This is the first story in a four-part series on cash management. The second story examines How to Segment Surplus Cash. Flight Risk, the third story, explains why there may be a mass exodus of corporate cash from money-market instruments. Loosening Without Losing, the final story, explores how treasurers can prepare for a rise in interest rates.
“Let corporations return to their stockholders the surplus cash holdings not needed for the normal conduct of their business,” said Benjamin Graham, the father of security analysis, in 1932.
Even before the current era’s “trapped cash” and record corporate profitability, investors have scrutinized the rapid accumulation of cash. Graham grumbled about suspect corporate coffers in the teeth of the Great Depression, well before recovery was underway (or even certain).
Yet liquidity is valuable. The manifold uses of cash span the defensive (reducing the expected costs of distress) and the offensive (quickly acquiring a suddenly available asset or a company’s own stock in times of market dislocations).
The associated threats and opportunities vary with a firm’s industry and maturity: cash is most valuable when value-adding investments abound and raising cash (via retained earnings or externally) is slow or costly. It’s not surprising, therefore, that cash is deemed more valuable for early-stage firms, whose prospects depend critically on research and development or other investment expenditures.
The Value of One Dollar: $0.23 – $1.80
Several research studies have examined the relationship between balance-sheet cash and market capitalization. The most recent and comprehensive findings suggest that investors value the incremental dollar at anywhere from $0.23 to $1.80. The different valuations aren’t arbitrary however; they are explained by a small collection of company characteristics.
Cash is worth more to firms in the following situations:
- Companies with valuable investment options. Start-up firms trying to develop a new technology or business model, or companies in a rapidly consolidating sector.
- Firms that are yet to be profitable. Early-stage companies whose margins are too thin to generate sufficient retained earnings.
- Firms facing limited or expensive access to external capital. Companies without a readily tapped source of additional liquidity.
In contrast, cash is worth less to firms that can be described as the following:
- High credit quality. Investment-grade firms with perceived unfettered access to external capital raises.
- Stable growers. Firms with smooth, predictable investment needs, and whose earnings comfortably cover those needs.
- Distressed companies. Companies whose expected use for surplus liquidity is to pay down debt, which is expected to enrich lenders without benefiting shareholders.
We have integrated the findings of three recent studies into the value of cash for firms of all sizes and maturities. The figure below matches a company’s life-cycle stage with the value investors ascribe to one dollar of balance-sheet cash. (Click on the image to enlarge.)
As we move from left to right in the figure, we see how retained cash becomes decreasingly valuable as a company matures. Once a company is “producing capital,” or generating more earnings than it can profitably reinvest, the value of a retained dollar quickly falls below par. For companies with the highest credit strength, as represented by having a commercial paper program, balance-sheet cash is worth less than half its face value.
Permanently Reinvested Earnings
The buildup of offshore corporate cash accelerated after 2004’s Homeland Investment Act, which allowed a one-time repatriation of permanently reinvested earnings (PRE) at a reduced tax rate. Since that time many corporations with foreign earnings have continued to accumulate so-called “trapped” cash.
In 2014 we studied valuations of high-cash, global corporations in the technology, biotech and pharmaceutical sectors. The figure below gives the results of a multifactor regression analysis that explains changes in market capitalization for those firms. (Click on the image to view a larger version.) The results line up squarely with the life-cycle findings above. For those companies — each one highly profitable, mature and with easy access to external capital — an additional dollar of cash may only be valued by shareholders at $0.55.
What Explains Market Capitalization/Assets?
Like the earlier studies, this one doesn’t differentiate between on- and offshore cash: companies have only recently begun to disclose this information, so a more detailed study will have to wait. However we did test one factor, effective tax rate, which provides an early look. Controlling for other factors, companies with higher effective tax rates enjoy a higher valuation multiple. A possible explanation is that investors anticipate lower tax leakage for such firms if and when they decide to repatriate the PRE.
Advice for CFOs
A clear understanding of both the benefits and costs of additional balance-sheet cash helps guide decision-making about appropriate levels of liquidity in the capital structure.
First, investors in large, mature companies don’t want their management teams acting as cash managers. “Stick to the knitting” and follow Mr. Graham’s advice. Second, time is of the essence: investors benefit when surplus capital is returned swiftly. That allows them to redeploy it in equity-type investments, rather than in money markets. Third, consider the downside of leaving cash trapped offshore. If shareholders discount idle cash by 45%, it might be better to repatriate and distribute the cash, even if it costs upwards of 35% in tax leakage to do so.
Finally, If your company is small, unprofitable and with only limited or costly access to external capital raises, then cash is precious: the value of each extra dollar on the balance sheet can be $1.30 or higher. In those, circumstances hold on tightly to retained earnings, and consider taking advantage of today’s generationally low debt costs to enhance financial flexibility.
Hans Tallis is a managing director in the corporate finance group at Wells Fargo Securities, and an adjunct professor of finance and economics at Columbia Business School.
 Dollar values sourced from the following publications: 1: Pinkowitz, Lee F. and Rohan Williamson. “What Is a Dollar Worth? The Market Value of Cash Holdings.” Working Paper (2004). 2: Faulkender, Michael and Rong Wang. “Corporate Financial Policy and the Value of Cash.” Journal of Finance 61.4 (2006): 1957-1990. 3: Tong, Zhenxu. “Firm Diversification and the Value of Corporate Cash Holdings.” Working Paper (2008).
 Source: Capital IQ, FactSet, and Wells Fargo Securities. Population includes quarterly financials and valuations from 2001-2014 for Apple, Microsoft, Intel, Google, Oracle, Cisco, Symantec, Qualcomm, eBay, Pfizer, Merck, Bristol-Myers Squibb, Abbot, Stryker, Zimmer, Amgen, Medtronic, Becton Dickinson, & Co., and Biogen Idec.
Scale = log(Revenue in $bn).