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Apologies in advance for separating the Costco stock valuation aisle from the ketchup, dog food, hand soap, and toilet paper (which is located in the back of the store, sir).

Roark, I follow your math, but I don't follow your logic. What's wrong with my thinking? Basically, my disagreement/confusion references the differences between the aggressive financial behavior implicit in your COST economic modeling, and COST's actual very conservative approach.

(Of course, I would appreciate other comments besides any HR's insights chooses to offer on this matter.)

Here are your two posts re COST economic returns:

http://boards.fool.com/Message.asp?mid=22738903

http://boards.fool.com/Message.asp?mid=22740971

*********

For example, Costco ended August 04 with $7.6b in equity and $1.3b in long-term debt, for roughly $9b in invested capital. It should do something more than $1.5b in EBIT this fiscal year, which should produce maybe a billion in NOPAT. Nothing special at 11%.

Okay, I follow the math and follow the logic. So far, mi comprehendo.

But it began the year with an amazing $3 billion in cash (and the interest is not included in NOPAT numbers, assuming I've gotten them right). Separate that cash that out, and suddenly Costco is investing only $6 billion of capital and producing $1 billion of NOPAT for a 16.7% return.

Costco ended FY04 in August with cash and cash equivalents representing 6.5% of their 04 annual sales. I understand the shortcut you made, for the purpose of illustration, to apply all the cash as a reduction in invested capital.

Clearly, COST has excess cash ... but how much and how should one treat it for the purposes of a ROIC calculation?

From FY1998 through FY2002, Costco's cash and equivalents ran about 2% of the year's sales ... +/- .25%. In 2003 it spiked to 3.63% and in 2004 it spiked to 6.5%.

I would suggest that at least 50% of that excess cash should be seen as permanent capital for the purposes of ROIC.

At the quarter ending May 05, COST had a cash balance of $4.05 billion. Of that balance, $626m consists of debit/credit card payment from the weekend sales prior to the quarter's end ... a little over 1% of COST's FY05 run rate. That's probably the absolute bare minimum cash needs for COST. 2% of sales may be a more acceptable number("1 week/52 weeks"), but with conservative COST, why not 3%?

COST has a $500m stock buyback program from Nov 2001, which was extended in 2004 (at that point, never utilized) up through Nov 2007. Although they purchased $47m in shares from May to June this year, combine it with a $55m quarterly dividend (recently raised), and it's difficult to see how COST can shrink that cash balance dramatically ... unless they expand operations dramatically, finish that 3 year $500m buyback program soon (and start and finish another soon), or boost the dividend big-time.

In fact cash could still be building up for the next few years (putting aside any possibility of a MSFT-style one-time dividend). Behavior in the out-years has to be dramatic to outweigh a decent discount rate in a DCF model, so ...

I'm confused. How should we treat excess cash? It seems a waste to apply a simple mullet haircut to every scalp if one has some barbering skills.

Then you have the fact that Costco owns both the land and building roughly 80% of its locations. This naturally depresses return on capital as real estate cap rates are going to be below excellent-business returns. If we assume that Costco could lease its stores like the majority of retailers and pay 8% or so, then return on capital for the core business would look a lot better than the 16.7% listed above.

Again, I follow the math but don't follow the reasoning.

True, Costco could lease it stores from third party REITs or other real estate investors. But they choose not to. Shouldn't we penalize or reward COST for their actual capital management?

Moreover, isn't COST (and others) paying 8% on store leases because their lessor is achieving acceptable cash-on-cash returns by owning a warehouse within a 65-75% LTV (loan to value) loan structure? Costco is doing the opposite (low debt, high equity) ... which is their choice.

Even if they engage in operating leases for more than 90+ of their 400+ warehouses, or conducted a sale-leaseback, such options would have left/will leave COST lots more cash on the balance sheet. So the problem returns ... and Costco's inability to reinvest cash quick enough in the business to prevent excess billions will be made even worse.

I have the same conundrum with ROIC calculations for ITT Tech (ESI). They own a lot of their schools, which depresses their return on capital. They've chosen at times to buy existing schools or construct new ones rather than purchase expensive stock, start a dividend, or grow the company faster. Really, they only seem capable of opening up X amount of schools in a given year ... at least successfully.

