4 mistakes when valuing companies with large cash holdings - and how to avoid them

2012-08-20 06:52 -  , Value Investing

Valuation of Cash Holdings

There exist various companies, that hold sizeable amounts of cash. I am sure you have at least some examples in your mind soon.

How to value those companies?

Multiply the estimated earnings power with a multiplier and add the cash holdings thereafter.

That or a similar approach is the way, the value of those companies is often estimated. And this approach is not completely wrong. After all, cash holdings could be paid out as dividends and therefore benefit shareholders. So you could afford to pay a higher price for a company, that holds large amounts of cash, as if there were no cash holdings.

But nevertheless there are some things, you should pay attention to, because the valuation approach mentioned above can easily lead to an overestimation of the company value.

1. Interest Income leads to double counting the value of cash holdings

Let’s begin with the least dramatic error. When estimating the earnings power of a company, one normally looks at past results. When a company hold large amounts of cash for many years, interest income of these are naturally included in the past earnings. If you now write forth past earnings into the future, you include the interest income in the calculation of the company value. If you now add cash holdings to that value, you have counted the value of the cash two times somehow. When estimating the earnings power of a company, you should therefore only count earnings, that are generated by the core business.

Why is the error you would make not that dramatic? Simply because interest for cash is very low, especially with current interest rates. The difference in the calculated company value should therefore be not that big. Especially if you take into account, that every determination of a company value can only be a rough approximation.

2. Debt?

Another issue one should pay attention to, is if the company has a considerable amount of finance debt on its balance sheet.

What is the benefit, if a company has say 10 m€ cash and at the same time 10 m€ interest bearing debt? If the company repays its debt with the cash, it is free of debt thereafter. Like a conservative investor likes it. Now the cash is naturally not available for dividends (or profitable reinvestments) any more.

It is clear that a company does not have to repay its debt. It can keep the debt and pay the cash to shareholders as dividend. But one should consider whether this is really value-creating. Isn’t a company financed with more debt worth less for shareholders, than a company with lower amounts of debt? I think yes, because debt generally increases risk. Therefore it is maybe more useful, not to view cash holdings, but only net cash. Therefore the amount of cash, that goes beyond finance debt.

3. Does the company really not need the cash for its operations?

Another question with cash holdings is: are these really not needed for the business permanently? I have ignored this question in some articles on my german blog before and was criticized by my readers legitimately.

Every company needs a certain amount of cash for its business. Mostly these are not very big in relation to the company value, so that the error one can make in the valuation might be tolerable. But in some special situations a valuation can go far wrong.

The cash holdings on the balance sheet of a company are naturally measured at a certain point in time. But does that mean, that this situation must be the same during the whole fiscal year? Maybe the inventory is excessively low at the balance sheet date because of seasonal fluctuations. Then the company might need much cash during the next year to fill up inventories to a normal level.

Also because of non-regular events a company can accumulate larger cash holdings, that are required soon again. For example during the financial crisis the following happened with some companies: Sales dropped and with them receivables. Also inventories were sometimes adjusted to lower needs. As long as the company remained profitable, the amount of available cash rised considerably. An investor who valued such a company during this period, could easily make the mistake to assume, that this cash is not needed for the business and overestimate the value of the company. Naturally, after sales reached normal levels again, the cash had to be used to increase working capital again.

4. will the cash be used wisely in the future?

Now let’s come to the last and maybe most important error one can make in valuing cash holdings of a company. If a company holds excess cash, will this be used wisely in the future? Because only then they are of value for shareholders. It is not easy to forecast those things. But maybe it is possible to risk a forecast by looking how wisely cash has been employed by the management in the past.

I will only give some some negative examples, which should lead to some scepticism about the value of the cash:

Having much cash available sometimes tempts management to aquire other businesses at a high price. Aquisitions are not generally a bad thing, but if the price is too high, shareholders of the buying company lose value and shareholders of the aquired company gain the same amount.

Also popular is, to do simply nothing, while cash holdings grow larger and larger and a meaningful use is not in sight. As long as the company delivers good results and continously raises its dividend, shareholders celebrate this as a conservative and safety conscious company policy (current example from Germany: Fielmann). As soon as results worsen or even the stock price drops, shareholders begin to become angry because of the oh so shareholder-unfriendly company policy (current example from Germany: Bijou Brigitte). Value-creating is this in neither case.

Cynics may value the cash holdings worthless in such a case and furthermore view all earnings that are not paid out as dividends immediately as non-existent. Realists may see at least some gained security for the company due to the cash holdings and see some value in them. Dreamers expect a change in the company policy soon (sometimes dreams may come true).

Conclusion

A company holding cash, that is not needed for the business itself, is definitely worth more than a company without. Important is, to estimate, which part of the cash is really excess cash. After that one must decide, how much that part is worth. This can be any number between 0 and 100% of the cash. It is not easy, to estimate this. But to simply view excess cash as worth 100% the amount of the balance sheet may be too optimistic in many cases.


Comments [1]

  1. Behavioral Investors · 2012-08-21 01:36 · #

    Good points – #4 is the most common problem at cash-rich firms, or hidden non-debt liabilities such as pensions / operating leases. Also note that during the mortgage crisis, several ostensibly cash-rich companies in fact had invested some of their total “cash and marketable securities” in auction rate securities which rapidly became illiquid. I wonder how much of the “cash” at apparently undervalued Chinese firms can really be counted on..

Commenting is closed for this article.