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With short-term risk free rates hovering around zero and cash amounts close to historical highs, you’ll expect the money effect on PE to become more pronounced now than previously. The interest income from cash was estimated using the common cash balance during the course of the entire year and average one-year T.For your 12 months Bill rate.
Update: The PE impact is large, within the last five years especially. It really is perhaps being exaggerated by the inclusion of financial service companies in the sample, since cash and short-term investments at these companies can be huge and are actually not much like cash holdings at others.
If you take them off from the test, the cash effect does get smaller. Cash balances have mixed not only across time, however they are also different across areas and within sectors, across companies. It delivers the message that there surely is no simple guideline that will continue to work across all companies or even across companies within a sector.
Perhaps, the ultimate way to check out the aftereffect of cash on PE is to choose a company, and take it through the cleansing process, a very simple one that requires few inputs relatively. Use this spreadsheet to try it on your favorite (or not-so-favorite) company. In an investing world filled with complications, simple measures like PE maintain their hold because they’re easy to compute and easy to utilize.
However, there’s a price that people sometimes pay for this simplicity, and in periods like this one, where interest rates are at historical lows, we may need to reassess how we use these methods to compare companies. In particular, I believe we have two separate companies to their cash and operating parts, and deal with both separately, because they are so different in terms of risk and earnings power.