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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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Further, assume that the market anticipates that they will overpay by $50 million on this acquisition. The cash will then be valued at $185 million.

Estimated Discount on Cash Balance ( )( ) = "Probability acquisition Expected Overpayment acquisition = ( 0.3)($50 million) = $15 million Value of Cash = Cash Balance – Estimated Discount = $ 200 million - $ 15 million = $ 185 million !

The two factors that determine this discount – the incremental likelihood of a poor investment and the expected net present value of the investment – are likely to be based upon investors’ assessments of management quality. Cash is more likely be discounted in the hands of management that is perceived to be incompetent than in the hands of good managers.

Separate versus Consolidated Valuation: Summary It is easy to see why so many valuations make mistakes with cash holdings. The differences between the approaches are subtle and the inputs have to be fine-tuned to

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In this case, cash trades at a lower price to book ratio than the operating assets do and the presence of cash will push down the price to book ratio for the firm. Of course, the reverse will occur in firms where operating assets generate sub-par returns and trade at below book value. Here again, the solution to the problem is to net cash out of both the market value and book value of equity when computing price to book ratios.

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Firm & Enterprise Value Multiples In general, analysts have been more cognizant of the effects of cash when using firm value multiples. In fact, most analysts use enterprise value, which nets cash out of the market value of debt and equity, to compute these multiples in the numerator. Since the denominator is usually a variation of operating income (EBITDA, after-tax operating income), the resulting multiple should not be affected by cash holdings. There are two

areas, though, where analysts have to show caution:

The cash balance that is netted out against firm value usually is from the most • recent financial statements. To the extent that there are seasonal factors affecting expenses and cash balances, using the most recent cash balance can skew the multiple. For instance, assume that a firm builds up a large cash balance towards the end of every December to meet large cash outflows that it expects to incur in January. Using this cash balance to compute enterprise value will result in a low enterprise value multiple (and perhaps a buy recommendation). In the presence of seasonal variation in the cash balance, it makes more sense to look at the average cash balance over the year rather than the most recent cash balance.

When using enterprise value to capital ratios, cash should be netted out against the •

book value of capital, just as it was in the price to book calculation:

Market Value of Equity + Market Value of Debt - Cash EV/ Capital Invested = Book value of Equity + Book value of Debt - Cash The failure to adjust for cash in the denominator will generally bias multiples downward and more so for companies with significant cash balances.

!

Note that the cash adjustment is robust to various actions that can be taken by the firm that reduce or augment the cash balance. A firm that pays a large dividend or buys back stock will reduce its cash balance but the market value of equity will also decline by an returns has no effect on value or the price earnings ratio.

equivalent amount. A firm that borrows a substantial sum just before the end of a fiscal year will report a higher cash balance but it will also report more debt outstanding.

The final caveat that we should add relates to divestitures of portions of existing business, especially towards the end of a fiscal year, when computing enterprise value to operating income or cash flow multiples. The divestiture will replace operating assets with a large cash balance (the proceeds of the divestiture) but the operating income or EBITDA from last year will include the earnings from the assets that were divested. To get a more realistic estimate, we have to either remove the portion of the EBITDA that is attributable to the divested assets or use a projected number that does not include earnings from these assets.

How does the market value cash?

In the last section, we considered how best to value cash in both a discounted cash flow and in a relative valuation. Ultimately, though, the discussion cannot be complete without examining how the market values cash. After all, if the market systematically misestimates the value of cash, there will be no payoff to the analyst who values it correctly. Pinkowitz and Williamson (2002) tried to estimate the value that markets were attaching to cash by regressing the market values of firms against fundamental variables that should determine value (including growth, leverage and risk) and adding cash as an independent variable.25 They concluded that the market values a dollar in cash at about $1.03, with a standard error of $0.093. Consistent with the motivations for holding cash, they found that cash is valued more highly in the hands of high growth companies with more uncertainty about future investment needs than in the hands of larger, more mature companies. Surprisingly, they find no relationship between how the market values cash and a firm’s access to capital markets. In an interesting contrast, another study that applies the same technique to non-US markets finds that a dollar in cash is valued at only $0.65 in emerging markets with weak stockholder protection.26 25 Pinkowitz, L. and R. Williamson, 2002, What is a dollar worth? The Market Value of Cross Holdings, Working Paper, Georgetown University.





26 Pinkowitz, L., R. Stulz and R. Williamson, 2003, Do firms in countries with poor protection of investor rights hold more cash?. Working Paper, SSRN.

Schwetzler and Reimund (2004) extend this analysis to look at cash holdings in German companies.27 Relating the enterprise value of German firms to their cash to sales ratios, they conclude that firms that have lower cash holdings than the median for the industries in which they operate trade at lower values whereas firms that hold excess cash (relative to the median) trade at higher values. Faulkender and Wang (2004) find contradictory evidence, at least in the aggregate.28 The conclude that the marginal value of a dollar in cash across all firms is $0.96, In other words, markets discount cash by a small amount rather than add a premium. Furthermore, the marginal value of cash decreases as the cash holding increases and as firms borrow more money. The marginal value of cash is also lower for firms that pay dividends rather than buy back stock, reflecting the tax disadvantages accruing to dividends during the sample period. Finally, the marginal value of cash is much higher for firms that are capital constrained and have significant investment opportunities. They attribute the differences between their findings and the findings in earlier studies to the fact that they used equity values rather than enterprise values to estimate the value of cash.

