How do you determine "excess cash" for Enterprise Value calculations from a balance sheet?

Question

The formula for Enterprise Value that I often see is:

EV = Total Debt + Market Cap - Cash

Often "Cash" is refined further as "Excess Cash" in this formula. My question is how can I determine the amount of excess cash a company has from it's balance sheet?

Is it as simple as subtracting Current Liabilities from Total Cash, since it would be advisable for a company to keep enough cash on hand to meet these types of liabilities, and therefore this portion would not be considered excess?

Then we'd have:

Excess Cash = Cash & Equivalents + Long-Term Investments - Current Liabilities

In Apple's case, this results in $49B of excess cash. I've also seen people use the general rule that any cash exceeding 20% of revenue is "excess".

What is the proper way to do this, in general, or pros/cons of different approaches? Am I missing something?

Answer 1

​​​​​You're not missing anything. Excess cash is somewhat of a nebulous concept. To different people it means different things. The answer is that excess cash varies for each company depending on their business. For instance, some companies need very high amounts of working capital. A company may be increasing their inventories and therefore will require more cash on their balance sheet to fund growth. If a company always needs this extra cash, some investors prefer to leave that cash out of a valuation because the company cannot run profitably without it. Think about what happens to your calculation of Enterprise Value if you subtract excess cash as opposed to cash. Excess cash is always less than cash. Therefore by subtracting excess cash you increase EV. Since one common valuation metric is EV/EBITDA, a higher numerator will make the stock seem more expensive - that is the EV/EBITDA ratio will seem higher when using excess cash as opposed to cash. So using excess cash in your valuation methodology is basically a conservative concept. Depending on the business 20% of revenues seem way too high as a reserve for excess cash. 2% is a much better rule of thumb.

Answer 2

20% is almost certainly too high. I agree with 2%, as a very rough rule. It will vary significantly depending on the industry. I generally calculate an average of the previous 2-3 years working capital, and deduct that from cash.

Working capital is Current Assets less Current Liabilities. Current Assets is comprised of cash, prepaid expenses, and significantly, accounts receivable. This means that CA is likely to be much higher than just cash, which leaves more excess cash after liabilities are deducted. Which reduces EV, which makes the EV/EBITDA ratio look even more pricey, as Dimitri noted.

But a balance sheet is just a snapshot of the final day of the quarter. As such, and because of seasonal effects, it's critical to smooth this by averaging several periods. After calculating this for a few companies, compare to revenue. Is it close to 2%?

Answer 3

Excess Cash = Cash & Equivalents + Long-Term Investments - Current Liabilities

The problem this calculation of excess cash is that "long-term investments" can be illiquid things like real estate. Another flaw is that it gives no credit for Current Assets, like receivables, which can be used to offset Current Liabilities.

The first thing I'd do is "net out" Current Assets and Current Liabilities, then add Cash back in. Excess Cash = Current Assets - Current Liabilities + Cash & Equivalents.

It would be nice if GAAP would require Long-Term Investments to be broken out as a) liquid long-term investments (stocks, bonds) b) illiquid long-term investments (real estate, private equity, etc)