When a Dollar May Not be a Dollar: The Value of Surplus Cash

Many students of security analysis believe that valuing “surplus cash” on a company’s balance sheet is an easy task. Just add the nominal value of the surplus cash to the value of the operating business derived from some other method like DCF. Alternatively, take the market value of the firm and deduct the nominal value of surplus cash to arrive at market’s assessment of the fair value of firm’s operating business – called Enterprise Value (EV).

In other words, surplus cash can simply be added to the the fair value of the business estimated by the analyst to arrive at value of firm or it can be deducted from its market value to arrive at EV.

After all, a dollar is worth a dollar, no more, and no less. Isn’t it?

Is it?

Using the idea of “dollar auction,” I have, over the last 11  years, routinely auctioned Rs 100-notes for as high as Rs 600 in my class. The red-faced winning bidder at the end of each such auction becomes the laughing stock for his/her classmates.

How can educated students value a currency note for more than its nominal value? The dollar auction game combines several psychological tendencies such as envy, deprival super reaction, low contrast effect, reciprocity, and social proof, resulting in a comical illustration of the prisoner’s dilemma again and again in my classroom. Under certain circumstances, as the dollar auction game shows, its rational for an individual to overpay for a Rs 100 note.

What about other situations where the nominal value of surplus cash residing on a company’s balance sheet differs from its fair value? While accountants and auditors would prefer to use nominal value (for them, its better to be precisely wrong than to be approximately right), we, as security analysts must consider the possibility that sometimes, or maybe even often, a dollar is not really worth a dollar.

So, what are the general principles to keep in mind while valuing surplus cash?

First, know what is surplus and what’s not. Money lying in bank accounts or mutual funds, but which are provided by customers (see advance from customers and/or deposits on the liabilities side of the balance sheet) are not surplus. This “other people’s money” is not surplus to the needs of the business. “Surplus” means that if you take it out, you don’t have to replace it. You can’t take out money taken from customers as advances without feeling the need to inject it back in the business. Although there are huge advantages of holding this type of “other people’s money” (that’s the subject matter of a future post), such advantages do not convert operating cash to surplus cash. For example, at this time, cash on the balance sheets of companies like EIL or BEL is not necessarily surplus because of large advances from customers as source of that cash.

Similarly, cash in some seasonal businesses may be surplus in lean seasons but required for conducting business for busy seasons. Such cash must not be treated as surplus even if the balance sheet date happens to lie in a lean season.

Second, other things remaining the same, a $100 bill in the hands of a value creator is worth more than $100 to his investors. Conversely, the same $100 is worth less than $100 in the hands of a value destroyer. Be wary of cash on the balance sheet of companies which have a demonstrated track record of value destructive allocation-of-capital decisions (primarily dividend policy, acquisitions, expansion, and  diversifications).

Capital allocation skills matter.

Third, other things remaining the same, a $100 bill in the hands of scoundrel is worth less than $100 to his investors. Conversely, the same $ 100 is worth more than $100 in the hands of the honest manager. Be wary of cash on the balance sheets of companies run by crooks. Cash on Infosys’ balance sheet is worth more than cash on Aftek’s balance sheet.

Corporate governance matters.

Fourth, the further the cash is kept from the investor who has to put a value on it, the less valuable it becomes to him. This happens, for example, in the cash of holding companies which have subsidiaries which have subsidiaries which have the cash. In other words, the closer the cash resides near the pockets of the investors, the closer to it’s nominal value, should be its fair value to investors, other things remaining the same.

Distance from the owners matters.

Those, then are the general principles I think about when I think about surplus cash.

15 thoughts on “When a Dollar May Not be a Dollar: The Value of Surplus Cash”

  1. Professor, it’s always delightful to hear how you think about a specific aspect of analysis. I too have observed numerous people incorporating cash into their calculations of value, and have often been intrigued by their comfort levels of just stick to the ‘formulae’ they’ve been handed and not really thinking about each of those steps and their applicability in a particular situation.

    Many of the points you’ve raised have also been points I have given a lot of thought to, but have not always been able to arrive at satisfactory conclusions. So I read your post with keen interest.

    Some follow-up questions –

    1) You spoke about adjusting the surplus cash for seasonal fluctuations in the company’s requirements of cash. I find this quite a difficult thing to do. That’s because the detailed balance sheet is available only once a year, at year end in the annual report. The summary balance sheet available every six months is often too abbreviated to be able to decipher actual surplus cash levels. How do you solve this problem of adjusting surplus cash for seasonal requirements?

    2) Why would it be important to more aggressively discount cash lying with the subsidiary’s subsidiary of a company? Is it because of the multiple layers of dividend distribution taxes that will erode the cash if it has to be repatriated first through the hierarchies of the numerous parent companies and finally to the investor? Or are there any other considerations involved?

    3) Sometimes cash is found lying in instruments where the very nature of the instruments make one wonder whether otherwise seemingly surplus-cash can actually be counted as surplus cash. For example, Divyashakti Granites’s FY11 balance sheet had Rs 8.5 cr lying in an E.E.F.C (Exchange Earners’ Foreign Currency) Account. This is like a current account in the sense that the company earns no interest on such an account. Looking at the rest of the balance sheet, it looks like this is surplus cash. But in light of the fact that the company has chosen to keep the money in a current account, should one still consider it as surplus? Rs 8.5 crs is material for the company as its market cap has been ranging Rs 22 crs.

