Issue #8: Use Cash Reserves to Find Undervalued Stocks
Learn how cash and debt adjustments refine the P/E ratio to reflect a company's true valuation.
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The P/E ratio is a common metric used to evaluate a company's valuation by comparing its current share price to its earnings per share (EPS). However, this ratio can be skewed by significant cash holdings or debt levels.
Cash sitting on the balance sheet doesn't drive the company's earnings unless it's actively invested in growth initiatives or returned to shareholders.
For instance, if a stock trades at $100 per share but the company holds $40 per share in cash (after accounting for debt), the effective price you are paying for the actual business is $60.
With earnings per share at $10, the unadjusted Price/Earnings ratio would be 10 ($100/$10). However, if you exclude the cash, the adjusted P/E ratio drops to 6 ($60/$10). And the lower the P/E ratio, the better the bargain.
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