riskonthetwoinvestmentswillmaketheprice-earningsratio
a function of the size of the cash balance. To see why,
considerafirmwith$1billion investedinoperating assets
and$250millionincash. Assumethat theoperating assets
generatea12.5percentaftertaxreturn,withacostofcapital
of 10 percent,andthatthecashearns 4 percent,withacostof
capitalof 4 percent.Forsimplicity,assumethattheearnings
frombothcomponentswillstayfixedinperpetuityandthat
thefirmhasnodebt.Wecanestimatethevalueofanintrinsic
priceearningsratioforeachcomponent(moneyamountsin
millions of dollars):
Inthiscase,cashtradesatamuchhighermultipleofearnings
becauseitisriskless,andtheprice-earningsratioforthefirm
willriseascashincreasesasaproportionoffirmvalue.Note,
though,thattheeffectofcashonP/Eratioscanshiftquickly
ifweintroducegrowthintothepicture,inconjunctionwith
excess returns. If thereis expectedgrowth in theearnings
fromoperatingassets,thevalueoftheoperatingassets(and
the implied P/E ratio) will increase.
24 Atsomegrowthrate,theP/Eratioforoperatingassetswill
exceedtheP/Eratioforcash.Oncethishappens,increasing
thecashholdings ofafirm(asa percentofits value)will
reduce the price-earnings ratio rather than increase it.