5 Stocks That Are Cheaper Than You Think

There are a lot of reasons to dislike excess cash on a company's balance sheet. The simple fact is that most CEOs are not Warren Buffett and so capital allocation is probably not one of their foremost skills.

As a result, bad things can happen when companies start building huge stockpiles of cash. One of the worst possibilities is that the CEO decides it's time to take over the world and shareholder value gets kneecapped as the head honcho negotiates a bunch of large, overpriced acquisitions. Also potentially damaging are big share buybacks. Though these are typically pitched as shareholder friendly, management teams often end up throwing big bucks around when the company's stock is anything but cheap.

More innocuous, but suboptimal nonetheless, is allowing the cash to sit around gathering dust. Particularly with safe, secure investments yielding next to nothing these days, cash that a company has no plans for really does absolutely nothing for shareholders.

However, gobs of cash on the books may also obscure the true value and performance of a company. For investors who dig into the numbers, that may create opportunities others are overlooking.

Cash, the master magician
There are two primary areas where cash might throw investors off the scent of a good investment: valuation and return on equity.

The value of a company with a ton of cash should be calculated in two separate pieces: the value of the excess cash and the value of the operating business. For obvious reasons, the cash should be valued dollar for dollar, while the operating business can be valued any number of ways.

Any investor who assumes the valuation reflects the operating business alone and tries to calculate, say, a price-to-earnings ratio based on the full price tag will end up thinking that the market is giving the business a much heftier valuation than it actually is.

Meanwhile, a company's return on equity is meant to reflect the returns that a business can generate in relation to the capital that's been invested in the business. Extra cash that a company keeps around is capital that hasn't been invested in the business and yet still inflates the company's equity. That drags down the company's overall return on equity.

So with a wave of its hands and a tap of its wand, the illusionist Excess Cash can simultaneously make a company look more expensive and less profitable.

A cash-rich quintet
There are a lot of companies sitting on a ton of cash right now. Here are five that might look a lot more appetizing to investors if they unloaded their cash hoard.

Company

Net Cash

Current P/E

Ex-Cash P/E

Current ROE

Ex-Cash ROE

Google (Nasdaq: GOOG  )

$26.5 billion

21.6

18.4

18.4%

58.2%

Cisco (Nasdaq: CSCO  )

$23.9 billion

19.4

16.1

15.8%

34.3%

eBay (Nasdaq: EBAY  )

$4.5 billion

10.9

9.2

17.2%

25.0%

Dell (Nasdaq: DELL  )

$6.2 billion

17.0

12.0

25.2%

NM*

Western Digital (NYSE: WDC  )

$2.4 billion

5.5

3.7

29.7%

65.0%

Source: Capital IQ, a Standard & Poor's company, and author's calculations.
P/E = price-to-earnings ratio.
*NM = not meaningful; Dell's net cash exceeds its equity value.

It's hard to classify Google's ex-cash P/E as "cheap," but when we consider the amount of cash the company is holding, the valuation definitely looks more reasonable. What's more striking, though, is how much of an impact Google's cash has on its equity returns. Without the drag from its cash, Google's capital-light, highly profitable business model is shown in high relief.

Stripping out Cisco's cash, we actually end up with a below-market multiple on what I consider one of the very best tech companies, if not one of the very best companies, period. Cisco may be a different story than the rest of the companies here, though, since it's one of a select few companies -- Oracle (Nasdaq: ORCL  ) being another -- that has made great use of acquisitions to grow and prosper. So it may actually behoove investors if the company keeps some cash available for takeovers.

While Google and Cisco are largely looked at as currently successful companies, the valuations for both eBay and Dell reflect the market's perception that both businesses are facing tough times. With brutal competition from the likes of Hewlett-Packard (NYSE: HPQ  ) in what's become largely a commodity business, I find it hard to get too excited about Dell. eBay, however, not only carries a lower valuation than Dell, it also packs more excitement -- particularly when it comes to the PayPal-driven payments side of its business.

But perhaps the most intriguing stock here is Western Digital, which isn't exactly a growth company working in an exciting, new technological field. In fact, it's quite the opposite. The market sees flash and other solid-state storage from companies like SanDisk as a mortal threat to WD's core disk drive business.

However, when we strip out the cash that WD already has on its books and consider the extremely healthy cash flow that the company is producing, I come to the same conclusion my fellow Fool Eric Bleeker reached when looking at WD competitor Seagate: It may just be too cheap to pass up.

Now it's your turn to chime in. Do you think cash-hoarding companies are throwing investors off the scent of good investments? Head down to the comments section and share your thoughts.

While these cash-rich companies may have piqued my interest, my first love will always be companies that pay healthy dividends.

Google is a Motley Fool Rule Breakers pick. eBay is a Motley Fool Stock Advisor recommendation. Motley Fool Options has recommended a bull call spread position on eBay. The Fool owns shares of Google and Oracle. Try any of our Foolish newsletters today, free for 30 days. The Motley Fool has a disclosure policy.

Fool contributor Matt Koppenheffer does not own shares of any of the companies mentioned. You can check out what Matt is keeping an eye on by visiting his CAPS portfolio, or you can follow Matt on Twitter @KoppTheFool or on his RSS feed. The Fool's disclosure policy assures you no Wookiees were harmed in the making of this article.


Read/Post Comments (13) | Recommend This Article (72)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On July 13, 2010, at 6:38 PM, PoorBaseballFool wrote:

    Things have changed. For the better there is the eBay Buyer Protection and the eBay Bucks program, a rebate program.

    For the worse, while reducing the listing fees they have increased the final value fee, the fee they get if your item sells. There are more scammers and more legit sellers that violate the rules. eBay seems to have a hard time catching them or maybe they just look the other way.

