5 FTSE 100 Firms With Cash To Spare

These cash-rich companies are cheaper than they look.

Many companies operated with historically high levels of debt in the easy borrowing days before the credit crunch. But the chickens came home to roost when the world went into a financial tailspin followed by recession.

Dividend cuts and rights issues became the order of the day. Yet for all the subsequent talk of companies conserving cash and strengthening their balance sheets, it's been more a case of companies reducing their debt rather than eliminating it.

I was surprised to find, when looking through the most recent results of FTSE 100 firms, that only about one in 10 actually have net cash.

The table below gives some stats on five cash-rich blue chips.

As you can see, these companies don't come cheap on a price-to-earnings (P/E) measure. Even the lowest rated of the quintet, miner Antofagasta, is highly rated relative to peers such as Anglo American (LSE: AAL), on a P/E of 8.2, and Rio Tinto (LSE: RIO), on a P/E of 6.9.

Are the companies in the table genuinely over-priced compared with others in their sectors? Surely they deserve some premium for their hoards of cash? How should we quantify it?

Adjusted P/E

One way to put companies with different amounts of cash and debt onto a level playing field is by calculating an 'adjusted' P/E. What is an adjusted P/E? Let's take the first company in the table above, Rolls-Royce, as an example.

The standard P/E is calculated by dividing the share price (865p) by the earnings per share (61.5p in Rolls-Royce's case, using 12-month forecasts), giving a P/E of 14.1.

To calculate an adjusted P/E, we can subtract the net cash per share from the share price (865p minus 46p equals 819p), and divide the adjusted share price by the earnings per share (61.5p), giving a lower P/E of 13.3.

If Rolls-Royce had net debt of 46p per share rather than net cash, we would add the 46p to the share price. In this case, doing the same calculation, the P/E would rise to 14.8.

What to watch

For some companies, levels of cash and debt may be very seasonal – retailers, for example. Retailers tend to have less cash (or more debt) ahead of their crucial Christmas trading period because they build up stock in preparation. After Christmas -- all being well! -- retailers' tills are bursting with cash.

Of our five companies, we might expect fashion house Burberry to show this phenomenon. And indeed it does:

Note that, despite the seasonality, Burberry's net cash has been steadily rising. This cash has come from Burberry's highly cash-generative business. Beware of firms that have been struggling and only have cash on the balance sheet because they've issued new equity.

Another thing to watch for arises because there may have been an event since the most recent balance sheet date that will have significantly impacted on how much cash the company has. None of our five companies are in this situation, but keep an eye out for companies whose net cash is sure to be lower, perhaps because it's made a substantial acquisition.

This leads on to the very important question of what a company does with its excess cash. Companies can do all sorts of things: for example, increase investment in their existing business, make acquisitions, pay a special dividend or pledge to increase the ordinary dividend at a faster rate, or implement a share buyback scheme.

Cash on the balance sheet is only valuable if a company uses it wisely. It's worth zilch if a company fritters it away, say, on an acquisition that destroys rather than enhances shareholder value or on a share buyback scheme when the shares are grossly overvalued.

Using cash wisely

How a company has employed excess cash in the past is probably the best guide to the value of its current cash pile.

Rolls-Royce, for example, was able to use its cash to invest heavily in technology, product and infrastructure through the latest recession. Such investment can bring surprisingly long-lasting momentum coming out of a recession. In fact, Rolls-Royce is confident it can double its revenues over the next decade.

Meanwhile, Petrofac, an oil and gas facilities services provider, has what it calls a "build and harvest" strategy, whereby it invests in projects, adds value and then sells on. Petrofac has been enormously successful, its value increasing around five-fold since its flotation in 2005.

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Foolish bottom line

Adjusted P/E is a useful quick-and-dirty method to get a handle on the valuation of companies with different levels of cash and debt -- and not too intimidating for novice investors. Remember, though, that excess cash is only valuable if the company employs it wisely!

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Further investment opportunities:

• The One UK Share Warren Buffett Loves
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• Top Sectors Of 2012

> G A Chester does not own shares in any of the companies mentioned in this article.