Understanding Valuation Multiples With Respect to Cash 11 comments
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A common mistake people often make refers to how a firm’s cash stockpile is treated in the valuation process. Specifically, Investors err when they subtract cash from market value before calculating an earnings multiple that includes interest income. P/E multiples are calculated using EPS, or net income per share. This figure includes interest income that is generated from a firm’s cash investments.
It’s incorrect to make assertions regarding P/E ratios based on cash/share values. For instance, $100 share price & $5 EPS, and has $20 cash/share, the firm’s P/E is 20x. End of story. No adjustments are to be made, nor should the $20 cash/share have any bearing/relevancy in that scenario. Its true and only P/E multiple is 20x.
The common mistake is to adjust the share price by the cash/share and then divide earnings. Hence: 100-20= 80/5 = 16x. If the $20 cash/share earns 5%, then it contributes $1 to EPS. If cash were eliminated from the calculation, it needs to be done on both sides. EPS would then be $4 not $5, and $80/$4 is 20x. Multiple doesn’t change because the value of the cash was captured in the share price as well as the EPS. Therefore, cash/share doesn’t have any effect on P/E multiples and shouldn’t be part of P/E analysis.
EQUITY VALUE MULTIPLES:
Let’s take Apple (AAPL) for example: Price = $172.55, Cash/Share = $23.45, FY09 EPS Estimate = $6.06. The forward P/E is 28.5x. The incorrect computation is to subtract cash from the share price before dividing by expected EPS: $172.55 - $23.45= $149.10 / $6.06 = 24.6x. The rationale people give for making this mistake is that one share of Apple represents $23.45 of cash and a business that generates $6.06 in EPS, thus an investor can purchase the earnings stream for $149.10.
Here’s the issue- the cash balance contributes to earnings in the way of interest income. Without the cash stockpile, EPS would be lower. One must not assume that Apple’s FY09 EPS will be $6.06 without interest income, thus a higher multiple should not be assigned on the basis of its high cash/share. In FY07, Apple earned $647 million in interest from its cash holdings, which totaled $15.4 billion at year-end. In per-share terms, interest income contributed roughly 51 cents to Apple’s reported FY07 EPS of $3.93.
Apple’s P/E multiple based on FY07 EPS is 43.9x. Without interest income, EPS falls from $3.93 to $3.42, and subtracting cash from share price, Apple’s historical P/E is 43.6x. That’s roughly the same as the multiple calculated with cash included in both price and EPS. The common mistake is not subtracting out interest income from EPS while taking cash out of the share price. Therefore, it’s incorrect to subtract cash from one figure without taking it out from the other figure as well.
Since P/E ratios represent income that includes interest income, the conversation of cash/share is inappropriate, as it has no bearing on value, nor multiples in that regard. It’s incorrect to assert that a firm’s P/E multiple is actually lower because it has a relatively high cash/share, and that one should consider cash/share in tandem with P/E ratio. The cash/share is accounted for in the P/E ratio because it’s a part of the “E” or earnings, which includes interest income. The cash balance is the present value of future interest income, thus the two are the same.
ENTERPRISE VALUE MULTIPLES:
In instances where EBIT or EBITDA figure (Earnings before Interest, Taxes, Depreciation, Amortization) is used in a price multiple, then cash holdings should be considered since interest income (expense) is not captured. Thus, a P/EBITDA multiple makes an incorrect comparison since cash and debt aren’t included in the value of the denominator but are in the share price, or market value of the equity. To properly compare EBITDA, one should use enterprise value, or EV, in place of share price, or P. EV is the market value of the equity plus value of debt minus cash. Therefore, the multiple becomes EV/EBITDA. Cash holdings are excluded from the value figure, numerator, as well as excluded from earnings stream, EBITDA, in the denominator.
