Do Cash-Adjusted P/E Ratios Work?
A guest speaker in my lecture last week mentioned something interesting:
Apple looks like a growth stock on a P/E basis, but when you strip out the cash horde and examine the cash-adjusted P/E ratio, Apple is selling at 7-8x.
I followed up with this comment and googled around a bit to find articles on the subject. As expected, there is a belief that cash-adjusted P/E ratios are important for stock performance. This certainly seems like a reasonable idea. Here are some articles on the subject:
As a natural skeptic, I love to examine unproven “common wisdom” and “rules of thumb.”
- Investors who look at P/E ratios, without adjusting for “cash,” may incorrectly identify a stock as “expensive,” when the reality is the stock is “cheap.”
A natural way to test this hypothesis is to examine the performance of stocks on a P/E basis and a “cash-adjusted” P/E basis. We perform this analysis on the universe of all NYSE/AMEX/NASDAQ stocks. For these figures we simply sort the universe of firms each June 30th into ten decile bins based on P/E or cash-adjusted P/E. We examine equal-weight portfolios and market-cap weighted portfolios. We eliminate all firms in the bottom 20 percentile of market cap to ensure micro-caps do not drive the results.
Here are the basic stats on the lowest decile portfolio (Glamour) and the highest decile portfolio (Value) using equal-weight portfolio construction:
It doesn’t seem that cash-adjusted P/E is any more powerful in predicting future performance than the stand-alone P/E.
A more sophisticated way to analyze the hypothesis is to look at P/E deciles, and then sort within these deciles on Cash P/E. The basic idea is that holding constant P/E, low Cash-adjusted P/E firms should outperform high cash-adjusted P/E firms. Or in other words, stocks like Apple that have a high P/E, but a low cash P/E should outperform, on average, those firms with equally high P/Es, but higher relative cash-adjusted P/E.
The theory makes sense, but what do the data say:
In the 1st decile (glamour stocks), seperating the universe on cash-adjusted P/E doesn’t really do anything–maybe adds 50-60bps, which is statistically no different. We get an odd result for the 10th decile (value), where the low cash-adjusted P/Es actually perform worse! There is a bit of evidence in deciles 2-8, suggesting that investors may not appreciate cash-adjusted P/Es as much as they should. Of course, slight changes in methodology (market-cap weight vs equal-weight, include negative P/E firms vs exclude negative P/E firms, and so forth) jumble up this chart. Overall, there is certainly no systematic or pervasive evidence that focusing on cash-adjusted P/E is a magic bullet. From a statistical standpoint, it really doesn’t matter. However, from a point estimate perspective, using a cash-adjusted P/E might work for stocks that are neither extreme growth or extreme value (ie bins in the middle).
We are just beginning this research project and plan to have a working paper out in the next few weeks with all the details. In the meantime, be weary of reports wielding the “cash-adjusted P/E turns this growth stock into a value stock” answer. In the end, buying any stock with an extemely high P/E (cash-adjusted or not) is a bad bet, on average, and buying any stock with a very low P/E tends to be a good bet.
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Definitions of common statistics used in our analysis are available here (towards the bottom)