Net of Cash as crude valuation method

[TheMotorcycleBoy]

Hi all,

I finally cut my losses on Zytronic (ZYT), the SP has stumbled more and more since a couple of recent warnings. I'm also learning that small AIMs aren't really for me! Anyway, while I was umming and ahhing about what to do first thing this morning I googled for more info. From here:

https://uk.advfn.com/stock-market/londo ... share-chat

in a few of the posts, people were saying things like:

"it's been on 10x net of cash for quite some time"
"Net of cash the P/E is about 10 I reckon so not excessively cheap"

Can someone confirm that I'm right in guessing that this is another valuation technique, that is,

Price i.e. Market capitalisation = 10 (in this case) x Net Operating Cash Flow

i.e. we use net CFO not net income as the metric, in other words P/NetCFO not P/E?

I did briefly check this hypothesis out by reference to the date of posts, the SP at that time, the NetCFO and the number of issued shares and it seemed about right. Does that sound correct or am I missing something?

thanks Matt

[SalvorHardin]

My guess is that they are talking about removing the cash when valuing the business, rather than a cashflow valuation.

The argument for doing this is that when looking at a business which holds a lot of cash relative to its market capitalisation, then it makes sense to remove the cash to see what the business is worth (lots of cash on the balance sheet distorts the PE ratio of the underlying business). So we have:

Market Capitalisation = Value of the business (including debt) plus the cash owned by the business

which becomes

Market Capitalisation - cash owned by the business = Value of business (including debt)

e.g. A company with market cap. of $5 billion has $1 billion of cash and earns $400 million per annum (PE of 12.5). Removing the cash (and to simplify matters let's assume that it earns no interest) you get a business valued at $4 billion earning $400 million, which is a PE of 10. If the cash was earning interest you could reduce the business' earnings by the amount of interest to make the calculation more accurate.

You often see people doing this when looking at Berkshire Hathaway because it has a huge cash pile (currently just over 20% of its market capitalisation). Another variation seen with Berkshire Hathaway is to remove the value of its investments to see what value the market places on its wholly owned and majority owned subsidiaries (the PE of these is much lower than that of the S&P500).

[TheMotorcycleBoy]

My guess is that they are talking about removing the cash when valuing the business, rather than a cashflow valuation.

The argument for doing this is that when looking at a business which holds a lot of cash relative to its market capitalisation, then it makes sense to remove the cash to see what the business is worth (lots of cash on the balance sheet distorts the PE ratio of the underlying business). So we have:

Market Capitalisation = Value of the business (including debt) plus the cash owned by the business

which becomes

Market Capitalisation - cash owned by the business = Value of business (including debt)

e.g. A company with market cap. of $5 billion has $1 billion of cash and earns $400 million per annum (PE of 12.5). Removing the cash (and to simplify matters let's assume that it earns no interest) you get a business valued at $4 billion earning $400 million, which is a PE of 10. If the cash was earning interest you could reduce the business' earnings by the amount of interest to make the calculation more accurate.

You often see people doing this when looking at Berkshire Hathaway because it has a huge cash pile (currently just over 20% of its market capitalisation). Another variation seen with Berkshire Hathaway is to remove the value of its investments to see what value the market places on its wholly owned and majority owned subsidiaries (the PE of these is much lower than that of the S&P500).

Thanks Salvor,

I think that cracks it, to be honest. I have to admit that another one of my profit warning AIMs is Advanced Medical Solutions (AMS) also has a big cash pile I believe. Now in the past, when attempting to do my own crude valuations, in addition to using Discounted Cash Flows, I have used Earnings Power Value (EPV) which I mainly learnt from this excellent little book. In the chapter where he introduces EPV, which he does so very clearly using that classic firm WD40, he firstly works out EPV by calculating "Distributable Cash Profits" (this is mainly EBIT with various adjustments), which he then capitalises using a discount rate and divides by the number of shares to get SP. After getting the first set of estimates, he then proposes that WD40 (at the time) had a reasonable quantity of spare cash, and were someone to buy all the company's shares then they would get all this cash too, and so in the second bunch of estimates he adds *most* of the cash to the "Distributable Cash Profits" just prior to dividing by the number of shares.

So returning to my subject of valuing cash rich firms, I have often observed what a difference this is in the estimates depending on whether the cash is added back or not. I guess to a tycoon then consideration of a business's residual cash is an important factor, however to an investor like you or I, then in these low interest rate days perhaps a surplus cash could also point to the firm struggling to find further growth areas so actually not be quite such a good thing, especially if they don't pay much out as divs.

I think what I'm trying to say (and struggling a little!) is that what I've spotted regards cash-rich firms making EPV valuations look somewhat vague, is removed, but by viewing things slightly differently and using the "net of cash" adjustment which you've just explained.

Will take a look at this in more detail sometime soon!

thanks again, Matt

[TheMotorcycleBoy]

Hi Salvor,

I read Peter Lynch's excellent "One up on Wall Street" the other month, and he makes positive remarks about firms with net cash, and eludes it's reducing effect on the Price multiple.

So we have:

Market Capitalisation = Value of the business (including debt) plus the cash owned by the business

which becomes

Market Capitalisation - cash owned by the business = Value of business (including debt)

e.g. A company with market cap. of $5 billion has $1 billion of cash and earns $400 million per annum (PE of 12.5). Removing the cash (and to simplify matters let's assume that it earns no interest) you get a business valued at $4 billion earning $400 million, which is a PE of 10. If the cash was earning interest you could reduce the business' earnings by the amount of interest to make the calculation more accurate.

So as a formula:

PE net of cash = (Share Price - Cash per share)/EPS

Matt