I have noticed that some investors are using ex-Cash P/E in an attempt to portray Apple (NASDAQ:AAPL) as undervalued. One sentence in and I'm sure there are already some Apple fanatics getting ready to pounce on a dissenting viewpoint. I would like to remind the militantly Pro-Apple crowd that I own Apple. Since I own the company, it should go without saying that I think it is at least slightly undervalued. Regardless, this article is not about whether Apple is overvalued or undervalued, but rather whether ex-Cash P/E is an appropriate way to value Apple. For those who are unaware, ex-Cash P/E is a variation of the P/E ratio that is calculated as: (Market Cap - Cash & Cash Equivalents) / Earnings. In Apple's case, I've noticed that ex-Cash P/E calculations tend to include long term marketable securities as cash equivalents. Fundamentally, I find the ex-Cash P/E ratio to be grounded in the idea that arbitrarily lowering market cap while holding earnings constant will result in a better valuation. This article is not about disparaging investors who currently use ex-Cash P/E ratios. In the past, I've calculated an ex-Cash P/E or two myself. However, I do hope to demonstrate my belief that those using ex-Cash P/E would be better served by other methods.
A Few Issues
-Need to Determine Amount of Excess Cash
Ex-Cash P/E is meant to reveal the value of a business excluding any excess cash. This can present a challenge because excess cash is not plainly stated on the balance sheet. Rather than trying to determine excess cash, many simply subtract the entire ~$165 Billion of cash and securities held by Apple at the end of Q3 2014. Ignoring that ~$127 Billion of this amount is classified as long term securities, Apple still does not have an excess ~$165 Billion of cash and marketable securities. More specifically, Apple will need some of this cash to run the business and pay foreign withholding taxes on repatriated earnings. First, it's no secret that businesses require some amount of cash to operate on a day to day basis. Generally, 1-2% of sales is used to estimate the amount of cash need to run the business. Apple generated ~$178 Billion in revenue over the past twelve months. Using this number, we can assume that the company needs to keep between $1.78-3.56 Billion in cash on hand. There is also the issue of repatriation taxes. A large portion of Apple's cash and investments were generated overseas. This means that Apple will have to pay taxes when repatriating this money to the United States. It's tough to calculate the exact amount of taxes that Apple would have to pay, but it's pretty safe to say the company will be left with noticeably less than its reported amount of cash and marketable securities.
-Cash On Hand Impacts Other Financial Statement Metrics
When looking ex-Cash P/E, it's important to consider the other impacts of stripping a company of all of its cash. Starting with the obvious, excluding cash can have a negative impact on a company's liquidity ratios. As mentioned earlier, ex-Cash P/E is intended to deal with excess cash. It's important to realize that it is impossible to remove a large amount of cash without impacting liquidity ratios. I would argue that if the exclusion of cash results in an unacceptably low quick ratio or current ratio, then it should not be treated as excess cash. An ex-Cash P/E calculation should also consider that a large amount of cash and marketable securities can allow for the generation of large amount of interest income. Without cash and marketable securities, the company would not be earning any interest income, so I believe it is necessary to subtract interest income in order to determine ex-Cash P/E. For an example of how this works, take a look at Apple's fiscal 2013. I'm using numbers from 2013 because it is the most recent completed fiscal year. In 2013, Apple generated ~$1.29 Billion from interest when the excluding interest expense on its debt. The company had $37.04 Billion in net income during the same period. I recognize that interest was a relatively minor portion of net income, but it can still skew calculations.
-Need to Account for Debt
Finally, I find it strange that investors are willing to remove any amount of cash from Apple's Market Cap without considering debt. At the end of Q3 2014, Apple had $29.03 Billion in long term debt. I recognize that Apple has significantly more cash and marketable securities than long term debt, but I believe it is necessary to account for the amount of leverage a company employs. Consider a scenario where Apple borrows $100 Billion and leaves it in the bank. In this case, the increase in debt would cause the company to appear more attractively valued when using ex-Cash P/E. This makes no sense to me and I doubt I'm the only one. I'm sure many of recognize that if you are going to subtract cash from Market Cap, you also need to account for debt. This is the general idea behind Enterprise Value. Generally, Enterprise Value is calculated as the sum of a company's Market Cap and its net debt. Enterprise Value fixes the leverage related issues encountered when using ex-Cash P/E. Enterprise Value is frequently coupled with EBIT. EV/EBIT is often used to value a company independent of its capital structure. Using EBIT as the denominator helps to eliminate the interest issues discussed in the previous paragraph.
As shown above, I believe ex-Cash P/E has its fair share of flaws. While ex-Cash P/E is a quick and easy way to paint an optimistic picture of Apple, I don't believe it is a sound way to value the company. First, due to general cash needs and the potential for foreign withholding taxes, it's tough to say exactly how much excess cash Apple has. Further, I don't believe it is right to exclude cash without considering the effects this will have elsewhere in the company's financial statements. I also see no reason to subtract cash while ignoring debt. After looking at ex-Cash P/E, it should be apparent why EV/EBIT is widely to evaluate a company independent of its capital structure. I should also note that while EV/EBIT is an improvement, it is not perfect. There is still the issue of determining excess cash once taxes and capital needs are accounted for. While I tend to agree with those who believe Apple is undervalued, I do not believe ex-Cash P/E should be used to prove this point.
Disclosure: The author is long AAPL. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.