Probably the most used ratio when talking about stocks is the p/e ratio. It’s the price per share divided by earnings per share. It gives you a rough idea of the profitability of a company. There are a number of things however that can distort the p/e ratio. One of those is cash.
All of the data I’m going to use here is available free from Yahoo! Finance. Let’s take a look at Microsoft. Currently the stock trades around $45, with $2.67 in indicated earnings. $45 divided by $2.67 gives us a p/e of roughly 17. The average p/e for a stock in the S&P 500 is around 19 so that’s not too high. But that p/e is actually overstated.
Microsoft has approximately $60 billion in net cash available (cash minus debt). They have about 8.25 billion shares of stock outstanding. That means that Microsoft has about $7.25 a share in available cash. Why do we care? Generally we’re interested in the operating part of a company’s business. Cash is just cash. Or looked at another way, if Microsoft paid out that $60 billion in cash as a special dividend, the stock would drop by almost exactly $7.25 a share.
So if that’s the case, we can do an adjustment to the p/e ratio. $45 minus $7.25 gives us a price of $37.75. If we now divide that by $2.67, we get a p/e ratio of approximately 14. That seems pretty reasonable, especially in a market that is near all time highs.
This is not an endorsement to run out and buy Microsoft. But it’s a good idea to do this calculation for stocks you are researching. By subtracting out the cash, you may find a stock trading for a lot more reasonable price than you think. One caveat. In some cases that cash may be stuck overseas because of tax considerations. That cash may not be as available as it looks.