,000, or 4.6
Since Company ABC's ratio of 4.6 is less than the industry average of 5.2, the investor-analyst evaluated a number of other metrics to determine why the company was undervalued relative to its peers.