Perhaps COST has the same management limitations. I could absolutely plug in assumptions that management behavior will change and they will Lampert their balance sheet ... but they won't.

Well, all of this is a long-winded way of saying, Huh? As small passive investors, we can only react to management or try to predict their actions. I know in the case of Costco splitting the real estate and excess cash apple in half doesn't make a huge difference in their ROIC, but I'm really interesting in the logic of where, why and when to split the apple. There's no takeover prospect or management change on the horizon to provide a quick improvement to capital utilization.

Plus, my family left the country on vacation and I'm bored with Google Earth. I'm working and they're spending. Be a kind soul and help poor EightTrack make more money.

ET
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That's probably the absolute bare minimum cash needs for COST. 2% of sales may be a more acceptable number("1 week/52 weeks"), but with conservative COST, why not 3%?...I would suggest that at least 50% of that excess cash should be seen as permanent capital for the purposes of ROIC.

Sure, when you really run through the numbers you should charge Costco with some amount of cash they need to hold at no return to run the business - in particular the cash that doesn't sit somewhere earning a market interest rate. But I think your 50% suggestion sounds way too high. There at a lot of ways to guess at this, and only so much value in pinning the tail directly in the center...but I don't think Costco needs to keep $1.6b to run its business. In its 04 K, Costco disclosed that a 1% change in interest rates would impact interest income by $27 million based on then-current cash and investment balances. If $2.7b of the balance is invested in interest earning assets, the bulk of those balances aren't likely to be required to run the business.

Costco has long admitted that it's overcapitalized with excess cash, so the last several years don't necessarily set a floor for required cash balances. They ran the business with cash & equivalents at less than 1% of run rate revenues in the mid 90s. I think 1% of sales sounds like as good a guess as any -- anything within spitting distance still leaves you with a significantly different recent capital return picture.

In fact cash could still be building up for the next few years (putting aside any possibility of a MSFT-style one-time dividend). Behavior in the out-years has to be dramatic to outweigh a decent discount rate in a DCF model, so ...

This is very similar to your real estate comment below, but I'm a little too tired to organize my reponse sans redundancy. My general view, despite years of whining about Debs and their stupid cash build up is pretty much this: Lower returns on capital are not necessarily less valuable. As long as the cash is earning a market rate, it shouldn't lower your DCF valuation by virtue of its low returns because it's also lower risk. The problem I have when companies I own build up cash is not so much that I feel guilty charging 1 and 20 to own a bank account -- nor is it quite the typical existential-yet-too-greedy-to-discuss-Camus investor mediation of "If a tree never pays dividends, are we all worthless saps?" -- but more specifically that I'm scared management is going to do something stupid or worse and waste the cash.

My point here is that Costco keeping a bunch of cash doesn't necessarily make that cash worth less than cash, or hurt the underlying value of the business. While there is always some theoretical agency risk involved, Costco comes out on right end of the good-trustee-for-your-bank-account totem pole as far as I'm concerned. So while the cash position should, in fact, lower nominal ROIC and nominal stock appreciation, it shouldn't hurt the value of the business. Investors who want to participate in the "core" retail business only could go so far as to take a leveraged position in the stock, though maybe more realistically they could just take a more concentrated position than they otherwise would to account for the fact that part of what they are owning is uber-safe cash.

But the important thing underlying all this is that unless you allow for cash to be worth cash even if they don't pay it all out and it earns crappy but market interest rates, you are liable to undervalue the business part of the business (I did say I was tired) by misundertanding its economics. Does this mean that I would be absolutely neutral as a Costco shareholder to its amassing huge amounts of cash without paying any out? Nah. Agency risk isn't zero and a Delaware corporation isn't the most efficient tax structure for your bank account, but I personally wouldn't seriously penalize Costco valuation-wise for its cash position.

True, Costco could lease it stores from third party REITs or other real estate investors. But they choose not to. Shouldn't we penalize or reward COST for their actual capital management?...I have the same conundrum with ROIC calculations for ITT Tech (ESI). They own a lot of their schools, which depresses their return on capital. They've chosen at times to buy existing schools or construct new ones rather than purchase expensive stock, start a dividend, or grow the company faster. Really, they only seem capable of opening up X amount of schools in a given year ... at least successfully.

