Previously, dear reader, you and I have discovered that robotics companies are firmly entrenched in the knowledge economy and their assets look like other knowledge economy companies’s assets. Robotics companies only hold only a limited amount of real assets but lots of financial assets.
As a related question, what is the value of the cash (and financial assets) on the balance sheet to investors? There might be several issues with holding so much cash. Particularly, money in a company should be employed making more money, ‘earning or returning’ as the saying goes. Are there valid reasons to hold so much cash? And if so, how should we value the cash that knowledge economy companies hold?
Cash Is King! (Or at least a founding father)
Bottom line up-front: Valuations are always wrong. What’s interesting is how they are wrong. Assuming a dollar is worth a dollar is as good a rule as any, but is almost always wrong. Nobody is really sure which way (too much or too little) it is wrong. Below, is an elaboration of some of the issues with valuing cash which may come into play when valuing particular companies. (And you thought that at least cash of all things had a fixed value — don’t we all wish!)
There are various criticisms of excess cash on the balance sheet, below are some of the most common.
1) Holding the extra cash reduces returns, i.e. to buy into the business you have to buy a pile of cash beyond what is ‘necessary’ to run the business. Further, the rate of return on cash has been essentially zero and certainly below inflation lately, so holding the portfolio the stock represents of a highly profitable business, plus cash must necessarily produce a lower expected return than just the business.
2) Because of agency problems, management may be incentivized to use the cash to reduce volatility or ‘save’ the business if it falls on hard times, even if the investors could get a markedly higher rate of return in the market. From an investor’s point of view this would be systematically wasting money. Employees, customers, management, and trading partners might have a very different view.
3) Holding lots of cash is said to signal that the company does not have profitable investment opportunities commensurate with the cash that it is generating and the company’s growth may slow in the future. Further, holding lots of cash signals that you don’t know, or are ignoring, the traditional Anglo-Saxon business administration. English speaking investors generally expect management to maximize monetary returns over the forecasting horizon and put shareholder interests ahead of all others.
Some countervailing points that you will often hear are along the following lines.
A) Although holding cash reduces returns, for a volatile security like a fast growing knowledge economy company, having cash on the balance sheet dramatically reduces volatility. If investors want more exposure to the underlying business for the same initial investment, lever-up. Since we are talking about cash holdings, buying on margin is almost a perfect antidote to management’s lackadaisical cash management policies if you feel that way. [But seriously, who is their right mind thinks you need to lever-up when buying tech stocks?]
B) Although management might ‘burn’ cash saving a failing business, which would be better redistributed to investors, more likely, they are going to have the flexibility to engage in acquisitions and new ventures without having to deal with the whims of the security markets. [Has anyone seen a rational market lately? Please let me know.]
Or has anyone read the Wall Street Journal? Tech companies are routinely attacked for having their fixed life fund investors exit—Groupon and Facebook each got front page hatchet jobs over the past two days with nary a mention that these funds had been planning to sell now for, oh say, 8-10 years! Talk about journalistic malpractice. Would you want to go to the public markets in that environment? I sure wouldn’t. If I was management, I’d say that if investors are that irrational, I’ll keep the cash and do what they should have done with the money.
C) Finally, although cash on hand may sometimes signal that the companies are running out of investment opportunities, it certainly signals to would be competitors that the said company is in a position to stick around for a long time and bitterly contest any erosion of their market position. This may greatly enhance the value of the underlying business asset.
D) This is a successful tech company. It is run by the founders, for the founders (i.e. management). If you don’t want the privilege of investing and taking whatever returns the founders deign to give, please step aside and allow the next investor to purchase stock. But this isn’t really a justification. Founders are investors too, especially once the company goes public, with theoretically the same motivations as other investors since their stake is highly liquid.
Further research on technology companies and their cash management policies should address the following issues:
I) Are there structural reasons beyond the creation of new businesses and defense of existing businesses for technology/knowledge companies to hold lots of cash? It does not occur to me that there is anything about a maturing knowledge business that seems to require massive amounts of cash. Law firms and accounting firms do not seem to hold too much cash, but they are also typically private and can make much more drastic changes than public companies.
II) Are there frictions between the interests of various classes of investors? Particularly when there is a founder controlled/managed company, cash on the balance sheet is probably as good to them from a control perspective as cash in the bank and better from a tax perspective. Should investment banks or others creating the classes of stock have new mechanisms to deal with this?
III) What are the true limits on investment opportunities? My firsthand observation has been that the greatest constraint on growth of robotics companies is management attention. It may be that most technology companies have massively profitable investment opportunities, but management attention is engaged on current projects and hiring into the management circle is not that easy. What is the needed resource to change this? How can cash be used to obtain this resource? Can it? Is passion required?
IV) Are there ways that management could resolve some of the market frictions that require them to hold lots of cash? The public markets seem to mercilessly abuse tech companies—no they don’t look like utilities, but the highs and lows that they are pushed to seems unjustified—there just doesn’t seem to be enough new information about their future prospects to justify either one. Can management take steps to make access to public markets, particularly debt markets more reliable? Could banks make money by providing massive, typically undrawn, lines of credit that would provide much of the same protections to management?