It should be noted that all of these studies are based upon very large samples of diverse firms. While they all try to control for differences across firms using proxies for growth and risk, the regressions themselves have limited explanatory power aqnd the proxies are not precise. For instance, the historical sales growth is an imperfect proxy for future growth; this can translate into large shifts in the coefficients on cash. The bottom line is that the studies all agree that the market treats a dollar in cash differently in the hands of different firms, and that we cannot automatically assume that cash will be valued at face value at all firms.

Financial Investments So far in this paper, we have looked at holdings of cash and near-cash investments. In some cases, firms invest in risky securities, which can range from investment-grade bonds to high-yield bonds to publicly traded equity in other firms. In 27Schwetzler, B. and C. Reimund, 2004, Valuation Effects of Corporate Cash Holdings: Evidence from Germany, HHL Working Paper, SSRN.

this section, we examine the motivation, consequences and accounting for such investments.

Reasons for holding risky securities Why do firms invest in risky securities? Some firms do so for the allure of the higher returns they can expect to make investing in stocks and corporate bonds, relative to treasury bills. In recent years, there has also been a trend for firms to take equity positions in other firms to further their strategic interests. Still other firms take equity positions in firms they view as under valued by the market. And finally, investing in risky securities is part of doing business for banks, insurance companies and other financial service companies.

1. To make a higher return Near-cash investments such as treasury bills and commercial paper are liquid and have little or no risk, but they also earn low returns. When firms have substantial amounts invested in marketable securities, they can expect to earn considerably higher returns by investing in riskier securities. For instance, investing in corporate bonds will yield a higher interest rate than investing in treasury bonds and the rate will increase with the riskiness of the investment. Investing in stocks will provide an even higher expected return, though not necessarily a higher actual return, than investing in corporate bonds.

Figure 6 summarizes returns on risky investments – corporate bonds, high-yield bonds and equities – and compares them to the returns on near-cash investments between 1990 and 2000 28Faulkender, M. and R. Wang, 2004, Corporate Financial Policy and the Value of Cash, Working Paper, SSRN.

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Source: Federal Reserve Investing in riskier investments may earn a higher return for the firm, but it does not make the firm more valuable. In fact, using the same reasoning that we used to analyze near-cash investments, we can conclude that investing in riskier investments and earning a fair market return (which would reward the risk) has to be value neutral

2. To invest in under valued securities A good investment is one that earns a return greater than its required return (given its risk). That principle, developed in the context of investments in projects and assets, applies just as strongly to financial investments. A firm that invests in under valued stocks is accepting positive net present value investments, since the return it will make on these equity investments will exceed the cost of equity on these investments. Similarly, a firm that invests in under priced corporate bonds will also earn excess returns and positive net present values.

How likely is it that firms will find under valued stocks and bonds to invest in? It depends upon how efficient markets are and how good the managers of the firm are at finding under valued securities. In unique cases, a firm may be more adept at finding good investments in financial markets than it is at competing in product markets.

Consider the case of Berkshire Hathaway, a firm that has been a vehicle for Warren Buffet’s investing acumen over the last few decades. At the end of the second quarter of 1999, Berkshire Hathaway had $69 billion invested in securities of other firms. Among its holdings were investments of $12.4 billion in Coca Cola, $6.6 billion in American Express and $3.9 billion in Gillette. While Berkshire Hathaway also has real business interests, including ownership of a well regarded insurance company (GEICO), investors in the firm get a significant portion of their value from the firm’s passive equity investments.

Notwithstanding Berkshire Hathaway’s success, most firms in the United States steer away from looking for bargains among financial investments. Part of the reason for this is their realization that it is difficult to find under valued securities in financial markets. Part of the reluctance on the part of firms to make investments can be traced to a recognition that investors in firms like Proctor and Gamble and Coca Cola invest in them because of these firms’ competitive advantages in product markets (brand name, marketing skills, etc.) and not for their perceived skill at picking stocks.

3. Strategic Investments During the 1990s, Microsoft accumulated a huge cash balance. It used this cash to make a series of investments in the equity of software, entertainment and internet related firms. It did so for several reasons29. First, it gave Microsoft a say in the products and services these firms were developing and pre-empted competitors from forming partnerships with the firms. Second, it allowed Microsoft to work on joint products with these firms. In 1998 alone, Microsoft announced investments in 14 firms including ShareWave, General Magic, RoadRunner and Qwest Communications. In an earlier investment in 1995, Microsoft invested in NBC to create the MSNBC network to give it a foothold in the television and entertainment business.

Can strategic investments be value enhancing? As with all investments, it depends upon how much is invested and what the firm receives as benefits in return. If the sidebenefits and synergies that are touted in these investments exist, investing in the equity of 29One of Microsoft’s oddest investments was in one of its primary competitors, Apple Computer, early in

1998. The investment may have been intended to fight the anti-trust suit brought against Microsoft by the Justice Department.

other firms can earn much higher returns than the hurdle rate and create value. It is clearly a much cheaper option than acquiring the entire equity of the firm.

4. Business Investments Some firms hold marketable securities not as discretionary investments, but because of the nature of their business. For instance, insurance companies and banks often invest in marketable securities in the course of their business, the former to cover expected liabilities on insurance claims and the latter in the course of trading. While these financial service firms have financial assets of substantial value on their balance sheets, these holdings are not comparable to those of the firms described so far in this paper. In fact, they are more akin to the raw material used by manufacturing firms than to discretionary financial investments.

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