As more large corporations build up cash on their balance sheets, the analytical process of equity valuation becomes more complicated. In many cases, net cash on the balance sheet is a substantial percentage of market cap and, as I have explained in a post to my Instablog, this tends to distort P/E analysis.
In order to better approximate the private market value of equities, I have started using a new metric - EPEE. EPEE is the ratio between enterprise price and enterprise earnings. "Enterprise Price" is simply market cap minus net cash or plus net debt; this is the same as the enterprise value used in EBITDA analysis. It removes cash from the valuation in order to isolate the performance of the operating entity. "Enterprise Earnings" is a somewhat new concept - it is simply earnings minus net interest income or plus net interest expense. It isolates the earnings of the operating entity. EPEE is an useful mechanism for evaluating equities. Once EE is determined, a multiple may be assigned to it to determine whether on an EPEE basis the enterprise is overvalued or undervalued. Assuming a multiple can be assigned, a target market cap for the stock can be determined by multiplying the multiple times EE and then adding net cash to calculate a target market cap. The assumption is that the private market value of the company is the value of the operating enterprise plus the value of the cash.
I have begun analyzing companies with large amounts of cash on their balance sheets on this basis. It is interesting that, even with respect to companies with enormous amounts of cash, net interest income seems to be miniscule. This, of course, is another feature of the ultra low interest rate environment we are in, and it is another reason that valuation methodology must be tailored to this particular set of odd circumstances. Normally, a company might earn 4 or 5% on its cash hoard and, thus, EPEE might be very close to P/E due to the fact that EE is a lot lower than E because interest income has been backed out. With very low levels of interest income, however, the cash on some corporate balance sheets is trading at multiples of 40, 50 or higher to one and distorts P/E analysis enormously.
Getting to CISCO (CSCO), which has net cash on its balance sheet of over 20% of market cap, I have calculated net cash as of the most recent quarterly financial report at 23.65 billion dollars. This produces an EP, or Enterprise Price, of 91.4 billion dollars. Using earnings estimates for fiscal 2011 (current year) of 8.92 billion dollars and fiscal 2012 of 10.13 billion dollars, I then calculated Enterprise Earnings by backing out net interest income. As in many cases, net interest income was negligible (CSCO has some debt and the interest on the debt is almost as large as the interest income on the net cash).
At any rate, using this analysis, CSCO's current year P/E is 12.8, but its current year EPEE is 10.3. CSCO's 2012 P/E is 11.4, but its 2012 EPEE is 9.1.
This analysis has to be refined taking into account presumptions about share repurchases (which will change both the share count and the amount of cash on the balance sheet). However, it does suggest that a stock like CSCO may be undervalued because it is not getting enough credit for the cash on its balance sheet. As a general proposition and as a matter of simple mathematics, the gap between EPEE and P/E will be largest for those companies which have the largest proportion of net cash to total market cap. Two other companies which would likely garner similar results are MSFT and INTC.
As noted above, this phenomenon is yet another peculiar quirk in valuation analysis produced by the ultra low interest rates of the past two years. I have not analyzed whether it results in a market-wide distortion (I have not tried to calculate the EPEE for the S&P 500, for example), but I think it is safe to say that it produces a bias in the direction of undervaluation for certain large cap stocks.