This is an extension of some discussions I’ve been having and some blogs I had recently written on inflation and bonds. Because as you think about inflation and investment returns, you inevitably come to a point where the discussion turns to the cash on corporate balance sheets. I was going to put up some charts based on the Federal Reserve’s Flow of Funds data but thanks to Google, the Trader’s Narrative and the good folks at the Financial Times, I don’t have to (click here for the video). But let’s take a look at some of these charts to tee this up:
Indeed, this view shows there’s a record amount of cash available. But when you look at it on a debt-adjusted basis…
Not so massive a pile now, is it?
Share buybacks seem to be the most obvious use of the excess cash at the moment. And with good reason. The prospects for future growth don’t look particularly good at the moment. So if you were going to do fundamental analysis of equities right now via a dividend discounting model (let’s use the Gordon Growth Model as an example):
Your denominator gets larger as the spread between required rates of return and growth rates expand. And as a result, the valuation for the stock is lower. If this sounds like a bearish case based on fundamental analysis, it is. How do you boost the price in this event? Simple: demand a lower rate of return. Good luck in getting your investors to go along with that.
But let’s try to take this train of thought and think strategically. If you’re a corporate Treasurer or CFO and view the economy and your business the same way, that means you would be expecting P/E multiple compression: prices fall while earnings level off and growth rates turn anemic. All of which leads to an interesting question: why do a buyback now if you can get more bang for the buck later? The case could be made for saving some dry powder.
As always, feel free to leave a well-reasoned, on point comment.
Deep Thoughts by Professor Pinch 
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I’m throwing lemons into your argument. I won’t feel bad if you delete this. You asked, “Why do a buyback now when you can get more bang for your buck later?” Answer: Depends on the the variance of cash flows between industries. “owner’s in industries where asymmetry of information is large (fast growth, a lot of R&D, high tech) will retain larger fraction of equity than industries with little asymmetry of information (steel and foods). Conversely, owners in industries where the variance of cash flows is relatively large and sensitive to business cycles (construction) will retain small fraction of equity than those where variance of cash flows is small (regulated, gas, telecom). Source: http://www.tau.ac.il/~spiegel/teaching/corpfin/Topic4.pdf
You bring up a good point. Cash flows across industries/sectors don’t respond the same way at the same time in the economic cycle. So throwing lemons, rotten vegetation (a la William Wallace in Braveheart) and other substances at my theorizing is something I don’t shy away from.
Just keep it classy and don’t throw any flaming bags at me or my doorstep and we’ll be good.
Hey there, I like where your piece is headed. In the last few weeks there has been an increasing buzz about the cash on corp balance sheets.
A few points I’d like to add:
1) The second chart doesn’t tell the whole story. It shows cash as a percentage of debt. The absolute cash looks like it has grown tremendously. A more complete picture would be cash/net debt. But one could suppose that this is just details.
2) Comparing cash to market cap might also be good, as this would show the markets thoughts on growth rates. I agree that if there is slower growth ahead, it might pay to wait. Obviously we don’t know, but have some good guesses.
3) Spreads between credit and equities (measures, say, as free cash flow to equity yields) seem quite wide. This loops in market cap from above, but more importantly shows how little cash is worth. Risk free rates at current low rates, plus combined with whatever corp spread, make it attractive to be levered.
4) The above charts are in aggregate. Some sectors, say like technology, have companies that are arguably underlevered/overcashed. I don’t know what Google, Apple, Microsoft, and Intel will do with all their cash, but if they’ve got a sense that their stock is cheap, buy it. It just might be a better yield than whatever the corporate treasury currently owns.
5) Finally, the equities might already factor in the slow growth, so even if the economics come in weaker in future periods, it may not be a bad time to do buybacks. (This is more a market timing call vs. anything else.) These programs take time to implement. Highly unlikely they’ll bottom tick their own stock.
Anyway, great stuff. Love the food for thought.
I wish I had the discipline to blog. Anyway, looking forward to your next post.
Thanks. Lots of valid points and some pretty neat ideas. Maybe one of these days I’ll have time to implement one or two 😉
I’m more concerned that firms are doing buybacks in the first place!
See http://www.businessweek.com/investor/content/mar2010/pi20100331_243638.htm among a relatively large body of work criticizing buybacks as an efficient use of cash.
Have to say I agree especially when you relate cash to debt. I don’t think it’s a *good* use of cash but I do think it’s the most likely at this stage.
Which, in my view, is short-sighted, given the amount of debt coming due over the next three years.
Do not trade stocks so my view is that as an amateur. Maybe stock buy backs are for marketing purposes. Stock buybacks limit supply forcing prices to increases. Everyone wanting to be a cool kid. This happens in futures with the buy gas in summer and buy natural gas in winter. It makes a logical leap.
Ana_lyst the only job of a company is to increase stock price. It is their fudiciary responsibility.