When it comes to business, cash is king. The more cash company has, the better. It can also cause a problem, mainly how to value a business with a significant cash position on its balance sheet.
What does the cash do?
Cash has many uses. The first step of evaluating a company’s cash balance is to establish what the capital will be used for. If a company has to keep a certain amount of cash on its balance sheet at all times to maintain liquid operations (high working capital requirements), then the cash may have less value than that held by an investment firm holding back dry powder.
When you have some idea of what the cash will be required for, you can start to place a value on it. Not all cash is created equal however. Tech companies such as Apple Inc. (AAPL, Financial) and Microsoft Corp. (MSFT, Financial) are notorious cash hoarders, but a significant amount of this cash is held overseas. Repatriating the cash would result in an additional tax charge, which would reduce the overall cash holding. Under current U.S. tax laws, cash repatriated is taxed at 35%, so every one billion dollars in cash held overseas is worth $650 million back home.
The question of how much cash is really worth causes another issue; how much is cash really worth to the average investor?
Is that your money?
Unless you are investing in a liquidation situation, the chances of actually seeing any of the cash the company in question holds are slim. What’s more, with a large cash balance on the balance sheet, the chances of a company making a disastrous value destructive acquisition are greatly increased. Considering cash from this perspective, you could then argue a substantial cash balance is more of a liability than an asset.
Separate the cash and business
Valuing a business separately to its cash is not a new concept, but it is a concept Aswath Damodaran, professor of the Stern School of Business at New York University, believes is relevant for the current low interest rate environment.
Aswath argues that in the current environment, cash earns a low return. If you were to take cash as a standalone asset, its low return would translate into a high price-earnings (P/E) multiple. In other words, cash does increase a company’s valuation because it produces a terrible return. With this being the case, the professor argues that how the P/E multiple is used should be reconsidered in the current environment. Specifically, he believes “we have to separate companies into their cash and operating parts, and deal with the two separately because they are so different in terms of risk and earnings power.”
By using this approach, however, you once again fall into the trap of taking for granted the fact the cash will at some point be returned to shareholders. If you have a share trading at a multiple of five times earnings on a net of cash basis, it could look cheap, but what if management used this cash to acquire another business? Suddenly, the company no longer looks as cheap as it once was.
Enterprise value is one way to work around this issue.
Enterprise value excludes cash balances, but it does have its own drawbacks. For example, the enterprise value calculation includes the value of investments and minority business interests, which may themselves be subject to a degree of subjectivity.
To get around this issue, operating enterprise value is an attractive alternative. And, if you really want to go the extra step, core enterprise value is even more reliable. Operating enterprise value, as is name suggests, only includes operating assets of the business while core enterprise value only includes core business activities. Calculating core enterprise value may be slightly more complex than operating enterprise value as it requires some estimation of non-core business divisions, but if you are looking for a method of valuation that excludes leading non-core and cash figures, it is a great alternative.
Disclosure: The author owns no stock mentioned.
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