Accounting for, Valuing, and Pricing Cash
If you believe the accounting balance sheet, this company is half software and half cash but that is misleading for two reasons. The first is that assets on accounting balance sheets are not marked to market and can remain at low values, even as their earnings power rises. The second is that accounting rules (absurdly) treat R&D, the biggest capital expenditure at technology firms, as operating expenses, which then results in those assets never showing up on the balance sheet. The ripple effects of understating the book value of equity can be seen in the high returns on equity that I report for the firm.
- Expected net income from software = $72 million
- Expected reinvestment to generate growth = 2%/36% = 5.56%
- Value of Software business = 72 (1-.0556)/ (.10-.02) = $850 million
- Expected pre-tax income from cash = $ 200 (.02) = $4 million
- Cost of equity = Riskfree rate = 2%
- Value of equity = 4/.02 = $200 million
How will bringing in debt into this process change the game? Let's assume that you borrowed $300 million and bought back stock in this company, while leaving the existing cash balance unchanged. Reducing your market cap by roughly $300 million will augment the effect of cash on PE and make the non-cash PE ratio even lower.
Cash Balances and PE: Determinants
The US Market: PE and Cash
At this point in this discourse, you may be wondering why we should care, since companies in the US have always held cash and had to earn close to a short-term risk free rate on that cash. That is true but we live in uncommon times, where risk free rates have dropped and corporate cash holdings are high, as is evidenced in this graph that looks at cash as a percent of firm value (market value of equity+ total debt) for US companies, in the aggregate, from 1962 to 2015 and the one-year treasury bill rate (as a proxy for short term, risk free rates):
|Data from Compustat & FRED: Computed across all money-making companies|
I know that the talk of a bubble gets louder each day, and while there may be legitimate reasons to worry about the level of stock prices, those who base their bubble arguments entirely on PE ratios (normalized, adjusted, current) may need to revisit their numbers. All of the versions of the PE will be "pushed up" by the cash holdings of US companies and the low interest rate environment that we live in.
Sector Differences in Cash and PE
It delivers the message that there is no simple rule of thumb that will work across all companies or even across companies within a sector.
Perhaps, the best way to check out the effect of cash on PE is to pick a company and take it through the cleansing process, a very simple one that requires relatively few inputs. Use this spreadsheet to try it on your favorite (or not-so-favorite) company.
Rules for dealing with cash