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The Problem With P/E - And What You Can Do About It

|Includes: Apple Inc. (AAPL)

Imagine a security called A1. It's a perpetuity that doesn't grow and lasts forever. It earns $10 annually from now until eternity. If a proper discount rate is determined to be 5% at the time of valuation, the fair value of A1 should be worth the present value of the earnings stream, calculated as $10/0.05, or $200. The P/E of the security would then be $200/$10, or 20x. Market participants would interpret this as paying 20 times annual earnings.

Now assume that a second security A2 can be purchased. Let's say A2 is in every way the same as A1, yielding a $10 annual payout that lasts forever, except for one difference. If you purchase security A2, it also comes with an additional $100. The $100 bill is yours to keep, with no restrictions. What should a knowledgeable market participant pay for security A2? Easy. The fair value of security A2 is simply A1+$100, or $300.

Now let's take a look at the P/E of A2. Since you are buying the security for $300 and getting $10/year in earnings, the P/E is $300/$10, or 30x. Notice this is a much higher multiple than what was paid for A1. A simple relative comparison based solely on the P/E ratio would suggest that A2 is overpriced at 30x earnings relative to A1 at 20x. We know that isn't true, however, and both A1 and A2 are priced appropriately. So what's going on? P/E is supposed to allow for an apples-to-apples comparison. What went wrong?

In this example, the price of security A1 was based solely on the present value of the earnings stream. Thus, it was appropriate to say that one would be paying 20x the annual earnings. However, in the case of security A2, the price was a composite of both the present value of earning and the excess cash. Using an unadjusted P/E ratio to evaluate A2 just isn't appropriate because the resulting price is due to more than just earnings. This condition is depicted below;

As you can see, the excess cash causes a distortion in the P/E measure. For a P/E ratio to be comparable across the board, it should exclude the market value of excess capital. This means that any capital not required for maintaining or growing earnings must be deducted from the security's price. In the case of A2, backing out the $100 in excess capital results in an adjusted P/E of ($300-$100)/$10, or 20x. The adjusted value is now consistent with A1's P/E.

Adjusting P/E in this manner will have a bigger effect for companies that hoard cash. For instance, Apple's P/E looks much lower when adjusted for its excess capital, even after that capital has been discounted for repatriation taxes. This adjustment is also useful for market indices through different time periods. During the recession, many of the S&P 500 companies were holding cash they really didn't need. An adjusted P/E ratio would do a better job comparing market levels from time periods of higher excess capital with the market levels of more cash lean times. For those of you out there analyzing cash rich companies, you might be surprised by what you find. Good luck and happy investing.