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My investing philosophy mostly centers around the Value discipline and GARP- Growth at a Reasonable Price. This blog includes commentary on market conditions as well as fundamental analysis of specific companies. Graduated from Rhodes College with a degree in Business with concentration in Finance & Marketing. Currently working on obtaining the CFA designation. Previously worked in Mortgage Trading for a major bank. Use MS Excel extensively for developing investment models, notably valuation models based on DCF methods.

Monday, August 25, 2008

Understanding Valuation Multiples with Respect to Cash

A common mistake I see people 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. It’s 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.


Let’s take Apple (nasd: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.


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 & 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. 


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. 


Anonymous said...

Nice piece, but your font is SO small. Can you increase it? Will make those numbers easier to decipher.

Turley M Muller said...

I increased the font size up a notch. One thing you can do is to change the text size in your web browser. Usually it's found under the "View" menu. That may help too.

Jawaid said...

Your site is very informative and quite different from the other blogs is this domain...wish you best of luck...keep it up.

Jane said...

I want to thanks Turley Muller for providing such a wonderful article

Free Music said...

thanks for this tutorial

Amortization schedule said...

This is all very insightful, a good tip from a financial expert can be a life savior specially now that we are all affected by the financial crisis. I have my own amortization schedule but I need reassurance the I am doing the right thing...

Anonymous said...

but i think your example is still somewhat wrong.
because it's right only in case of Earnings Yield and Interest rate for the Cash are same.

in first paragraph.
you've assumed that Interest rate for the cash as 5% and P/E 20x which is 5% Earnings Yield.
what if Interest rate isn't same with Earnings Yield? like 3%?
it should be like this.

1) $100/$5 = P/E 20x
2) $80/$4.4 = P/E 18x

Interest income $20*3%=$0.6
so EPS without cash is $4.4

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