    1. Thanks.

      My response to:

      1) Merely because its difficult doesn’t make it unnecessary :-). If you know the business is seasonal, then would it not be prudent to assume cash as not permanently surplus i.e. treat it as an operating asset. Such prudence will ensure that you don’t conclude a business to be cheaper than it really it.

      2) This in consistent with Graham’s philosophy to distrusting holding company structure. See “unsuitability as a type of complication” on page 646 of 3rd edition of Security Analysis in which Graham writes about unsuitable corporate setups which include holding companies, companies with large cash holdings, diversified conglomerates, closed-ended mutual funds, and companies of all common-stock-type in an enterprise where a substantial amount of senior capital is needed to create an adequate earning power for the common. Elsewhere he has specifically talked about using corporate pyramiding to alienate minority stockholders from their wealth by inserting several layers of holding companies and subs between the stockholder and his property.

      3) Money may be lying in an interest bearing account or non-intrest bearing account. After all the balance sheet is just a snapshot of a moment in time. The money may have moved from a non-interest bearing account to an interest bearing one a day after the balance sheet is drawn up but you won’t get to know about this transfer. It’s a good question to ask however, as to why the money which is surplus, lying in a non interest bearing account. To determine of the cash is surplus, you must think of the consequences of its withdrawal from the company. If the business begs to return it, then it wasn’t surplus in the first place.

      1. Dollar Auction is a killer..GOD !!

        2) even Enron was full of cash..( was a holding company )
        on distance from owners matters : why so ? … of course Graham and you have explained it but i don’t have 3’rd edition ( i have sixth’s e-book ) under which topic it is covered ?
        so as Taha ( Hi !! ) asked dividend tax isn’t an issue ? ( or i don’t know that inter-company dividends are not taxed.)

        looking at R power they have provided debt to their own subsidiaries ( if i am not wrong ) #goodstructure? … what do you think of tax issue on it as in manner how it will hamper the free cash flow at the end of the day. ( you being a fantastic authority)

        good night !!

        PS “garmi bahut hai”

  2. Sir,

    Nice thoughts. Thanks for enlightening.
    I have always wondered why some companies hold cash in FDs/current accounts where others are invested in fixed income funds….is there any difference in valuing these? Also, I notice that several monopolies have cash in CA/FDs and not have them invested in long term instruments. Is there a reason for this?

  3. Sir, Some more details on how to think about surplus cash would be really helpful. For example, since you mentioned EIL in your post, so looking at the cash balance at the end of FY2011 – INR 1,798 cr. If this is not surplus cash and is actually advances from customers, then it should show up in current liabilities. So looking at details of current liabilities:

    Sundry creditors INR 309 cr.
    Sundry deposits INR 151 cr
    Advances INR 887 cr
    Service tax payable INR 26 cr
    Other liabilities INR 170 cr

    So the advances from customers and deposits adds up to – INR 1,038 cr. (151+887)

    So the surplus cash should then be 1,978-1,038 = INR 760 cr.

    Is this the right way of thinking about surplus cash ?

    1. Yes, with a caveat.

      If the float (deposits + advances) is permanent, and since its non interest bearing, its fair value on EIL’s books will be below its book value. So if you replace book value of float with its fair value in your equation for estimating surplus cash, the value of surplus cash will rise.

      Also, you should use FY12 figures, which can be obtained from:

      Click to access Engineers_India_Ltd_280512.pdf


  4. Dear Professor, i would like to see one article from you primarily referring to dividends, what is their scope in buying a stock n its importance in various aspects, n in different situations of various companies

  5. Hello Sir,

    Would not it be prudent to deduct the entire Current Liabilities from Cash balance to check the surplus cash (on principles of conservatism). This will ensure that I have deducted all advances from customers as well. Also, should the Long Term debt be also reduced to derive the Value of Surplus Cash… as your definition speaks of Surplus cash being one which does not need to be replaced once taken out. Hence theoretically, one must exclude the both Debt as well as Curr. Liab. to arrive at surplus Cash. I understand that I am ignoring the money generated from Debtors and inventories to repay Curr Liab. But, Surplus Cash is something which is left over after replaying all your liabilities, whether short or long term. Am i right?. Regards Ronak.

  6. Also for businesses which hoard some cash in their balance sheet as a fall back option for adverse periods (prudent managers do it for cyclical businesses in my view) irrespective of the stage in the business cycle/season has to be assumed a part of Invested capital and also in valuations if one were to look at the firm as a going concern. This cash typically looks “unencumbered” for the untrained eye.

  7. Dear Fundoo Professor, post carrying out due diligence on the type of cash holdings maintained by various companies, I tend believe that there is no true “Surplus Cash” for a growing company in India. The reason being on umpteen occassions, I find that the cash sitting in fixed deposit with banks are actually the margin money the company has to keep to obtain various non-cash financing facilities like Bank Guarantees, Letter of Credits etc which remain outstanding for long periods of time. This is especially true for import dependent companies and companies in infrastructure/ construction space. However, your treatment of customer advance & deposit is new insight to me and I will try to incorporate it in my work. Regards,

Comments are closed.