Microsoft's (MSFT) - Get Microsoft Corporation Report 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 Computerundefined, Cisco Systems (CSCO) - Get Cisco Systems, Inc. Report and Symantec (SYMC) - Get Symantec Corporation Report as well as smaller-caps such as NetIQ( NTIQ) and SupportSoft (SPRT) - Get Support.com, Inc. Report, 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.
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.
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.)
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
Seligman Global Technology Fund, 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."