Frank Voisin is a value investor and independent analyst whose site, Frankly Speaking, contains Frank’s investment theses as well as educational material to help investors avoid value traps. Subscribe to Frank’s feed here.
Professor Aswath Damodaran from NYU’s Stern School of Business tackled the popular notion that companies are holding too much cash. These arguments have been increasing in the media in the wake of the massive cost cutting done throughout the Great Recession which, now that revenues are growing again, is resulting in ever-increasing cash balances (in the aggregate) on corporate balance sheets.
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Damodaran argues that it is improper to say that companies like Apple, by having massive cash balances earning less than the company’s cost of capital, are “leaving money on the table”. The proper discount rate is not the company’s cost of capital, but instead the discount rate associated with that “project”, namely the interest rate on the cash, which makes cash a neutral investment, by definition.
No investor in a company is ever hurt by cash being invested in low return, riskless assets (commercial paper, treasury bills). What investors should worry about is what the company may do with the cash: take bad investments or overpay with acquisitions. I would rather that the cash earn 0.16% in T.Bills than be invested in projects earning 6%, if the cost of capital for those projects is 9%.
To make a judgment on whether to attach a “stupidity discount” to cash, investors should look at a company’s track record. They should discount cash balances in the hands of companies that have a history of over reacting, poor investments and bad acquisitions. They should not discount cash balances in the hands of companies where managers are selective in their investments and have earned high returns (on both projects and for their investors).
Damodaran even has an academic study he authored on the subject: Dealing with Cash, Cross Holdings and Other Non-Operating Assets: Approaches and Implications.