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.
Imagine a tech company with US$30 billion in government bonds. Would we value that portfolio at $30 billion? No, because it’s not clear what the company will do with that cash and bond pile
This approach would be effective if dealing with tech giants (and other cash-rich businesses) that were sitting solely on a large stack of government bonds. Some assume that such companies are invested entirely in these risk-free assets, which is, sad to say, an over-simplification. Tech companies have ventured well beyond riskless government bonds in terms of asset allocation, and that makes matters much more complicated.
Imagine a tech company with US$30 billion (£22.8 billion) in government bonds. Would we value that portfolio at $30 billion? No, because it’s not clear what the company will do with that cash and bond pile. It could invest some of it in companies – showing a negative net rate of return – believing them to be exciting start-ups with a great future. Or, more prosaically, it may just be making a bad investment decision. Tax issues could be another reason why a tech company has large-scale holdings of government bonds.
That there is such a huge cash pile, which may be worth less than its face value, inevitably draws criticism from activist investors. In what may be named the “Carl Icahn view” – after the corporate raider who asset-stripped the airline TWA following a hostile takeover – much of this money is being wasted. It’s being invested in low-yield government bonds and in projects with low or negative rates of return.
In this old-school way of thinking, the money should be given back to its rightful owners – the shareholders. And in the 1980s and 1990s, it may well have been.
But a modern giant tech company may say that cash-rich companies are able to “hold their breath” longer than anyone else in a price war. The cash pile, therefore, has an asset value above and beyond its financial worth. That surplus also allows tech companies to buy potentially disruptive newcomers. We have seen this with Facebook’s acquisition of both Instagram and WhatsApp, although Yahoo!’s less profitable purchase of Tumblr is proof that this strategy doesn’t always work.
In short, the counter-argument to the old school is that this financial cushion is part and parcel of value creation on the operating side. You can’t separate operating assets and financial assets.
American novelist F. Scott Fitzgerald famously declared that the very rich “are different” from the rest of us. The same can be said of cash-rich companies in relation to traditional businesses
So, back to valuations. Putting a strategic value on showing your competitors that your business is here to stay is tricky – but it’s important to try. We can do a scenario analysis and make our assumptions explicit to arrive at some sort of value. The objective is an internally consistent algorithm and our process is disciplined by comparing with other valuations.
I stress once again that this approach is valid for any cash-rich business, not solely those in the tech sector. But it’s interesting to ask why such companies seem to accumulate so much cash and so little debt.
First, and perhaps most obviously, they are extremely profitable – or rather perhaps, those that break through into profit tend to generate large surpluses. Furthermore, their management teams place great value on ensuring the business is a long- term player. Additionally, they have, in general, been clever in mitigating the fiscal consequences for such a portfolio by using good tax planning.
American novelist F. Scott Fitzgerald famously declared that the very rich “are different” from the rest of us. The same can be said of cash-rich companies in relation to traditional businesses. Putting a value on their financial and operating assets requires new tools and thought habirs. It’s a challenge, but one to which we can rise.
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