I have been analyzing some of the many ways in which ultra-low interest rates are relevant to equity valuations. Many analysts seem to take the position that very low rates will induce economic growth and that, therefore, to the extent that such growth materializes, stock prices will rise. I have tried to take the analysis a step further to identify ways in which very low interest rates tend to lead stock prices higher - completely independently of any effect such low interest rates have upon the economy.
One of the very anomalous aspects of our current situation is the combination of extemely low interest rates and the very strong balance sheets of non-financial corporations. We now have many corporations with an enormous pile of cash on their balance sheets at the same time rates remain low by historic standards. In extreme situations, this cash can produce serious distortions in PE analysis. I have not yet determined whether it is pervasive enough to produce a distortion in PE analysis of the S&P 500 or other indices, but with respect to certain individual stocks, the distortion can be substantial.
In order to understand how this works, let us take the hypothetical example of a company that has a market cap of $12 billion, $2 billion of net cash on its balance sheet, and annual earnings of $800 million. The company's PE is 15 but the cash has produced a serious distortion in the PE ratio.
Let us assume that the $2 billion cash produces 3% after tax income or $60 million. That means that the company's earnings without the income on the cash equal $740 million. In essence, the company consists of $2 billion cash and an operating company that produces $740 million. Using the $12 billion market cap and backing out the $2 billion cash, the operating company is priced at $10 billion. But $10 billion is only 13.5 times $740 million and, thus, the company is really trading at 13.5 times earnings. The distortion is due to the fact that, on the company's balance sheet and for purposes of valuation, the cash is priced at 33.3 times earnings(which is a roundabout way of saying that interest rates are low).
Looked at another way, let us assume we have three companies, all of which are in the same business and have the same prospects, costs, etc. but somewhat different sized operations and different financial structures. Each company earns $800 million a year and trades at 15 times earnings and, therefore, has a market cap of $12 billion. But Company A has no cash and no debt, Company B has $2 billion in net cash and Company C has $2 billion in net debt. Assuming the the net after tax interest income of Company B is 3% or $60 million and the net after tax interest expense of company C is 3% or $60 million, the three companies would have widely varying private market values even though they each have the same market cap. Company B produces earnings of $740 net of income on cash and, if the 15 PE is correct, should be worth $13.1 billion ($740mx15= $11.1b. $11,1b+$2b= $13.1b). Company C produces earnings before interest expense of $860 and is worth $10.9 billion ($860bx15=$12.9. $12.9b-$2b= $10.9b). And, of course, plain old company A is worth $12 billion. Of course, if the companies trade at prices which reflect their respective private market values, they will have to trade at different PEs and Company B may appear to be "expensive" because it trades at the highest PE of the three.
There are all sorts of complications here. Is the 3% rate reasonable, is the cash really worth 100 cents on the dollar if it is held overseas, is it reasonable to assume that the company could operate with zero net cash, etc. However, it is clear that there is potential for serious distortion in the analysis of companies on a pure PE basis.
The importance of this distortion is largely dependent on the size of the cash hoard in proportion to market cap. In this regard, I am in the process of analyzing some of the more extreme situations such as WDC, MSFT, INTC, CSCO and TLAB and will provide more detail in Part 2.
Disclosure: I am long MSFT, CSCO, INTC.
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