tag:blogger.com,1999:blog-8152901575140311047.post3319474104840813214..comments2024-03-29T05:33:33.027-04:00Comments on Musings on Markets: The Value and Pricing of Cash: Why low interest rates & large cash balances skew PE ratiosAswath Damodaranhttp://www.blogger.com/profile/12021594649672906878noreply@blogger.comBlogger17125tag:blogger.com,1999:blog-8152901575140311047.post-76986597787674534822015-10-14T03:02:58.602-04:002015-10-14T03:02:58.602-04:00Very good post. I have opined that lower interest ...Very good post. I have opined that lower interest rates tend to cause higher P/E ratios. Also a very good point about cash on the balance sheet. I forget which stock, but my broker did the very same calculation on a very cash rich company. He took the price, subtracted out the cash per share, and then recalculated the Price to Earnings Ratio.<br /><br />As far as debt on the balance sheet, there is a counter argument that there is a cost of capital to the owners equity (assets minus debt) on the balance sheet. The argument is made that the owners equity has a higher cost of capital than the debt. The business owners (shareholders) demand a higher rate of return than what is represented by the interest payments on the company debt. In a very low interest rate environment, adding low interest debt to the balance sheet would reduce cost of capital. If a larger portion of your balance sheet is low interest debt your cost of capital would be decreased.<br /><br />For example, a strong balance sheet is 75% equity and 25% debt. Let's say the company levers up a bit and goes to 60% equity and 40% debt. If the market return of stocks is expected to be 6-7% and market interest rates are at 3%, it would seem to be a no brainer that a 60/40 balance sheet would have a lower cost of capital than a 75/25 balance sheet. You can see why companies will issue debt and then retire some of their outstanding stock, particularly if the dividend yield on the stock is higher than the coupon on their bonds! And that is exactly what companies have done.<br /><br />A counterargument to all of this is that it is no shock to the market that Apple has a lot of cash <br />on its balance sheet. That is priced into Apple's stock price. Also the fact that companies have floated a lot of debt is also priced in.Anonymoushttps://www.blogger.com/profile/03238360815957285811noreply@blogger.comtag:blogger.com,1999:blog-8152901575140311047.post-78821840590291486362015-06-04T17:56:25.268-04:002015-06-04T17:56:25.268-04:00I don't work in finance, but I try to understa...I don't work in finance, but I try to understand a rational approach to the markets as explained in your blog. I'm hoping you can clarify a few calculations that have me lost<br /><br />If we assume that the company can maintain its existing return on equity of 36% on its new investments in perpetuity<br /><br /> Expected net income from software = $72 million<br /> Expected reinvestment to generate growth = 2%/36% = 5.56%<br /> Value of Software business = 72 (1-.0556)/ (.10-.02) = $850 million<br /><br /><br />I'm thinking reinvestment is the growth needed in fixed assets to generate the 2% income growth. If the fixed assets did not grow then the income would not grow. To generate 2% growth, with a return on fixed assets of 36%, requires an increase of 5.56%<br /><br />But then the value of the software business has me stumped. The investment is not based on 72, which is the numerator, but on 200. 200 needs to grow by 5.56%, so the net income from software seems like it should be 72 decreased by that amount not by 5.56%Anonymousnoreply@blogger.comtag:blogger.com,1999:blog-8152901575140311047.post-72192879757208459342015-06-04T12:27:01.313-04:002015-06-04T12:27:01.313-04:00Shouldn't the Return on equity on software be ...Shouldn't the Return on equity on software be 18% and not 36% ?<br />Here's how I got 18%<br />Net income from software = $72<br />Equity = $400<br />So return on equity on software = 72/400 = 18%<br />Since you explicitly mentioned Balance sheet, I'm assuming this was a yearly balance sheet and not a 6 monthly ? (though the 36% seems to indicate it was a 6 monthly snapshot)<br />Thank you!Apprentice of Agamashttps://www.blogger.com/profile/00336510029421716346noreply@blogger.comtag:blogger.com,1999:blog-8152901575140311047.post-6661837309654060992015-06-02T18:28:41.442-04:002015-06-02T18:28:41.442-04:00Andre,
Good point about trapped cash, but I don...Andre,<br />Good point about trapped cash, but I don't think it is as big a factor as you think. The trapped cash is at best about 25% of total cash, looking across all US companies, and a big chunk of that cash is in Europe earning even even less than it does in the US. In fact, there is a simple way to tell. If the cash is being invested to generate significant income, it has to show up as interest income and that interest income number for companies where it is available is actually well below 1%. Aswath Damodaranhttps://www.blogger.com/profile/12021594649672906878noreply@blogger.comtag:blogger.com,1999:blog-8152901575140311047.post-4556826460871142692015-06-02T15:32:38.949-04:002015-06-02T15:32:38.949-04:00Your point is that cash have always been distortin...Your point is that cash have always been distorting PEs. But now, this distortion are bigger than ever, since US companies have big amounts of cash yielding lower than ever interest rates.<br /><br />You chart “PE and Non-cash PE: US companies” shows that cash used to add around 1 point to PE (that’s it: PE – Noncash PE), but since year 2000, this difference started to grow and now is adding almost 5 points to PE (in 2014 PE was 16,58x and Non-cash PE was 11,90, so cash added 4,68x to PE).<br /><br />But, you stated that US companies have huge amount of cash overseas. And you make the simplistic assumption that all this cash is being invested on US 1 year T-bill. But if this money is being invested abroad, how can we be sure that it not being invested in assets yielding more than 1 year T-bill? <br /><br />In fact, what if, before year 2000, companies were doing exactly what you supposed (that´s it: getting something on the range of US 1-year T-bill on their cash), but since then, they started to invest more and more of their cash overseas, yielding more than US 1-year T-bill, in a way that this would offset the excess cash? Summing up: in this scenario, maybe the final effect on PE would be something neutral (cash would still be adding around 1 point to PE)… <br /><br />How can we be sure that this is not the case?Anonymoushttps://www.blogger.com/profile/00733295098225656754noreply@blogger.comtag:blogger.com,1999:blog-8152901575140311047.post-80176427060773987262015-05-31T12:21:26.576-04:002015-05-31T12:21:26.576-04:00An update would be great.
