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The Price of Excess Cash

Microsoft's (MSFT) bold plan to pay out a whopping $32 billion special dividend has put the spotlight on tech companies burdened with the "problem" of too much cash.

This issue, which is besetting an elite cadre of companies that include larger-caps such as Apple Computer (APPL), Cisco Systems (CSCO) and Symantec (SYMC) as well as smaller-caps such as NetIQ (NTIQ) and SupportSoft (SPRT), has left investors grappling with how to value excess cash.

The question: Should investors subtract out cash from the price of a stock when computing a price-to-earnings valuation?

The answer, unfortunately, isn't straightforward. While the practice of subtracting out cash to value a stock appears to be growing, some investors say it has its shortcomings.

"I don't ex cash out because it is management's decision to hold that as an asset," said Chris Bonavico, a fund manager at Transamerica Investment Management. "When you buy the stock you are buying the cash, so you can't ex it out."

However, several analysts and investors say it makes sense to use enterprise value to come up with a stock multiple. Enterprise value looks at the worth of a company the way an acquirer would -- taking into account a company's cash and debt. The figure is calculated by taking the market cap and then subtracting cash and adding debt. Most software companies don't carry debt, so calculating enterprise value typically involves only subtracting cash.

A Makeover for Cash-Flush Companies
A stock's valuation often looks better when cash is subtracted out
Stock Forward P/E Enterprise Value/EBITDA
Microsoft 20.73 22.41*
Apple 36.08 49.65
Cisco Systems 19.32 18.3
SanDisk 15.86 4.8
Siebel Systems 35.37 20.11
SupportSoft 32.29 9.95
Symantec 30.74 24.44
Veritas 21.70 14.68
Source: Reuters via Yahoo!Finance
*Enterprise Value for Microsoft does not account for the company's special one-time dividend.

In addition, some analysts and investors also reduce the earnings figure in the denominator of a P/E ratio by subtracting out the interest income generated from excess cash.

Proponents of subtracting cash say it offers a better way to value a company's operations. "What you want to do is really separate the operations of the company from the balance sheet of the company," explained Sanford C. Bernstein analyst Charlie Di Bona.

Using Veritas Software (VRTS) as an example, an analysis goes like this: With its stock price currently sitting at about $21.40, Veritas is trading at about 21 times forward 2005 earnings of $1.02 a share.

But as Lehman Brothers analyst Neil Herman suggested doing in a note last week on Veritas, subtracting out the company's $3.74 net cash per share would value the company's operations at $17.66. Excluding that cash (and including debt), Veritas' stock is trading at an even lower -- and more attractive -- 17 times forward earnings.

Citing that "attractive valuation," Herman maintained his overweight rating on Veritas. (Lehman has done noninvestment banking business for Veritas in the past 12 months.)

Earlier this year, Goldman Sachs analyst Rick Sherlund made a similar argument for Microsoft, going a step further by also deducting the investment income Microsoft receives from its cash from the earnings in the denominator of a P/E ratio.

"The stock is selling for 22 times our calendar 2005 EPS estimate of $1.31, but if we back out the cash of $5.58 per share and investment income of $1 billion (after tax 6 cents per share), we calculate a P/E of 18.8 times, a 9% premium to the market," Sherlund wrote. (Sherlund has an outperform rating on Microsoft, and his firm has done banking with the company.)

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