One problem with using a simple P/E ratio as a measure of value is that it completely ignores the balance sheet. A company with a large amount of debt is certainly less attractive than a company with no debt, even if the P/E ratios and growth prospects are the same.
This can go the other way as well. A company that has a lot of net cash on the books is actually cheaper than the P/E ratio makes it appear. If you could buy the whole company at the current market price, your total cost would be reduced by the net cash, effectively lowering the price you pay. This makes the normal P/E ratio greatly inflated without an adjustment for cash.
Here are three examples of companies that have enough cash to significantly skew the P/E ratio.
More than just clogs
The story of shoe company Crocs, Inc. (NASDAQ:CROX) is one that pops up time and time again. After its IPO at the beginning of 2006, the stock more than quadrupled on strong sales of its ubiquitous clogs and extreme optimism for the future. Reality quickly set in, with sales declining and the stock falling off a cliff. It seemed that a company that derived almost all of its sales from a single polarizing product wasn't a great long-term investment at a nosebleed valuation.
Since this collapse, the company has greatly diversified itself. Crocs, Inc. (NASDAQ:CROX)' revenue resumed growth in 2010 and surpassed its 2007 peak in 2011. The company is no longer a one-hit wonder, and there is a legitimate growth story developing.
This newfound success has led to a serious pile of cash on the company's books. At the end of the most recent quarter, Crocs, Inc. (NASDAQ:CROX) had $289 million in cash and no debt, leading to $3.25 per share in net cash. With a stock price around $13.50 per share, this cash represents a full 24% of the total market capitalization.
Crocs, Inc. (NASDAQ:CROX)' standard P/E ratio based on TTM earnings is 11.5, but factoring in the cash lowers this ratio to the bargain level of 8.75. I wrote about Crocs' short-term issues in a previous article, and my conclusion was that earnings were likely being temporarily suppressed. The forward P/E ratio, including the effect of the cash, would then be even lower.
Video game juggernaut
Game company Activision Blizzard, Inc. (NASDAQ:ATVI) is responsible for two of the most successful video game franchises in history, Call of Duty and World of Warcraft. Call of Duty has become the de facto standard online shooter game, with the most recent iteration selling nearly 25 million copies since its release. The next version, Ghosts, is set to release this November.
World of Warcraft is a massively multiplayer online role playing game, or MMORPG, which users must pay a monthly subscription to access. With millions of active users worldwide, World of Warcraft is a cash cow for Activision Blizzard, Inc. (NASDAQ:ATVI), helping create a huge cash balance for the company. At the end of the most recent quarter, Activision had $4.55 billion in cash and no debt, leading to $4 per share in cash. With a stock price around $16.30, this cash represents about 25% of the company's total market capitalization.