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?
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.