It may sound odd to hear that valuing cash-rich businesses with minimal debt presents a greater challenge than companies with proportionately – often in straight cash terms – fewer financial assets and higher borrowings. Surely the matter should be more straightforward: a case of totting up the net cash balance and arriving at a figure? If only it were that simple.
To understand why it’s not, let’s look at the traditional corporate finance exam sat by MBA students. In such exams, candidates are typically asked to value and assess the asset-risk characteristics of companies with debt in their financial structure. The conventional manufacturing company would have a large pool of operating assets and some negligible financial assets, with liabilities comprising equity and debt. Assets should equal debt and equity on a market-value basis. Debt would usually comprise a relatively large portion of the financial apparatus.
It is a very different story for untypical cash-rich companies, which usually have very large financial assets (called “cash” but actually portfolios of bonds and other assets). The liability side is also different. There is negligible debt, if any.
At this stage it’s important to make clear that the challenges of valuing such companies apply regardless of the industry they’re in. Any tendency to cite tech companies as examples shouldn’t be interpreted as this just being a discussion about newer, digital corporations. However, such companies crop up time and again in MBA-type exercises, and students accustomed to valuing traditional manufacturing companies balk at applying a conventional formula to tech businesses. They feel uncomfortable because such companies have different financial structures.
In principle, the conventional valuation techniques ought to work. The standard procedure is this: if you know the risk characteristics of the financial portfolio, you can assess the risk characteristics of their operating assets.