Let's say you can b...An update would be great.<br /><br />Let's say you can borrow at 2% and invest the cash at 2%. Increasing the debt and leaving what you borrow in cash will then increase the cash effect on PE, but you will have a "debt" effect on PE which will offset the higher cash effect, so the intrinsic PE of the equity does not change.<br /><br />I don't agree that introducing debt will lower the intrinsic PE of the software business either though. It is still the same business. E.g. your 10% is really the cost of capital for the software business, and leaving issues such as tax shield of debt etc. aside the cost of capital does not change when you introduce debt. The cost of equity will rice though and therefore the intrinsic PE of equity will go down, as my simple illustration above shows (based on your illustration).<br /><br />The challenge with introducing debt, I would think, is that corporates obviously does not borrow at the 1-year T.Bill rate. And most of the debt is not short term.Anonymousnoreply@blogger.comtag:blogger.com,1999:blog-8152901575140311047.post-73183641309660839212015-05-31T08:57:51.564-04:002015-05-31T08:57:51.564-04:00My point was not that the PE would be higher but t...My point was not that the PE would be higher but that the cash effect on PE would be higher, with a higher debt ratio and a given mix of software/cash. One reason everything gets trickier with debt, is that introducing debt will lower the intrinsic PE for the software business, since my cost of equity will rise, as my debt ratio increases. It is one reason why I prefer to work with pre-debt numbers and compute enterprise value.<br />I think your focus on bringing in debt into the picture is the right one, since you can borrow and leave that borrowing sitting as cash. I am working on a follow-up post on incorporating the effects of debt on PE and hope that I can provide a cleaner more comprehensive way of adjusting for both cash and debt on PE.Aswath Damodaranhttps://www.blogger.com/profile/12021594649672906878noreply@blogger.comtag:blogger.com,1999:blog-8152901575140311047.post-7580515739525124522015-05-31T06:56:41.681-04:002015-05-31T06:56:41.681-04:00On your Apple comment "the cash effect on PE ...On your Apple comment "the cash effect on PE will be greater, because cash as a percentage of market capitalization will increase.". The way you calculate it for the market it will, but is that really correct?<br /><br />Let's turn the initial example on it's head and change your original company to:<br /><br />Assets: Software 850<br />Liabilities: Debt 200, Equity 650<br /><br />And let's assume they pay 2% interest on their debt as well (for simplicity).<br /><br />The intrinisic PE of the Software business is still 11.81, the intrinsic PE of the debt 83.33, but what is the intrinsic PE of the equity now? Wouldn't that be 650/(72-2.4) = 9.34.<br /><br />Clearly, most companies cannot borrow at the risk free rate, but are you not just looking at one side of the story? As your Excel sheet shows companies have more debt than cash, even though they have high levels of cash.Anonymousnoreply@blogger.comtag:blogger.com,1999:blog-8152901575140311047.post-69825110135767721262015-05-30T20:16:09.186-04:002015-05-30T20:16:09.186-04:00On the last comment, netting our debt from what? I...On the last comment, netting our debt from what? If you are suggesting that I subtract debt out of market cap, that makes no sense. That would be double netting out debt. <br /><br />The prior comment raises an interest question of whether adding debt to the equation would change the equation. If you borrow money to buy back stock, while holding on to your cash (which is effectively what Apple did), the cash effect on PE will be greater, because cash as a percentage of market capitalization will increase. Aswath Damodaranhttps://www.blogger.com/profile/12021594649672906878noreply@blogger.comtag:blogger.com,1999:blog-8152901575140311047.post-46941006534827578042015-05-30T18:31:39.219-04:002015-05-30T18:31:39.219-04:00agreed, not sure it makes sense to adjust for gros...agreed, not sure it makes sense to adjust for gross cash balances without netting out debt? Anonymousnoreply@blogger.comtag:blogger.com,1999:blog-8152901575140311047.post-29918966791085065172015-05-30T14:19:16.886-04:002015-05-30T14:19:16.886-04:00To follow up on Callums question. Would not debt l...To follow up on Callums question. Would not debt lead to the complete opposite effect, and given that companies still have more debt than cash your conclusions for the market should be completely opposite?<br /><br />With your way of calculating it, Apple leaving cash abroad and borrowing in the US to buy back shares pushes down the non-cash PE, as far as I can understand.