Investors Don't Need Your Excess Cash

Back in 2006, the Corporate Executive Board's Treasury Leadership Roundtable ran analysis on the three most persistent myths surrounding how companies should organize and use their financial capital. Given the upheaval in economies around the world, CEB conducted the same research again in 2010 to see if its findings still held true.

One of the three myths in the bubble-market days of 2006 centered on the likelihood of companies turning into leveraged-buyout targets. Because this is no longer a priority for most large companies, the roundtable did no further research into this area. In the current liquidity-rich environment, however, the other two myths certainly merit further investigation:

Myth No. 1. Holding excess cash balances (beyond reasonable liquidity requirements) is inefficient and creates a drag on company valuation.

Myth No. 2. Companies optimize their cost of capital by taking on some debt, but not too much (typically around a BBB credit rating).

These qualify as perennially important topics. Finance teams are particularly concerned about their companies' capital allocation capabilities, both in terms of knowing what level of risk to take on in raising capital and in making the right decisions in deploying it.

The 2010 findings regarding Myth No. 1 are consistent with those from 2006. Companies with higher cash balances tend to have higher valuation multiples. While valuation multiples have declined and the positive relationship between excess cash and valuation multiples has weakened considerably since 2006, no evidence whatsoever suggests that excess cash places a drag on valuation multiples today.

The Downside of Borrowing

As for Myth No. 2, the weighted average cost of capital (WACC) has also experienced a noticeable decline since 2009 as liquidity continues to improve. As with our previous findings in 2006, the credit-rating sweet spot of optimal WACC lies much higher than the widely accepted BBB rating.

Both myths persist, even though the data dispelling them remain as clear now as they were then. This is significant because institutional shareholders, their bankers, and often senior managers pressure chief financial officers and other finance executives to return excess cash to investors and instead acquire capital by raising debt in the favorable capital markets.

To justify this pressure, one or more of the following three basic arguments are used: a) Not returning cash is bad for the firm's stock price; b) "our competitors are returning cash;" and c) money should be in the pockets of the firm's owners. Such blanket rules do little to boost a firm's long-term growth prospects and therefore do not always benefit investors.

Furthermore, CEB research on companies—including the most successful ones of the past 20 years—shows that this point in the economic cycle is a crucial time to invest in long-term growth projects. Now more than ever, finance managers should think critically about what to with their cash. They should consider stress-testing their capital-structure scenarios against their company's long-term strategy.

After all, there is no better way to increase company valuation than to ensure long-term profitable growth.