Cash in hand –The double edged Sword

Fifteen years back
Me: Mummy, I need ten Rupees to buy Cadbury Diary Milk…
Mom :( After series of questions and negotiations): Ok, I’ll give you five Rupees dear…

Today...
Me: Mom, I need five hundred Rupees (I haven’t mentioned why do I need it)
Mom :( Without any further questioning brings the money from the safe): Is five hundred enough or do you need more??
Me:!!!

This analogy can be interpreted in different ways from a market perspective. This can be seen in the light of a startup company asking for funds and even though the business idea may be genuine the funds may be rejected and in the case of a big matured company investors fear to question the management. But in this article I would wish to see this from the perspective of the market perception of ‘cash in hand’ with some of the companies.

Before that I would wish to give you some technical background on this front. A company, out of its earnings every year, retains some of the amount for its reinvestment needs and gives out some of them as dividend. But company need not use the entire undistributed dividend for its reinvestment purpose. It can have some free cash in the balance sheet. We have a terminology in Valuation called as FCFE – Free cash flows to equity. Free cash flows to equity is the free cash available with the company after meeting every conceivable reinvestment needs .This is the potential dividend which can be given to the shareholders .(If you are so technically inclined , the formula for FCFE is Net Income – (Capex-Dep) – (Change in Non cash working capital) )*..
But companies don’t distribute the potential dividends every time. They distribute only 50-60% of this amount as dividends...What happens to the remaining amount...They get into the balance sheet of the companies as (excess) cash...This cash gets on piling up year after year...If you go and ask the CFO of a firm which is piling up such huge cash his response would be “We have strategic growth plans…We are looking for potential acquisitions.In a couple of years we may be needing this cash for that acquisition” or “(Assuming a non recessionary environment) – You never know, when will the economy be hit by recession..So we are basically saving it for the rainy day!!” – To certain extent the arguments could be justified and they are reasonable.

Now let us come to the main point of contention.When some firms have such a huge cash balance in their balance sheet, how do you value them...”Hey wait.Whats the big deal in valuing cash – Ten Rupees in cash is going to be valued as ten Rupees..What big deal about it”...Nope…, Assume that your company was giving you a returns of 15% in the past (In technical parlance ROE=15%)..You were also happy that you are earning good returns. But the company was piling up huge cash on its balance sheet by not giving dividends to the investors...After a few years, analysts start questioning the reason for pile up of such huge cash...Now the company to save its ego, acquires a totally unrelated business and the Strategy head gives a justification in terms of diversification of the business…Five years later, the company finds itself In a difficult position..The return of 15% has now reduced to 13% as the new business has started to erode shareholder value. The company finally realizes its mistake and divests that particular business…
Now the same company, if it starts piling up cash in the balance sheet, how is it going to be viewed by the investor..?Is he going to value that cash in the balance sheet at par value? He will not do..Right??.His reason for worry would be that ‘What If the company gets into another stupid diversification activity and loses that cash”...So in that case the cash in the hand will be viewed with skepticism and will be assigned a lower value in the market than its actual value …
Similarly if an investor observes a CISCO or Microsoft building up cash then it is going to have a positive effect as they know the cash will be utilized effectively…

Like the analogy of the son and mother that I started with, whether the investors attach a par value or above par or below par value to your cash in the balance sheet depends on the companies past credentials…”Markets are efficient dear!!”

*-Assuming completely equity funded company.