Cash Balances In Valuations

Cash Balances In Valuations

A firm’s cash balance is an essential parameter in business valuations. Cash is riskless when invested in bank deposits and is helpful when companies face a liquidity crunch due to poor earnings in a particular year. However, when companies have substantial cash balances over what is needed, investors demand that companies return this excess cash as #dividends or #buybacks.

In many cases, investors discount the value of the companies when they have excess #cashbalances. However, I believe this discount applies when companies use this excess cash in acquisitions or market expansion, where returns earned on these investments are less than the cost of capital. Therefore, companies with a track record of investing excess cash in high-growth areas/markets that generate returns much higher than the cost of money should not face a discount in their valuation. In addition, in my view, excess cash gives the company flexibility (an option) for growth initiatives rather than debt/equity issuances. However, the value of that option gets embedded in the investments made and the returns earned by the company.