CONCLUSION:
To calculate multiples correctly, one shouldn’t include components in the numerator without also including in the denominator. If one is computing P/E multiple, then cash/debt needs to be ignored because those values are captured in the EPS. If one is computing EBITDA based multiples, then EV instead of P, is the correct input for the numerator. Since EBITDA doesn’t account for interest income/expense, then it would be much higher for a debt-laden firm. If share price, P, were used instead of EV, then the numerator would be too low resulting in too low of a multiple. Adding debt to arrive at EV, increases the numerator to coincide with the exclusion of interest expense increasing the denominator as well.
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This article has 11 comments:
I agree that Apple's deferred revenues make the P/E multiple a poor metric for comparison, since cash earnings are actually much higher. I have been writing about this in the recent weeks, and why P/FCF is a better metric for evaluating Apple.
However, I was ignoring deferred revenue for the sake of this argument and was merely discussing a principle that applies to all firms, especially those with high cash/share.
Thanks for your feedback
P/E
P/E - Cash
P/EBITDA
P/EBITDA - cash
EV/EBITDA
P/FCF
Along with share price at end of FQ407.
Then we could see how they stack up. But since you did not give actual values for these, we cannot see how they compare. My guess is that using the P/FCP and the EV/EBITDA will still give a different number than the P/E.
Apple has a net margin of 14 or 15 per cent. I am not sure that they get that much on their cash. If they get only 8% on cash, then the P/E will be skewed higher. This is exactly what we have been trying to account for. The method (p/e - cash) may be simplistic, but perhaps it still gives a better valuation than p/e alone.
When a company is acquired, you better believe their cash balance is
used to determine the price being paid. Higher cash should equal a much higher P/E because it gives a company so many more options to expand than a company that relies on debt. It also makes a company much more likely to survive any downturn.
On a strickly mathmatical basis, you should not back out cash to calculate PE. But to determine what PE a company deserves, cash is a key element in the math along with its growth rate.
When a company is acquired, you better believe their cash balance is
used to determine the price being paid. Higher cash should equal a much higher P/E because it gives a company so many more options to expand than a company that relies on debt. It also makes a company much more likely to survive any downturn.
On a strickly mathmatical basis, you should not back out cash to calculate PE. But to determine what PE a company deserves, cash is a key element in the math along with its growth rate.
In evaluating a company's ability to generate quality earnings and growth, it's ridiculous to include a company's cash position and interest on the cash position in the P/E ratio (and ultimately the PEG analysis). Investors simply aren't interested in whether a company can achieve the financial milestone of earning interest on a cash position . . .
To obtain a true (actually truer) picture of a company's earnings generating power and growth, both the cash and the interest income generated by the cash should be excluded from the pro forma . . .
Where do they get these goofy accountants that think they're Larry Livermore . . .
I was focusing primarily on correct computation- to make an "apples to apples" comparison. If one subtracts cash from price, then essentially that's EV, which means interest income needs to be taken out of earnings as well, thus arriving at EV/EBITDA - a better income stream is NOPAT- Net Operating Profit After Taxes, or basically EBIDA (tax adjusted)
My intention was to broach a common occurrence where some folks make this mistake- here's one example where an author is off the mark: seekingalpha.com/artic...
You mention cash- as it provides value in the form of a strategic option. I agree. Large amounts of cash can give management options to undertake investments/strategies that will add value and forgo ones that will not.
However, not all firms flush with cash possess and implicit strategic option value that makes firm more valuable and affords a higher valuation.
Take MSFT's case several years back. It had tons of cash, however, if anything, it should have compressed the multiple because cash was building up from the lack of options and the lack of potential growth avenues. The cash in MSFT case was actually hurting its valuation since it was earning a lower return than being reinvested in the business, or distributed to SH so they could invest in higher return areas. Thus, the amount of cash, as it pertains to option-value, differs on a case by case business. For Apple, It would be hard to disagree that it doesn't add value, since Apple has numerous opportunities that will unfold. However, if the years go by, and the cash continues to mount with out being reinvested, it will eventually compress multiples. If that day ever comes.
when i hear microsoft hired jerry seinfeld, i must admit that my first thought was, 'smart move...those vista users will need some comic relief!'
disclosure: long appl