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«Dealing with Cash, Cross Holdings and Other Non-Operating Assets: Approaches and Implications Aswath Damodaran Stern School of Business September ...»

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Corporate Governance: Companies where stockholders have little or no power • over stockholders, either because of corporate charter amendments, inertia or shares with different voting rights, will accumulate more cash than companies where managers are held to account by stockholders.12 Insider Holdings: If insiders hold large blocks of the company and also are part of • the management of the company, we would expect to see larger cash balances accumulating in the company.13 There is also evidence that firms that accumulate cash tend to report sub-par operating performance, at least on average.14 10 Jensen, Michael C, 1986, Agency costs of free cash flow, corporate finance and takeovers, American Economic Review, v76, 323-329.

11 There have been several papers that show that companies with large cash holdings are more likely to make poor investments and overpay for acquisitions with the cash. See Harford, J. 1999. Corporate Cash Reserves and acquisitions. Journal of Finance, v54, 1969-1997; Blanchard, O., F. Lopez-de-Silanes, and A. Shleifer, 1994, What do Firms do with Cash Windfalls?, Journal of Financial Economics, v36, 337-360;

Harford, J., S. A. Mansi and W.F. Maxwell, Corporate Governance and a Firm’s Cash Holdings, Working Paper, SSRN. The last paper finds that companies with weak stockholder rights do not have higher cash balances but that they tend to dissipate cash much more quickly on poor investments than firms with stronger stockholder rights.

12 Dittmar, A.., J. Mahrt-Smith, and H. Servaes, 2003, International corporate governance and corporate cash holdings, Journal of Financial and Quantitative Analysis, v38, 111-133. Pinkowitz, Stulz and Williamson, 2003, Do firms in countries with poor protection of investor rights hold more cash?. Working Paper, SSRN. Both papers find that companies in countries where stockholders have less power tend to hold more cash. Their results are confirmed by Guney, Y., A. Ozkan and N. Ozkan, 2003, Additional International Evidence on Corporate Cash Holdings, Working Paper, SSRN. They compare cash holdings across 3989 companies in Japan, France, Germany and the UK and conclude that the stronger the protections for stockholders, the lower the cash holdings at companies.

13 Zhang, R., 2005, The Effects of Firm- and Country-level Governance Mechanisms on Dividend Policy, Cash Holdings and Firm Value: A Cross Country Study, Working Paper, SSRN. This paper finds that cash holdings are higher at companies where ownership is concentrated.

14 Mikkelson, W. H. and Partch, M., 2003, Do persistent large cash reserves hinder performance?, Journal of Financial and Quantitative Analysis v38, 257-294.

The Extent of Cash Holdings Cash holdings vary widely not only across companies at any point in time but for for the same companies across time. To get a sense of how much cash (and near-cash investments) companies hold, we looked at three measures of cash holdings.

The first is cash as a percent of the overall market value of the firm, defined as the • sum of the market values of debt and equity. Figure 1 presents the distribution of this measure for companies in the United States in January 2005.

While the median is 6.07% for this ratio, there are more than 300 firms where cash is in excess of 50% of firm value. There are also a significant number of firms where cash is less than 1% of firm value.

The second measure is cash as a percent of the book value of all assets. The • difference between this measure and the previous one is that it is scaled to the accountant’s estimate of how much a business is worth rather than the market’s judgment. Figure 2 reports on the distribution of cash to book value of assets for companies in the United States in January 2005.

The median for this measure is 7.14%, slightly higher than the median for cash as a percent of firm value.

The third measure relates cash to a firm’s revenues, providing a linkage (if one • exists) between cash holdings and operations. Figure 3 provides the distribution of cash as a percent of revenues for companies in the United States in January 2005.

The median for this measure is 3.38%, but there are a large number of positive outliers with this measure as well. Many young, high growth firms have cash that exceeds 100% of revenues in the most recent financial year.

While figures 1 through 3 provide useful information about the differences across all firms, it is still instructive to look underneath at differences across sectors when it comes to cash holdings. We computed the average values of the three measures outlined above – Cash/ Firm value, Cash/ Book Assets and Cash/Revenues – for different industries in the United States and the results are reported in Appendix 1 (at the end of the paper).15 Categorizing Cash Holdings Given the different motives for holding cash, it should come as no surprise that analysts have tried to categorize cash holdings in many ways. The most common one in practice separates the cash balance into an operating cash balance and excess cash. A more useful categorization from a valuation perspective is one that divides cash into wasting cash and non-wasting cash, based upon where the cash is invested.

15 The updated versions of these ratios will be accessible on my web site under updated data.

Operating versus Non-operating (Excess) Cash In the last section, we outlined why companies may hold cash for operating purposes. For many analysts, determining how much cash is needed for operating purposes is viewed as a key step in analyzing cash. Once that determination has been made, operating cash is considered to be part of working capital and affects cash flows, and cash held in excess of the operating cash balance is either added back to the estimated value of the operating assets or netted out against total debt outstanding to arrive at a net debt number. Making the determination of how much cash is needed for

operations is not easy, though there are two ways in which this estimation is made:

Rule of thumb: For decades, analysts have used rules of thumb to define operating • cash. One widely used variation defined operating cash to be 2% of revenues, though the original source for this number is not clear. Using this approach, a firm with revenues of $ 100 billion should have a cash balance of $ 2 billion. Any cash held in excess of $ 2 billion would be viewed as excess cash. The disadvantage of this approach is that it does not differentiate across firms, with large and small firms in all industries treated equivalently.

Industry average: An alternative approach that allows us to differentiate across • firms in different industries uses the industry averages reported in Appendix 1.

Based upon the presumption that there is no excess cash in the composite cash holdings of the sector, the industry averages become proxies for operating cash.