<br /><br />Anyway, interesting thoughts and well explained.Anonymousnoreply@blogger.comtag:blogger.com,1999:blog-8152901575140311047.post-1673661658976476842015-05-29T02:36:39.861-04:002015-05-29T02:36:39.861-04:00Quick question, your example is a company with no ...Quick question, your example is a company with no liabilities, but what do you do with short-term (or long-term) liabilities?Callum Thomashttps://twitter.com/Callum_Thomasnoreply@blogger.comtag:blogger.com,1999:blog-8152901575140311047.post-64839903820055588632015-05-28T18:09:12.294-04:002015-05-28T18:09:12.294-04:00The market-wide numbers come from adding up market...The market-wide numbers come from adding up market cap and cash balances across all companies in the market, including financial service companies and that skews up this ratio. (The data services just throw cash and ST investments into this item and for financial service companies, that can add up to huge values). <br /> If you look at only non-financial service company, the cash ratio drops to closer to 15% of market capitalization and the effect on non-cash PE is reduced. But the across time effect stays no matter which dataset you look at. If I get a chance, I will also compute market wide numbers for only non-financial service US companies, by year, and put that data up online as well.Aswath Damodaranhttps://www.blogger.com/profile/12021594649672906878noreply@blogger.comtag:blogger.com,1999:blog-8152901575140311047.post-14093008284392310172015-05-28T16:52:58.748-04:002015-05-28T16:52:58.748-04:00Aswath, I linked to your post on my blog. One of ...Aswath, I linked to your post on my blog. One of my readers questioned the large current difference between the PE and non-cash PE, and I don't have an answer. Do you have the explanation? Here is his comment:<br /><br />I enjoyed your post and found it very interesting, but it is quite a larger magnitude fo difference than I would have thought. Are you sure this is correct?<br /><br /> <br /><br />Thus would imply that cash to market cap is close to 30%, by my guess – if you assume that interest on cash is close to zero, lets call it 1% of earnings<br /><br /> <br /><br /> <br /><br /> <br /><br /><br />Earnings<br /> <br />100<br /> <br /><br />P/E<br /> <br />16.58<br /> <br /><br />Market cap<br /> <br />1658<br /> <br /> <br /><br />Earnings ex cash<br /> <br />99<br /> <br /><br />Ex cash P/E<br /> <br />11.9<br /> <br /><br />Market cap<br /> <br />1178.1<br /> <br /> <br /><br />Cash<br /> <br />479.9<br /> <br /><br />Cash to market cap<br /> <br />29%<br /> <br /><br /> <br /><br /> <br /><br />That seems like quite a lot to me – the S&P500 is currently valued at $19.2tn, so that would suggest cash balances were north of $5tn which sounds an awful lot ie its $10bn per stock<br /><br /> <br /><br />What am I missing and have you or Aswath checked that data, please?Kevin Erdmannhttps://www.blogger.com/profile/07431566729667544886noreply@blogger.comtag:blogger.com,1999:blog-8152901575140311047.post-15953819808479632742015-05-27T18:29:34.146-04:002015-05-27T18:29:34.146-04:00Kevin,
You are right. If you take out the cash fro...Kevin,<br />You are right. If you take out the cash from equity and compute an equity risk premium on only the non-cash assets, it would be higher than my already high number.<br />Anuj,<br />I wish I had the information to make the adjustment but I do not. Companies are not required (yet) to break out their trapped cash and tell us what it is invested. Interestingly, it looks like Apple has much of its trapped cash invested in long term investments (but does not specify what they are) rather than liquid, short term investments.<br />Aswath Damodaranhttps://www.blogger.com/profile/12021594649672906878noreply@blogger.comtag:blogger.com,1999:blog-8152901575140311047.post-30403839086637458232015-05-27T15:48:34.951-04:002015-05-27T15:48:34.951-04:00Great article, as usual.
If I am not mistaken, do...Great article, as usual.<br /><br />If I am not mistaken, doesn't this also mean that if you adjusted your equity risk premiums for leverage and cash balances, they would be higher than the published levels? This would be especially interesting since unadjusted ERP is already high.Kevin Erdmannhttps://www.blogger.com/profile/07431566729667544886noreply@blogger.comtag:blogger.com,1999:blog-8152901575140311047.post-50851221430861781782015-05-27T15:39:26.922-04:002015-05-27T15:39:26.922-04:00Are you adjusting the cash balances (in your PE gr...Are you adjusting the cash balances (in your PE graph) as you mentioned for tax liability after repatriation? I find it nearly impossible to discern this information in most public companies and it makes me wonder how much I may be missing in my valuation by using just the balance sheet number.Akhttps://www.blogger.com/profile/09646479250565629294noreply@blogger.com