S&P 500 cash hoards are playing havoc with measures of valuation

NOV 19, 20152:26 PM

[NEW YORK] Having extra money around is nice in a pinch. But it also doesn't earn anything, and that can make it hard to value companies with big piles of cash.

Analysts with Credit Suisse Group AG estimate that one measure of financial health for US large caps, return on invested capital, would be about 4 percentage points higher if not for the US$1.5 trillion of cash they've stashed in their balance sheets. The problem is simple: if you raise US$1 million and only spend US$500,000 on factories, your return is still judged against the original million.

Why does this matter? According to a note from the Zurich-based bank, when cash is obscuring profitability to the degree it is now, it also distorts valuation, making companies seem more expensive than they really are. Credit Suisse estimates that when excess cash is stripped out, stocks today go from the 80th percentile of priciness to roughly the historical average.

"Without 'excess cash,' the US market is producing near all-time high returns on capital with average valuations," analysts led by David Rones wrote in a report titled "The Cash Conundrum - Too much of a good thing?"

"With it, returns on capital have been stagnant for a decade and valuation multiples are far more extended." Curing the problem is easier said than done, the analysts wrote. Even after handing out almost US$5 trillion in buybacks and dividends since 2009, companies are still bathing in excess money - with a lot of it languishing overseas, where repatriation would be costly.

"For cash that is truly inaccessible to shareholders (or only accessible at a significant penalty), operating and valuation metrics are probably best assessed including the excess cash," they wrote.

Discussions of valuations and cash use are getting louder. In a global survey of money managers released by Bank of America Corp. this week, a record proportion of respondents said US equities are overvalued relative to the rest of the world, and more than half demanded firms raise capital spending.

Excess cash, or cash that exceeds the amount needed to cover short-term liquidity needs, now represents almost 10 per cent of corporate invested capital, compared to less than 5 per cent 20 years ago, data on 1,000 largest companies compiled by Credit Suisse show.

Analysts including Mr Rones use a suite of proprietary valuation tools to eliminate the impact of accounting variables and focus on cash flows. Using those, they calculate a return on capital of about 14 per cent last year when excess cash is eliminated - compared with 10 per cent when it's included.

"Cash is much less productive than other assets" such as plants or research and development, Mr Rones said in a phone interview.

"When you take that cash and consider its value as the reflection of the amount of earnings and cash flow it's going to generate, it's expensive because it's increasing the size of the business but providing little economic benefit."

At 18.6 times earnings, the Standard & Poor's 500 Index trades at a multiple that's 13 percent above its 10-year average, data compiled by Bloomberg show.

A higher multiple not only reflects rising cash levels, but also a decline in debt, according to Aswath Damodaran, a finance professor at New York University. At the end of last year, cash holdings at non-financial companies amounted to 7.3 per cent of their market value, higher than the median 7.2 per cent since 1962, his data show. At the same time, debt as a per cent of value fell to 24 per cent from 28 per cent.

"A low PE ratio can be indicative of cheapness, but it can also be the result of high debt ratios and low or no cash holdings," Mr Damodaran wrote in a June blog.

"Conversely, a high PE ratio can point to over priced stocks, but it can be caused by high cash balances and low debt ratios."

BLOOMBERG