    I used to sell tickets but I've found it more effective and convenient to sell on SubHub (an eBay company) or other ticket listing sites. Fees are high but you get more. Tickets are guaranteed to the buyer and the money to the seller.

  • Report this Comment On July 13, 2010, at 8:15 PM, TMFKopp wrote:

    @PoorBaseballFool

    So what's the bottom line for you? Is eBay doing an overall better job delivering value to its customers? It sounds like the StubHub segment has figured out how to please ticket sellers like yourself.

    Matt

  • Report this Comment On July 13, 2010, at 9:25 PM, richvermil wrote:

    Before these companies officers run off with all the generated cash in salaries and bonuses set by board members who are current and former officers of other corporations, you would think these cash hoarding businesses would offer a return to the "owners" in the form of a decent dividend.

  • Report this Comment On July 14, 2010, at 2:04 AM, TMFKopp wrote:

    @richvermil

    I agree with you 1,000%.

    As I noted at the outset of the article, there are a lot of good reasons for companies to NOT keep a ton of cash on their balance sheets. I made a similar argument here (http://www.fool.com/investing/dividends-income/2010/02/16/3-....

    There's certainly value in the cash that these companies have on their books, but they need to do something with it to ensure that shareholders benefit -- and my preference is generally a dividend.

    Of these companies, you may want to keep an eye on Cisco in particular. As I noted, the company has done well spending on acquisitions. It's also bought back a lot of stock. And Chambers (CEO) has been saying recently that the company will pay a dividend before he retires in a few years.

    Matt

  • Report this Comment On July 14, 2010, at 8:05 AM, energysystems wrote:

    What about a company like Exxon? Now, yes I'd like to see a higher dividend, but they are the best positioned company in their industry.

  • Report this Comment On July 14, 2010, at 8:14 AM, mvwon wrote:

    Can you please tell me how you calculate both the ex-cash P/E and the ex-cash ROE?

  • Report this Comment On July 14, 2010, at 9:36 AM, Gregeph wrote:

    I concur that Google is looking undervalued at these levels. I have a post on my blog about how value investing guru Glenn Greenburg thinks the stock is undervalued (from an interview at the Columbia business school) and how his hedge fund just purchased over 134,000 shares. http://gregspeicher.com/?p=115

  • Report this Comment On July 14, 2010, at 11:18 AM, TMFKopp wrote:

    @mvwon

    There are different ways you could go about this, but for the ex-cash P/E what I did was simply deduct net cash from the current market cap and divide by net income adjusted for the loss of the cash (that is, the interest income). Basically, it's as if the company used gross cash to pay off any debt it has and then paid the rest out to shareholders as a special dividend.

    For ROE, it's that same adjusted net income divided by the company's equity value less the net cash.

    Now I should point out that no company is going to want to drain cash to zero since they need some cash on the books to keep up day-to-day business. But for these purposes I just assumed we go all the way to zero rather than make likely faulty assumptions about what's the appropriate cash level for each business.

    Matt

  • Report this Comment On July 14, 2010, at 11:31 AM, TMFKopp wrote:

    @energysystems

    There are certainly reasons to like Exxon, but for the purposes of this article, it doesn't jump out at all. Exxon has a bunch of cash, but it also has a good deal of debt. To narrow down which companies I was going to look at more closely, I looked at net cash as a percentage of market cap. For Exxon that was at 1.5%, while Dell, for instance, was at roughly 25%.

    Matt

  • Report this Comment On July 16, 2010, at 7:54 PM, Winnerfrommidlan wrote:

    I like EBAY the best of this group as they have a solid position with their auction site and Paypal. I do like Cisco too as they are doing a good job with acquisitions. One other company piling up the cash is Intuitive Surgical, and they don't seem to know what to do with it. Maybe they should buy up their suppliers as they may be growing fast too.

  • Report this Comment On July 16, 2010, at 9:39 PM, mrjenny wrote:

    In a world turned upside down, cash seems to be too valuable. A menacing sign with inflation looming. That cash that those companies are hording, is being diluted by the Federal Reserve. Its a bit of a mystery to me but they seem al poised to use that cash. When the dollar heads down again that cash could become a real bad bet for international companies.

  • Report this Comment On July 17, 2010, at 7:46 PM, shbeavers wrote:

    There is at least one problem with declaring a stock as "cheaper than you think" because the company has a great stockpile of cash that you get certain "dollar-for-dollar" value for when you buy the stock. To whit, the portion of the price spent buying cash reserves is money that you are effectively setting aside rather than putting it to work for you.

    How about instead buying a different stock with a similar current yield and growth prospects where you only pay for a reasonably required amount of operating capital rather than a cash hoard - and then buying even more stock with the money you've saved so as to increase your returns? Sure, the value of your stock should grow as the company piggy bank increases but cash that's not reinvested in growing the business is not increasing the rate of return.

    Also, a cash hoard is not necessarily purchased at a dollar-for dollar value: if the company distributes excess cash as a one-time dividend, you end up paying tax on money that you could have simply held tax-free in your own account. Why would you want to have a portion of your share price handed back to you as a taxable dividend? Better to simply have a lower share price to begin with.

    Ultimately, if a company can't put the cash it earns to good use then it may eventually find a poor use for it - by buying a business it doesn't really understand or paying too much for one it does just because it can outbid all comers.

    At the end of it all, the stocks mentioned may well be "cheaper than you think" but not as much cheaper as it looks at first glance.

  • Report this Comment On July 21, 2010, at 3:33 PM, thisissubu wrote:

    Hi,

    I am a beginner. Though I understand the essence of this discussion, I am struggling to compute the ratios correctly. Can anybody help me by illustrating Google's number from the statement(s) and how we got all these values (21.6, 18.4, 18.4% , 58.2%)???

    Thanks a ton!!!!

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