All companies have some cash with them.
Even companies that have serious debt problems, maintain certain level of cash for carrying out their day-to-day operations.
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Valuing cash isn't as simple as it looks.
There are two ways in which the cash holdings of a firm can be valued.
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First, the cash can be considered an operating asset.
In this case, the valuation of the firm can be done from its final profit figure.
By "cash", I mean all
cash, cash equivalents, deposits and bonds.
In this case, the benefits of the cash holdings are included in the final profit figure and there isn't any need to give a separate value to the cash holdings.
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The second way is to value the company's operations and cash holdings separately.
This isn't as simple as the first way, but is more reliable.
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Here is a simplified example of how an
incorrect method of valuing cash holdings, can lead to absurd analysis.
Consider a company which has
- no assets, but cash of Rs 100 crore.
- corporate tax slab of 30%.
- dividend distribution tax rate of 15%.
Suppose the company keeps its cash in a 10% fixed deposit.
This gives a post-tax return of 7% annually.
There are 1 crore shares outstanding and the company's eps is Rs 7.
All of this interest is distributed as dividend.
The investors get Rs 5.95/share as the final dividend every year.
The market gives it a PE of 9 and the shares of this company trade at 63.
Dividend yield for the company would be 9.4%.
Now an analyst looks at the balance sheet of the company. He notices Rs 100 cash in the books of the company.
He values the stock in this manner:
Rs 7 eps and Rs 100 cash/share.
Thus, the company should at least trade at
PE of 5 to its earnings + Rs 100 cash/share.
= 35 + 100
= 135.
See the fallacy....
.
The analyst is
valuing the same asset twice.
First, he is valuing the cash at face-value.
Then, he is giving a PE multiple to the earnings from this cash.
The result is that cash of Rs 100 is getting valued at Rs 135.
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In fact, if the company were to distribute all cash to its shareholders, the shareholders won't get more than Rs 85 per share.
Remember, there is a dividend distribution tax of 15%.
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If an investor wants to separately value the cash holdings of a company, he should value the rest of the business by
using the operating numbers and
not the final profit figure.
Valuing Cash Holdings
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