- CFA Exams
- 2023 Level II
- Topic 5. Equity Valuation
- Learning Module 25. Market-Based Valuation: Price and Enterprise Value Multiples
- Subject 7. Price to Cash Flow

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##### Subject 7. Price to Cash Flow PDF Download

Advantages:

- It is more difficult to manipulate than earnings.
- It addresses the quality of earnings problem. For example, when company A uses "completed contract" revenue recognition method and company B uses "percentage of completion" method, the two companies can be compared only on the basis of their cash flows.
- It is more stable than P/E, since cash flow is usually less volatile than earnings.
- Studies show that P/CF explains differences in long-run returns on equity.

Disadvantages:

- Earnings plus non-cash charges approach ignores some cash flows (non-cash revenue and net changes in working capital).
- FCFE is preferable to CFO but it is more volatile and can be negative.
- Cash flows can also be manipulated.

**Determining Cash Flow**

**CF = earnings + non-cash charges = net income + dep/amort.**

To calculate CF an analyst would take net income and add back non-cash expenses, most notably amortization, depreciation and depletion. Note that this definition of cash flow is not theoretically correct since it ignores any changes in working capital accounts, such as inventories or accounts payable. Practitioners using CF often assume that the working capital is constant, which sometimes may not be a realistic assumption.

**CF = CFO + [net cash interest outflow x (1 - tax rate)]**

CFO incorporates all revenues and charges related to the on-going operations plus the net decrease in working capital accounts. It must be further adjusted to exclude components related to financial and investing activities, such as cash interest income.

Some practitioners may employ other definitions of cash flow, such as FCFE and EBITDA.

*Example*

- Current market price per share: $12.15.
- FY03 Leading EPS: $(0.12).
- FY03 Depreciation and amortization: $0.06.
- FY03 CFO per share: $0.012.
- FY03 FCFE per share: $(0.76).
- FY03 EBITDA per share: $0.18.

Diane examines the data and makes the following observations:

- CF per share value is negative: CF = EPS + D&A= $(0.12) + $0.06=$(0.06). The negative measure is not meaningful.
- P / FCFE is also not meaningful since FCFE is negative.
- P / CFO = $11.15 / $0.012 = 1012.5. This high but meaningless multiple is explained by an almost-zero cash flow provided by operations.
- The only meaningful multiple is P / EBITDA = $12.15 / $0.18 = 67.5, although a multiple this high is also suspicious and will hardly be used in relative valuation analysis.

**Valuation Based on Forecasted Fundamentals**

The fundamentals-based formula:

_{0}/ Cash Flow per Share

_{0}= (1 + g) / (r - g)

The fundamental drivers of P/CF, however defined, are the expected growth rates of future cash flows and the required rate of return. The justified P/CF based on fundamentals bears a positive relationship to the first factor and an inverse relationship to the second.

**Valuation Using Comparable P/CF**

- Same method as P/E, P/B and P/S.
- Low P/CF => undervalued.
- Control for:
- Return and risk.
- Cash flow.
- Growth rate.

**Learning Outcome Statements**

calculate and interpret underlying earnings, explain methods of normalizing earnings per share (EPS), and calculate normalized EPS;

explain and justify the use of earnings yield (E/P);

describe fundamental factors that influence alternative price multiples and dividend yield;

calculate and interpret the justified price-to-earnings ratio (P/E), price-to-book ratio (P/B), and price-to-sales ratio (P/S) for a stock, based on forecasted fundamentals;

calculate and interpret a predicted P/E, given a cross-sectional regression on fundamentals, and explain limitations to the cross-sectional regression methodology;

evaluate a stock by the method of comparables and explain the importance of fundamentals in using the method of comparables;

calculate and interpret the P/E-to-growth ratio (PEG) and explain its use in relative valuation;

calculate and explain the use of price multiples in determining terminal value in a multistage discounted cash flow (DCF) model;

explain alternative definitions of cash flow used in price and enterprise value (EV) multiples and describe limitations of each definition;

calculate and interpret EV multiples and evaluate the use of EV/EBITDA;

CFA® 2023 Level II Curriculum, Volume 4, Module 25

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**User Contributed Comments**
1

User |
Comment |
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Paulvw |
Which makes the fundamentals-based P/CF = (1-b)* Trailing P/E. |

I passed! I did not get a chance to tell you before the exam - but your site was excellent. I will definitely take it next year for Level II.