Valuation Question

[adios]

Hypothetical situation:

Company AAA has 0 long term debt; normal current assets and liabilities i.e. enough to have sufficient liquidity in its economic transactions; and basically only long term assets that generate cash flow such as property,plant, and equipment. The PE is 10 and a Price to Book Value ratio of 1.

Company BBB is identical to company AAA except that it has additional cash assets (just money collecting short term interest) not related to current operations the make it's book value 50% more than company AAA.

Revenue and earnings past and in the future are identical. Should company BBB have a PE of 10 since it's earnings and revenues are identical i.e. future cash flows are identical? My answer is no. Hopefully I phrased this question in a way that is understandable.

BBB should have a PE about 10.5 (probably slightly below). If you apply the Edwards-Bell-Ohlson valuation model, you'll get a PE of exactly 0.5 higher (than for AAA). But if you use one of the option-adjusted refinements, it will probably be a tad lower.

[adios]

A hectic week just getting around to answering responses. Thanks for the insight Paul. I come up with 15 but I probably made a mistake somewhere. Anyway perhaps you could provide some more insight for me regarding a real world situation. Several on the forum have said CSCO is overvalued as their trailing PE is 39. To me this number is deceptive. Looking at a balance sheet from last qtr for CSCO I see the following entries:


From Current Assets:

Cash And Cash Equivalents $9,484,000,000

Short Term Investments $3,172,000,000

Long Term Investments $9,377,000,000

I haven't read the details regarding CSCO's long term investment portfolio but if they are typical of other tech companies, they consist of debt securities exclusively that are highly liquid. Many of these companies made a lot of money in the late nineties and hoarded the profits and some of the cash found it's way into long term bond investments. I only bring this up because strictly speak the long term investments aren't cash but they tend to have good liquidity. Ok so if I add all of these assets up I come up with a little over $22 billion dollars. IMO the vast majority of these assets are not part of the on going enterprise in that they are not essential in generating future earnings. Ok CSCO will report it's interest income as part of it's earnings so to to get the true picture of earnings generated from the core business you would have to subtract them out. When I look at the market cap for CSCO I come up with aproximately $72 billion. So subtracting out the cash hoarde from the market cap I get a valuation of about $50 billion for the ongoing operations that are used to generate free cash flow. Based on that number the PE for the ongoing operations that generate future free cash flow is (50/72)*39 = 27 which is still high perhaps but is better than 39. There are some more very extreme examples of this in the tech sector

[Wildbill]

Debt securities? Many of them hold equities of small companies that they did deals with over time. YHOO has something like 8 companies stock, all part of deals done over the years where some of their payments came in warrants at times, but usually just stock or options that are slowly expiring. Very few of these will yield much of an interest return so don't count on it making much of any difference from a return perspective. Even worse, most could be written off, they are held at acquisition value, but think about it if you got some stock from Amazon in 1999 to pay you for a long-term advertising deal, what is your real position worth? Not much.

CSCO can't be valued in the traditional sense. I know, people went bust on such thinking, but it really can't. Anyone that thinks their business is just going to run as it does now until the end of time is kidding themselves. There will be new discoveries and new technology that they will exploit. They may never be the profitable company they once were, but I highly doubt you could suspect they would have operations at the level they are now for very long. They have a lot of clout and talent in-house, but if the drought lasts indefinitely, that clout and talent leaves. Should be interesting, I think at some point you will start seeing major companies like this one just essentially giving up and returning cash to investors or opening themselves up to being sold. You can sit on your hands awhile and wait for opportunities, but that amount of time is limited by the willingness of your people to do the same. Since the tech world as a whole sucks right now, people at these "name" companies in the Valley are just going to sit still and be thankful they have jobs, but if things start cooking and their company isn't getting in on the action, that is when people will jump ship and then the reason to be starts slipping away. There have been a few smaller tech companies that just decided to close shop voluntarily. They got plenty of VC money or IPO funding, but just didn't see worthwhile investments so they returned funds and closed their doors. That is the only way I ever see a Cisco or Sun going out. They have far too much money and talent behind them to just go down the road to bankruptcy. That is why even if you feel the price isn't justified now, there isn't a whole lot of value in shorting these names. They could return lots of cash because they could sell off assets at reasonable non-fire sale prices and return a lot of the stock price back in a final cash settlement. That certainly wouldn't be anyone's goal, but the writing will be on the wall soon enough in this scenario. These are companies that would be acquired if the whole industry wasn't sick.

[adios]

From the YHOO most recent 10-K May, 2002.

