Recently, a number of value investors have noted that large cap stocks appear rather cheap by historical standards. The P/E ratio is one of the most useful metrics for determining how cheaply a company may be purchased. But as we've discussed before, it cannot simply be applied blindly; company earnings may be temporarily depressed, or may be high due to one-time gains. But even if earnings are corrected or smoothed to reflect fluctuations in the business cycle, a company's balance sheet position may be so exceptional that it also has a material effect on a company's would-be P/E.
Consider some of the strongest cash generating businesses in the world: Apple, Google, Microsoft, and RIMM. Their P/E's are not that high considering the returns on capital that they generate. Furthermore, their P/E's are lower than they appear at first glance, as after adjusting for their cash balances, these companies appear even cheaper. The chart below illustrates this, by showing these four companies (along with cash-rich KSW, a company we have discussed as a potential value investment) with their P/E's after adjusting for their cash balances:
It is rare that a collection of cash-generating cash-rich companies such as those listed above are trading at such reasonably low P/E's. It should, however, be noted that on its own the P/E ratio does not convey enough information to determine whether an issue warrants purchasing. However, the higher the P/E, the more earnings must grow to justify the price, and the more the stock price will fall if earnings growth does not come to fruition. This is why value investors prefer stocks with low P/E's, as low expectations lower the potential for loss of capital and raise the potential for price appreciation.
Disclosure: Author has a long position in shares of RIMM, MSFT and KSW
8 comments:
Saj,
Did you sell RIMM and MSFT? I know they are both up a bit since you last wrote about them.
Hi Saj,
I thought you were long in RIMM? Actually I was going to ask you how you set your exit price on that one given that it was really a growth company and so tough to calculate when the margin of safety was gone?
Thanks,
Phil
Sorry guys, my mistake. I have corrected the disclosure statement.
Hi Saj,
Thanks a lot for you post.
How do you come up with the debt for enterprise value. did it include Account payable (i think so)? As with KSW, Finance Yahoo! said enterprise value only $8mil, but fidelity says its enterprise value at $22.65mil.
Hi Anon,
I use:
EV = market value of equity + debt - cash
I do not include accounts payable as debt. So for KSW, I would get about $8 million.
Hi Saj,
could you explain to me why you didn't include the AP? it's be very helpful to me. Many thanks.
Hi Anon,
If the companies are going concerns, similar receivables, inventory and payables balances will be required going forward. For this reason, none of them are included in this calculation. If you were calculating asset replacement values or liquidation values, then they would be very relevant and could not be ignored.
Thanks Saj,
fully understand it now.. as it's operating section, and the debt in enterprise value is in financing section of the business.
cheers
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