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The Price of Excess Cash

More recently, Sherlund calculated a new P/E for Microsoft by deducting only the $3-a-share special dividend rather than all of Microsoft's cash.

That second approach may make more sense because investors know exactly what will happen with that $3 a share, whereas what Microsoft will do with the remaining cash in its coffers is less certain.

"In a case like Microsoft, where management has committed to returning cash to shareholders, you can value that cash at face value," said David Merkel, a senior analyst with Hovde Capital and columnist for He believes the only time to deduct a company's cash on a dollar-for-dollar basis is when there is a definite liquidity event, such as Microsoft's special dividend, that truly gives investors control of the cash.

In the early 1980s, cash had that dollar-for-dollar value because so many corporate raiders were putting the cash on their balance sheets for use in buying other companies.

But in today's world, a more likely use of cash might be buying back stock -- a step Microsoft is taking in addition to its special dividend. But announcing a buyback plan is no guarantee a company will buy the shares, Merkel noted. Hence, he would only deduct 90 cents for every $1 of cash from a stock's price to value a stock because of uncertainty as to whether management will use that cash as it says.

Another situation in which you might not give a company full credit for its cash is if you don't fully trust management, perhaps because it has a bad track record with acquisitions or expanding into new markets, Merkel said.

Rich Parower, portfolio manager of the (SHGTX), echoed that argument. "We do try to reflect [cash] in the P/E ratio if we think it's going to get monetized -- if they're going to use it for something," he said. But "if we think it's going to sit there, you don't get a heck of a lot of credit."

For instance, if a company will use cash to buy back stock on a recurring basis, that helps earnings per share grow by shrinking the share count, notes Parower, whose firm holds Microsoft shares. For a stock buyback authorization, he said, he might discount the cash, giving the company credit for 50 cents to 75 cents on the dollar to calculate valuation.

Investors should also keep in mind that another reason not to deduct all cash is that a portion of it will likely be used for operations, Parower added.

Indeed, that's an additional part of Bonavico's argument against subtracting cash to calculate valuation. "That's part of operating the business -- albeit a low-returning part of it," he said, noting that tech companies typically earn less from the interest on cash than from operations.

Companies with large hoards of cash should have lower multiples (without subtracting out the cash) to reflect that such interest is not earning their equity cost of capital, Bonavico added.

Ultimately, deducting cash or a portion of it to come up with a stock's valuation may be just splitting hairs, said Jonathan Berk, a finance professor at UC Berkeley's Haas School of Business. "All those valuation techniques are pretty rough," said Berk, who cautioned investors against considering only P/E and similar ratios when buying stock. "You could get whatever number you want."
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