Any firm that holds a cash balance greater than the industry average will therefore be holding excess cash.

Cross Sectional Regressions: When examining the motives for cash holdings, we • referenced several papers that examine the determinants of cash holdings. Most of these papers come to their conclusions by regressing cash balances at individual companies against firm-specific measures of risk, growth, investment needs and corporate governance. These regressions can be used to obtain predicted cash balances at individual companies that reflect their characteristics.

Wasting versus Non-wasting Cash In our view, the debate about how much cash is needed for operations and how much is excess cash misses the point when it comes to valuation. Note that even cash needed for operations can be invested in near-cash investments such as treasury bills or commercial paper. These investments may make a low rate of return but they do make a fair rate of return. Put another way, an investment in treasury bills is a zero net present value investment, earning exactly what it needs to earn, and thus has no effect on value.

We should not consider that cash to be part of working capital when computing cash flows.

The categorization that affects value is therefore the one that breaks the cash balance down into wasting and non-wasting cash. Only cash that is invested at below market rates, given the risk of the investment, should be considered wasting cash. Thus, cash left in a checking account, earning no interest, is wasting cash. Given the investment opportunities that firms (and individual investors) have today, it would require an incompetent corporate treasurer for a big chunk of the cash balance to be wasting cash.

As an illustration, almost all of Microsoft’s $ 33 billion in cash is invested in commercial paper or treasury bills and the same can be said for most companies.

As an analyst, how would you make this categorization? One simple way is to examine interest income earned by a firm as a percent of the average cash balance during the course of the year and comparing this book interest rate on cash to a market interest rate during the period. If the cash is productively invested, the two rates should converge.

If it is being wasted, the book interest rate earned on cash will be lower than the market interest rate. Consider a simple example. CybetTech Inc. had an average cash balance of $ 200 million in the 2004 financial year and it reported interest income of $ 4.2 million from these holdings. If the average treasury bill rate during the period was 2.25%, we can

estimate the wasting cash component as follows:

Interest income for 2004 = $ 4.2 million Book interest rate on average cash balance = Interest income/ Average Cash Balance = 4.2/ 200 = 2.1% Market interest rate (treasury bills) = 2.25% Proportion of cash balance which is wasting cash = 1 – Book interest rate/ Market interest rate = 1 -.021/.0225 = 0.0667 or 6.67% Thus, 6.67% of $ 200 million ($13.34 million) would be treated as wasting cash and considered like inventory and accounts receivable to be part of working capital but the remaining $186.66 million would be viewed as non-wasting cash and added on to the value of the operating assets of the firm.

Dealing with Cash holdings in Valuation While valuing cash in a firm may seem like a trivial exercise, there are pitfalls in the analysis that can cause large valuation errors. In this section, we will consider how best to deal with cash in both discounted cashflow and relative valuations.

1. Valuing Cash in a Discounted Cashflow Valuation There are two ways in which we can deal with cash and marketable securities in discounted cashflow valuation. One is to lump them in with the operating assets and value the firm (or equity) as a whole. The other is to value the operating assets and the cash and marketable securities separately. As we will argue in this section, the latter approach is a much more reliable one and less likely to result in errors.

Consolidated Valuation Is it possible to consider cash as part of the total assets of the firm and to value it on a consolidated basis? The answer is yes and it is, in a sense, what we do when we forecast the total net income for a firm and estimate dividends and free cash flows to equity from those forecasts. The net income will then include income from investments in government securities, corporate bonds and equity investments16. While this approach has the advantage of simplicity and can be used when financial investments comprise a small percent of the total assets, it becomes much more difficult to use when financial investments represent a larger proportion of total assets for two reasons.

The cost of equity or capital used to discount the cash flows has to be adjusted on an • ongoing basis for the cash. In specific terms, you would need to use an unlevered beta 16Thus, if cash represents 10% of the firm value, the unlevered beta used will be a weighted average of the beta of the operating assets and the beta of cash (which is zero).

that represents a weighted average of the unlevered beta for the operating assets of the firm and the unlevered beta for the cash and marketable securities. For instance, the unlevered beta for a steel company where cash represents 10% of the value would be a weighted average of the unlevered beta for steel companies and the beta of cash (which is usually zero). If the 10% were invested in riskier securities, you would need to adjust the beta accordingly. While this can be done simply if you use bottom-up betas, you can see that it would be much more difficult to do if you obtain a beta from a regression.17 As the firm grows, the proportion of income that is derived from operating assets is • likely to change. When this occurs, you have to adjust the inputs to the valuation model – cash flows, growth rates and discount rates – to maintain consistency.

What will happen if you do not make these adjustments? You will tend to misvalue the financial assets. To see why, assume that you were valuing the steel company described above, with 10% of its value coming from cash. This cash is invested in government securities and earns a riskfree rate of say 2%. If this income is added on to the other income of the firm and discounted back at a cost of equity appropriate for a steel company – say 11% - the value of the cash will be discounted. A billion dollars in cash will be valued at $800 million, for instance, because the discount rate used is incorrect.

Separate Valuation It is safer to separate cash and marketable securities from operating assets and to value them individually. We do this almost always when we use approaches to value the firm rather than just the equity. This is because we use operating income to estimate free cash flows to the firm and operating income generally does not include income from financial assets. Once you value the operating assets, you can add the value of the cash and marketable securities to it to arrive at firm value.

Can this be done with the FCFE valuation models described in the earlier chapters? While net income includes income from financial assets, we can still separate cash and marketable securities from operating assets, if we wanted to. To do this, we would first back out the portion of the net income that represents the income from 17 The unlevered beta that you can back out of a regression beta reflects the average cash balance (as a percent of firm value) over the period of the regression. Thus, if a firm maintains this ratio at a constant level, you might be able to arrive at the correct unlevered beta.

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