What Excess Cash Is Really Worth

The Value of a Common Asset: Cash

The value of excess cash varies depending upon:

The willingness of management to part with the cash.
The ability of management to use the cash wisely.
The position that a company is in relative to the industry's pricing cycle.

One of the reasons I wrote this column was to respond to a question posed by Aaron Task: Is it legitimate to deduct the cash off the balance sheet of a company, value the operations of the company without the cash and then add the cash back in? The answer is a simple one: sometimes.

Cash on the balance sheet has two uses. It can be a cushion to buffer the company from adverse economic conditions, or it can be intrinsic to the operations of the company. The trick is in determining how much cash a company needs for its operations, capital expenditure and net debt repayment, together with how much it needs to protect against moderately severe adverse economic conditions. The cash in excess of those needs potentially can be valued separately from the rest of the company.

I say "potentially" because management may not want to part with the money. In a case like Microsoft (MSFT - commentary - Cramer's Take), where management has committed to returning cash to shareholders, you can value that cash at face value. With managements that will not immediately part with the excess cash, the question of how to value excess cash is trickier.

Use It Well

My first column for RealMoney covered how to value slack in the steel group. During 2002, Nucor (NUE - commentary - Cramer's Take) possessed a balance sheet that enabled it to cruise through an era when many of its competitors died, though their memory lives on at Pension Benefit Guaranty Corp. The excess cash on Nucor's balance sheet enabled it to buy up the assets of distressed competitors when few others could. Excess cash in the hands of a good management like Nucor, in the midst of a cyclical trough, was possibly worth more than its face value. Well-capitalized firms often benefit from volatility. Poorly capitalized firms fear volatility; they don't have a cushion against adverse deviation.

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David J. Merkel, CFA, FSA, is a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. Previously, he managed corporate bonds for Dwight Asset Management. At time of publication, neither Merkel nor his fund had any positions in the securities mentioned in this column, though positions may change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. While Merkel cannot provide investment advice or recommendations, he welcomes your feedback and invites you to send your comments to [e-mail].

Analyst Certification: All of the views expressed in the report accurately reflect the personal views of the research analyst about any and all of the subject securities or issuers. No part of the compensation of the research analyst named herein was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed by the research analyst in this report.

Merkel is employed by Hovde Capital Advisors LLC (the "firm"), a registered investment advisor with its principal office located in Washington, D.C. The Firm and/or its affiliates have or may have a long or short position or holding in the securities, options on securities, or other related investments of the issuers mentioned herein.