------------------------------------------------------------
Cash and Cash Equivalents, Short and Long-Term Investments. The Company invests its excess cash in debt instruments of the U.S. Government and its agencies, and in high-quality corporate issuers. All highly liquid investments with an original maturity of three months or less are considered cash equivalents. Investments with maturities of less than twelve months from the balance sheet date are considered short-term investments. Investments with maturities greater than twelve months from the balance sheet date are considered long-term investments.
The Company's marketable securities are classified as available-for-sale and are reported at fair value, with unrealized gains and losses, net of tax, recorded in stockholders' equity. Realized gains or losses and declines in value judged to be other than temporary, if any, on available-for-sale securities are reported in other income or loss. As of December 31, 2001 and 2000, the Company recorded unrealized gains on its marketable debt and equity securities of approximately $32.1 million and $49.8 million net of tax of $12.8 million and $19.9 million, respectively.
The Company has investments in equity instruments of privately-held companies. These investments are included in other long-term assets and are generally accounted for under the cost method as the Company does not have the ability to exercise significant influence over operations. The Company monitors its investments for impairment by considering current factors including economic environment, market conditions and operational performance and other specific factors relating to the business underlying the investment, and records reductions in carrying values when necessary.
The Company accounts for derivatives under Statement of Financial Accounting Standards No. 133 ("SFAS 133"), "Accounting for Derivative Instruments and Hedging Activities." SFAS 133 establishes methods of accounting for derivative financial instruments and hedging activities related to those instruments as well as other hedging activities. During 2001, the Company recorded in other income, gains on derivatives of approximately $4.6 million, related to equity instruments of other companies.
------------------------------------------------------------


Relevant Balance Sheet line items from YHOO 10-K

(in thousands, except par value)

Cash and cash equivalents $ 372,632

Short-term investments in marketable securities 553,795

Long-term investments in marketable securities 580,418

Restricted long-term investments 258,662

To wit, the following statement relates to balance sheet items:

Statement

The Company invests its excess cash in debt instruments of the U.S. Government and its agencies, and in high-quality corporate issuers. All highly liquid investments with an original maturity of three months or less are considered cash equivalents. Investments with maturities of less than twelve months from the balance sheet date are considered short-term investments. Investments with maturities greater than twelve months from the balance sheet date are considered long-term investments.
The Company's marketable securities are classified as available-for-sale and are reported at fair value, with unrealized gains and losses, net of tax, recorded in stockholders' equity. Realized gains or losses and declines in value judged to be other than temporary, if any, on available-for-sale securities are reported in other income or loss. As of December 31, 2001 and 2000, the Company recorded unrealized gains on its marketable debt and equity securities of approximately $32.1 million and $49.8 million net of tax of $12.8 million and $19.9 million, respectively.

Related Balance Sheet Items

Cash and cash equivalents $ 372,632

Short-term investments in marketable securities 553,795

Long-term investments in marketable securities 580,418

Statement

The Company has investments in equity instruments of privately-held companies. These investments are included in other long-term assets and are generally accounted for under the cost method as the Company does not have the ability to exercise significant influence over operations. The Company monitors its investments for impairment by considering current factors including economic environment, market conditions and operational performance and other specific factors relating to the business underlying the investment, and records reductions in carrying values when necessary.

Related Balance Sheet Items

Restricted long-term investments 258,662


Now for CSCO

Getting your data from Yahoo will make a liar out of you every time. I went to the SEC filings to get the data for both YHOO and CSCO. The relevant CSCO Balance Sheet items from most recent 10-K filing in September of 2002:

(in millions)
Cash and cash equivalents $ 9,484
Short-term investments 3,172
Investments 8,800

7. Investments

July 27, 2002 Fair Value

U.S. government notes and bonds $ 4,467
Corporate notes and bonds 6,938
Corporate equity securities 567
Total $ 11,972

Reported as:
Short-term investments $ 3,172
Investments 8,800
Total $ 11,972

++++++++++++++++++++++++++++++++++++++++++++++


As you can see a very small portion of the CSCO "Investments" are allocated to equity securities. The Yahoo method of reporting is the more common method IMO. Also a statement from the YHOO 10-K fits a lot of companies in tech land. That statement reads as:

The Company invests its excess cash in debt instruments of the U.S. Government and its agencies

Many tech companies have invested their "excess cash" (and there is lots of it compared to their market caps) in a similar manner. It should also be noted that CSCO and YHOO have zero long term debt. I'm not pounding the table on these companies but IMO when valueing many of these tech companies, a significant part of the market cap is comprised of assets related to excess cash and the PE should be evaluated in light of this. Check out the balance sheets would be my message.