Why Apple's Valuation On An Ex-Cash Basis Is A Bit Misleading For Potential Investors

| About: Apple Inc. (AAPL)

With Apple's (NASDAQ:AAPL) phenomenal success, the company's cash balance has dramatically grown over the past three years to $117 billion in cash and short-term investments as of June 30th, 2012 (from only $31 billion on June 30th, 2009). Today's balance reflects roughly $125 in cash per share for Apple (using 937.4m basic shares out per the latest 10Q).

With this substantial cash balance, I have seen many analysts, members of the media, and individual investors refer to an Apple P/E on an ex-cash basis. I believe this is a bit of a misleading method to value Apple stock for a couple reasons, and I believe investors should be cautious whenever they hear this type of reasoning.

First, to give a quick framework for my thoughts: Typically, an investor considers looking at a P/E ratio on an ex-cash basis if a company has significant excess cash levels (cash in addition to the necessary amount to run the business). The reason for this is that the company could hypothetically distribute the cash to shareholders or re-deploy that cash into higher return investments. Therefore, a P/E on an ex-cash basis would more accurately reflect the valuation of the core business, and not be diluted by low interest income returns (typically 0-1% today) from the cash. Often, investors cite this as an even more attractive reason to look at an investment, as the P/E (ex-cash) is lower than just the P/E.

In general, this is a subtle distinction. But when a company has $117 billion in total cash and nearly 20% of their market cap in cash, as Apple does, the distinction becomes more important. Using analyst estimates I pulled from Yahoo Finance, I calculate Apple's FY2013 P/E at 12.6x and FY2013 P/E ex-cash, ex-interest income at 10.5x. Not a huge difference on an absolute multiple basis, but on a percentage basis the traditional P/E is 20% higher than the ex-cash P/E.

Apple P/E Calculations, traditional and ex-cash

Now, the primary reason Apple should not be looked at on an ex-cash basis is that both Apple management and common sense have given us some indication as to the future size of Apple's cash balance, which will remain extremely large for at least the next few years. Basically, while Apple could hypothetically re-distribute $100+ in cash per share, management has already indicated to us their general cash and dividend plans in the near to mid-term.

In March 2012, Apple noted it would spend $45 billion over a 3-year period for dividends and buybacks (roughly $10 billion for buybacks to offset share dilution and $35 billion for dividend payments). There was a lot of anticipation ahead of this announcement, and in general, I believe most investors think this will be the main announcement from Apple on their cash plans for the next 2-3 years.

However, while this is a substantial amount of cash to be distributed, Apple is expected to generate anywhere from $30-$50 billion in free cash per year over the next 3 years, indicating the excess cash balance will still continue to rapidly grow.

Common sense indicates that Apple is not likely expected to make any more major announcements on use of domestic cash, as they recently did this announcement (6 months ago) for a 3-year program and the CFO seemed reluctant to announce any new capital distribution announcements for cash held abroad as long as the US continues to have a hefty repatriation tax (the caveats here are that a new White House administration could change this law and also that Apple, of course, does like to surprise). Additionally, any new announcement for cash held abroad would likely take some time to kick-in and work through the balances, all the while Apple is rapidly continuing to grow the cash balances. So this generally indicates that Apple will likely be keeping a very, very large cash balance for the next few years, and therefore, any Apple shareholder will only be getting a return of interest income on that excess cash balance. Basically, the hypothetical for Apple to return a substantial portion of its excess cash in the near-term is practically non-existent.

In my view, companies should typically not hold on to large excess cash balances, as investors realize very low return on these balances (if an investor wants to be exposed to cash, he or she can make that decision themselves, not have management dictate this), and if a company needs a large cash balance for an acquisition or capital investment, they should be able to use the public markets (that is often the reason companies cite to go public). I know this is a little theoretical, but for large, liquid, public companies, I think this can be practiced as well.

One other (minor) reason Apple's ex-cash valuation is misleading is that many who cite this do not subtract interest income from the "E" when doing this ratio. As interest income is quite low today, this only has a slight impact on valuations (in my analysis, not subtracting interest income drove a P/E ex-cash of 10.3x).

Now, I don't believe ex-cash valuations are inappropriate for all companies, more just for Apple specifically. In general, if the hypothetical re-distribution of excess cash has plausibility, then I believe an ex-cash valuation can be appropriate. I just don't see that in Apple's case. Additionally, while many investors cite the strength and attractiveness of Apple stock due to its large cash balance, I believe investors also need to be aware of the downside of Apple carrying a huge cash balance.

Disclosure: I am short AAPL. I may initiate a long SPY position as a partial hedge over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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