07 September 2008

Financial Alchemist Article on Valuation Ratios and Cash

A recent post by the Financial Alchemist explained why adjusting a company's Price/Earnings multiple to exclude Cash can produce misleading results if it is not accompanied by an adjustment to Earnings.

Turley Muller's excellent blog is one of our favorites.

His point is that Cash contributes Interest Income to Earnings; therefore, it is erroneous to exclude the Cash without excluding the Interest.  Turley explains this well, and he provides examples.

The amount of Cash and and Cash Equivalents a company has can be found in the Current Assets section of its Balance Sheet.  Interest income is generally shown as a non-operating gain on a company's Income Statement.

Why would investors subtract Cash/Share from the Price/Share?  Cash is required for liquidity, but a growing company's other Assets should produce the lion's share of future cash flows, earnings, and dividends.  When cash flows are expected to increase at a rate significantly higher than the interest earned on Cash, the component of the Price/Share that reflects Cash on hand deserves a lower multiple than the other components.

By subtracting Cash/Share, these investors are trying to remove the effect of the low-earning Cash on the P/E multiple.  Since some companies have Cash well in excess of normal needs, excluding Cash might enable fairer comparisons across companies.

It's debatable that the company's Cash level is a separable component of its share price.  It might be most true if investors have a reason to believe the company will rid themselves of excess cash with a dividend to shareholders.  Microsoft Corp. (MSFT) has done this, but it is relatively rare.

In any event, Turley's point is valid.  If you're going exclude Cash from the share price, you should also subtract the associated interest income.

At GCFR, we don't make the adjustments discussed above.  However, when we calculate Enterprise Value, we adjust Market Value for both Cash and Debt.  We then determine the Enterprise Value to Cash Flow from Operations ratio.  If company-reported CFO figures include Interest Income and Expense, we should consider removing them.  However, it's probably a minor consideration as we compare EV/CFO ratios not across companies but over time at individual companies.  We're more interested in discovering whether a company's Enterprise Value is increasing faster or slower than Cash Flow, when judged by historical norms at the company.


  1. Very cool site... linked it on mine, hope you don't mind.


  2. Thanks. We welcome the feedback and the link.