Adjusting earnings multiples

Sometimes valuing companies on a simple price-earnings multiple gives a misleading view of the value in the underlying business since some companies retain significant cash holdings. In the current low interest rate environment these cash balances yield very little, if anything, in the way of interest income, so make the standard PE ratio look artificially high when, in effect, it isn't if you adjusted for these cash holdings.

For instance, one of my best tips has been Netcall (NET), a small-cap company offering software to make telephone call-handling more efficient and one that has net cash on its balance sheet equivalent to almost a quarter of its current market value. This healthy financial position offers customers reassurance that the company will be around to fulfil its obligations on what can be long-term contractual agreements. But it also offers scope for Netcall to redeploy some of this cash pile to make earnings-enhancing acquisitions. And that is exactly what it is doing.

So if you strip out net cash from a company's share price, adjust the EPS figure for any loss of investment income and then recalculate the PE ratio, you get a far more accurate idea of the earnings multiple you are actually paying for the shares. In the case of Netcall, the forward PE ratio falls sharply from 13 to 10 on this 'net of cash' basis, which remains a very attractive valuation for a growing business in an earnings upgrade cycle.

Moreover, this process can throw up some bargain basement investment opportunities, such as Indigovision (IND) - the star performer of my 2012 Bargain Shares portfolio and a pioneer in internet protocol network-based security surveillance systems. When I strongly reiterated the investment case in the summer ('Tech stocks rack up gains', 6 August 2012) the share price was 350p and I calculated that the company was sitting on 100p-a-share of net cash at the time. Strip this out and the forward PE ratio fell from a reasonable 11 times EPS estimates of 32p for the year to July 2013 to a bargain basement 7.5 times EPS net of cash. Our first-mover advantage here paid big dividends, quite literally, because at the end of September the company not only announced bumper financial results, but also that it was paying out a hefty 75p a share of dividends to shareholders. This sparked a 50 per cent rerating of Indigovision's shares as the obvious value on offer, which we had recognised early, became abundantly apparent to a wider investment audience.