Market Cap & Cash

Hey guys, had a quick question about the relationship between market cap and cash on the balance sheet.

When you value a company and look at P/E multiples, do you guys simply look at market cap/earnings or (market cap - excess cash)/earnings?

In other words, should excess cash (cash not necessary for the day-to-day running of the business) be viewed as separate from market cap? If not, I guess you'd effectively be double-counting if you look at (market cap - excess cash)/earnings?

I've always viewed cash as not being included in market cap, but if you think about DCF analysis, the market cap or equity value of a company is really just the present value of cash flows generated by the business, including the cash currently on the balance sheet.

 
Best Response

If you want to be really exact about things, then yes - you should absolutely be stripping excess cash from any evaluation of multiples, because they're skewing the multiples. Stripping it from both sides, mind you - off of the market cap, as well as off of the equity value when working out P/B.

Of course, real life is rather a little more nuanced than this, because you have to consider that it is very difficult to evaluate how much a company really needs in capital. How much is needed for working capital? You're not going to know this without really getting into their books. How much do you need for a nice little margin of safety? Look at all of the cash that Uber is essentially sitting on now - they sure as hell don't need US$1B in working capital, given their business model, but if the market ever goes south they'll be well-prepared for it.

 

When you're working with smaller companies it's easier to find out operating cash, for the larger ones, we make assumptions that it's all excess.

Not really sure what you mean by "the market cap or equity value of a company is really just the present value of cash flows generated by the business, including the cash currently on the balance sheet."

The EV of the business is the PV of cash flows, which we then reduce by excess cash.

 

Yes, the price of a stock (and therefore price*shares) already includes the value of excess cash. Think of what would happen if a company with a lot of extra cash suddenly paid it out as a dividend. The price would fall as soon as the stock goes ex-dividend, investors would get the dividend, but their total return would be 0% (all else equal).

If you're comparing trading multiples between companies it can make sense to deduct the excess cash from the numerator (and once interest rates are > 0 you'll want to deduct interest income from the denominator). However, as Angus alluded to there are many companies who just permanently sit on too much cash (e.g. Google), so the market price you see already bakes in some investor expectation for never getting value from that excess cash. In cases like that you have to use your judgment.

 

Seems intuitive enough.

On a similar balance sheet adjustment note- how many investment analysts' adjust for goodwill? Say the company had a series of piss poor acquisitions for hefty premiums. And mgmt has since changed. I'd think you need to adjust ROIC, etc. however would like to hear from the pros

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