Investors Don’t Need Your Excess Cash
In 2006, Michael Griffin, Brian Tsui, and I ran analysis for Treasury Leadership Roundtable (TLR) members on the three most persistent myths about how companies should organize and use their financial capital. We’ve had numerous requests since then to update the data and see if it still holds true.
One of the three myths in those bubble-market days of 2006 centered on the likelihood of companies becoming leveraged buyout targets but, as this is not a member priority in today’s market, we did not investigate further. In the current liquidity rich environment, however, the other two myths are certainly worth further investigation. They are:
- Holding excess cash balances (beyond reasonable liquidity requirements) is inefficient and/or creates a drag on company valuation.
- Companies optimize their cost of capital by taking on some debt, but not too much (typically around a BBB credit rating).
Not only are these perennially important topics to tackle but, as our executive advisors out in the field tell us, finance teams are still highly concerned about their firms’ capital allocation capabilities – both in terms of knowing what level of risk to take on in raising capital and in making the right decisions in deploying it.
The Two Myths
Our 2010 findings are consistent with 2006. We still find that companies with higher cash balances tend to have higher valuation multiples. While the valuation multiples have declined and the positive relationship between excess cash and valuation multiples has weakened considerably since 2006, it is abundantly clear that there is still no evidence that suggests excess cash places a drag on valuation multiples today.
Weighted average cost of capital (WACC) has also experienced a noticeable decline since 2009 as liquidity continues to improve. And, similar to our previous findings in 2006, the credit rating sweet spot of optimal WACC lies much higher than the widely accepted BBB rating.
Our Advice to Finance Teams
Both these myths, however, still persist as strongly now as they did four years ago, even though the data dispelling them is as clear now as it was then. This is an interesting point because CFOs and other finance executives are continually under pressure from institutional shareholders, their bankers, and often senior managers to return excess cash to investors and acquire capital by raising debt, given the favorable capital markets.
This pressure is often justified by one or more of three basic arguments: because not returning cash is bad for the firm’s stock price; because, “our competitors are returning cash”; or because of the more basic fact that the money should be in the pockets of the firm’s owners. Our advice has been (and remains) that a blanket rule like this is not helpful to a firm’s long-term growth prospects, and therefore not always good for investors. This recent CEB Views exchange highlights some of the arguments.
Compounding this is the fact that our work on the most successful firms of the past 20 years shows that this point in the economic cycle is an incredibly important time to invest in long-term growth projects. So, now more than ever, finance managers should be thinking critically about what to with their cash, and stress testing their capital structure scenarios against their firm’s long term strategy.
After all, there is no better way to increase company valuation than long-term profitable growth.
Please leave a comment or contact me if you want to discuss this further. TLR members can use our ForecastWorks tools to test multiple capital structure scenarios at no extra cost; and so can CFO Executive Board members.