03 October 2015

Why Corporate Cash Hordes Make PE Ratios Look High

US corporations are holding more cash than ever. In 1980, they held nearly $500 billion. By 2011, they were holding nearly $5 trillion. [St. Louis Fed data and theories here.] In 30 years, the amount went up 10X.

Meanwhile, P/E are also higher than in 1980. Around that time, P/E ratios were about 10. Now, they are around 20.

While cash doesn't account for the whole of the difference in P/E, I think it gets overlooked in the popular press. 

For instance, Microsoft is selling for about $45 a share and its P/E ratio is just over 30. But Microsoft also has $12 of cash per share. If you pay $45 for Microsoft, you're really just paying $33. Your first $12 gets you $12. You pay cash for the stock and immediately get $12 in cash, almost like a rebate. (Okay. You don't actually get the cash. It stays with the corporation. But it is easier to price cash than it is to price future profits.) If you adjust Microsoft's P/E for this, the P/E is closer to 23. That's still high (apparently investors are still excited that Steve Ballmer has been replaced by the new CEO Satya Nadella? They really like Windows 10? Who knows?)
7 Biggest US Companies by Market Cap, PE Adjusted for Cash

Adjusting for cash adjusts PE ratios for companies to varying degrees. Apple's PE drops from 12.76 to 12.05. Berkshire Hathaway's PE ratio drops from 17.89 to 14.32. Johnson & Johnson's from 16.54 to 14.38. Google's 29.54 to 24.89. The companies with higher PE ratios are still companies with more exciting growth potential but PE ratios are generally higher because of all this cash. (PE is the ratio of today's price to the earnings, or profits, of the last 12 months - not the next 12 months. If your profit is expected to double in the next year, your PE ratio should be double that of a company whose profits are expected to remain unchanged.) 

Again, higher PE ratios are not just a function of companies carrying more cash, but adjusting for this phenomenon does lower PE ratios to something closer to historic norms. And it buttresses another claim as well. We live in a time when capital no longer limits. As investors look for places to put their trillions of dollars in capital, they are more likely to use it to purchase stock. Even if stocks seem over-priced by historic standards, what else are they to do with their money? Bonds pay ridiculously low rates. Commodities - even oil and gold - are falling in price. So they put their cash towards the purchase of companies. 

Oddly, the companies they're buying also have more cash than they know what to do with. Maybe its time to start shifting all that capital into entrepreneurial ventures that promise to create new jobs and wealth.

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