Can you imagine cash being a drag on your personal worth? Not likely. Yet in the world of investing in growth-oriented equities, too much cash can be a valuation problem. Analysts seem comfortable backing out cash per share from a stock's current value to illuminate how additionally cheap a stock is. My market experience suggests this analysis of cash is often too optimistic, and a more skeptical approach would steer investors away from potential value traps, or deteriorating business outlooks.
Cash and cash equivalents are traditionally highest amongst the rapidly changing technology industry: Apple (AAPL, $81 billion), Microsoft (MSFT, $52 billion) and Cisco (CSCO, $44 billion) are good examples. The positive attributes of balance-sheet strength and substantial free cash flow generation are balanced, however, against a number of potentially value diluting uses of this cash. Let's look at a few.
While a yield-oriented investor's primary concern is the stability and growth of a dividend, a growth-equity investor's main consideration is the capital appreciation derived from the vibrancy of the core business. In that pursuit, mounting cash balances have become a signal to the market that the rate of return of internal cash deployment may be declining and/or that industry competition is accelerating and the balance sheet may draw down to protect a franchise. In either case, these perceived market signals often force a discounting of a dollar of cash on a balance sheet to a dollar in stock value.
Investor concern centered on these issues is grounded in historical market experience. While dividends can be an important component of a stock's long-term total return, the transition to paying one, as Microsoft did in 2003, can be met with concern about the declining future growth potential from the company's primary business. This concern was directly translated into price-to-earnings multiple compression that is as relevant a return consideration as the dividend.
The record of successful mergers and acquisitions across all industries is mixed at best, but particularly difficult in technology companies that have often built success from the bold vision of an individual or a small team of innovators -- Apple, Google (GOOG) and Microsoft certainly are examples of this. How do you successfully merge an organizations with such an embedded culture related to a founder into another? It's possible, sure. Probable? No. Yet, with mounting cash balances, the pressure to make an ill-suited or timed M&A transaction is high. This disruptive risk also serves to discount the value of cash balances.
Apple's new spaceship campus design and Google's growing investment in solar farms, while small, also stand as current examples of the potential uses of cash in less than shareholder-friendly ways. Another candidate for cash use includes stock buybacks, which in the technology industry are often a negating force to the dilution from employee stock options. Interestingly, Barron's recently featured a column on the risks associated with cash held overseas. With so much of Apple, Microsoft, Cisco and other corporations' cash held overseas, these balances and cash-equivalent holdings could be worth significantly less if the euro falls apart.
While not an exhaustive review of the potential uses of corporate cash balances, these points are meant to bring a critical eye to the value of cash as a key component of an undervaluation argument for a stock. My experience suggests putting less emphasis on this often-lauded basis and, instead, placing the majority of your attention on the sustainability and predictability of a company's core business.