I answered this question on Quora: What is P/E Ex Cash?
To calculate the p/e (ex cash), subtract Cash from the market value before dividing by earnings.
So, P/E (ex cash) = (Market Value – Cash and cash equivalents)/Net Income
Why Use Ex Cash P/E Ratio?
There is a very good reason why this is done.
Let’s say you are looking at company A which is trading at $15/share with earnings of $1/share in the last 12 months. The P/E ratio is 15
Also consider another company B that is trading at $15/share with earnings of $1/share in the last 12 months. The P/E ratio is 15 as well.
Company A has $5/share on the books but only needs $2/share to run its business.
Company B has $3/share on its books and only needs $2/share to run its business.
See also: How to compute book value
Which stock is more attractive to you?
If you are still thinking they look similar, think of it from the perspective of someone who is interested in acquiring the entire company.
With Company B, this person can spend $15/share to buy $1/share of earnings and possibly pocket the extra $1 on the company books ($3/share cash – $2/share company needs to run its business)
See also: pb ratio
With Company A, this person can spend $15/share to buy $1/share of earnings and pocket the extra $3 on the company books.
in essence, this acquirer would only spend $15 – $3 = $12 to acquire $1 of earnings for Company A, while for company B he would spend $15 – $1 = $14 to acquire $1 of earnings.
The Company A is actually cheaper.
See also: PEG ratio
Ex- Cash P/E ratio will approximately tell you that company A is cheaper. The regular price to earnings ratio will not give you this detail.
There are other considerations, of course. Company A might have a higher debt load or some other factor that makes it less attractive than Company B. But ex-cash P/E ratio is a good starting point for valuation analysis.
The Ex-Cash P/E Ratio is not a Perfect Measure to Value Stocks
One limitation of ex-cash P/E ratio is that it only applies to companies with positive net income. For companies with negative earnings, ex-cash P/E ratio will be undefined.
Another limitation is that ex-cash P/E ratio does not account for changes in the amount of cash on the balance sheet. If a company has been consistently generating cash but not using it, the ex-cash P/E ratio will understate the true value of the company.
Investors should take care valuing a bank stock using Ex Cash P/E ratio. Banks carry significant cash on the books as part of the customer deposits and this is not necessarily bank asset.
Finally, ex-cash P/E ratio does not consider the real returns that a company’s shareholders are getting on their investment. If a company is paying out a large dividend to investors, for example, the ex-cash P/E ratio will understate the true value of the company.
Despite these limitations, ex-cash P/E ratio is still a useful tool for valuing companies, especially when compared to other companies in the same industry or sector.
You should also consider these other investor ratios