These points again seem to assume that owning stores reflects poor or inefficient capital management because it produces lower nominal returns on capital. But that isn't necessarily true. Owning stores, like holding cash, is yet another method of reducing risk by (among other things) reducing the debt implicit in operating leases. It's a lack of leverage and form of downside protection that ought to lower the return you'd require from actual Costco as comparaed to a Costco that leased all its stores. I don't think you need to assume the Lampertization of Costco's balance sheet to take a different view of its valuation because of its lack of lease leverage -- rather, I think the key is to understand the risk-based value differences between an already leveraged retailer and a Costco-esque retailer that doesn't show up in nominal returns on capital.

Now, I don't want to overstate what I really think here. I do think there are some benefits to being more aggressively capitalized that don't necessarily come out in the risk-adjusted wash. There's that tax deductibility of interest loophole, for one. And of course others much less dignified than myself who mark to market every day might notice that the market in standard sub-30% VIX times tends to look askance at risk adjusted capital structure but can be wooed quickly with the fruits of a good recap. Plus, there is always agency risk. I'm not trying to turn this into a thesis on the irrelevance of capital structure. But I don't think it's optimal to see the underlying returns of the business adjusted for excess capital as only valuable if there is a catalys to take the capital out of the business. While there might be some benefit to that, the much of the value already exists in the form of a safer investment.




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i know it's a minor point in the discussion, but as far as that "ROIC" cash, i just posted this on another thread:

http://boards.fool.com/Message.asp?mid=22745826

i tried the formula out using costco's latest 10-K and got 1.26% of revenue (roughly, $606,000 in operational cash). costco's CCC really helped the cause.
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HR ... thanks for the quick and thoughtful response. Really appreciate it.

The problem I have when companies I own build up cash is not so much that I feel guilty charging 1 and 20 to own a bank account -- nor is it quite the typical existential-yet-too-greedy-to-discuss-Camus investor mediation of "If a tree never pays dividends, are we all worthless saps?" -- but more specifically that I'm scared management is going to do something stupid or worse and waste the cash.

Agency risk ... misallocation of capital ... management self deception ... mauvaise foi ... Sartre ... stock get bashed like a man in an automobile accident ... Camus :)

Sève sans valeur d'arbre

ET






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As long as the cash is earning a market rate, it shouldn't lower your DCF valuation by virtue of its low returns because it's also lower risk

I don't understand. Since the cash is generating less than its Cost of Capital, mustn't this affect the DCF, or are you saying it has already hit the earnings number in your model and you don't want to double count?

confused,

Naj
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As long as the cash is earning a market rate, it shouldn't lower your DCF valuation by virtue of its low returns because it's also lower risk

I don't understand. Since the cash is generating less than its Cost of Capital, mustn't this affect the DCF, or are you saying it has already hit the earnings number in your model and you don't want to double count?


I believe what he's saying is that your aggregate discount rate for the firm should be lower than a pure-equity discount rate because you are, in effect, owning shares in a two-item entity. One of the items is the firm's operations and should be discounted at a pure-equity rate and the other item is a bank account and should be discounted at the risk-free rate.

I'm not sure how I feel about this.
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As long as the cash is earning a market rate, it shouldn't lower your DCF valuation by virtue of its low returns because it's also lower risk

I don't understand. Since the cash is generating less than its Cost of Capital, mustn't this affect the DCF, or are you saying it has already hit the earnings number in your model and you don't want to double count?


I believe what he's saying is that your aggregate discount rate for the firm should be lower than a pure-equity discount rate because you are, in effect, owning shares in a two-item entity. One of the items is the firm's operations and should be discounted at a pure-equity rate and the other item is a bank account and should be discounted at the risk-free rate.

I'm not sure how I feel about this.


That seems pretty strange to me.

Aside from the fact that I can own, by myself, a portfolio of 90% cash and 10% COST, or 50% debt and 150% COST, etc, as Roark mentioned it is tax-inefficent, right?

Also, as he also notes, the risk isn't just the Agency Risk of COST mgmt, it is that someone else will come along and buy the firm with their perhaps worthless stock waste the cash. Which seems to me that the risk would be increased right back to the pure equity rate, perhaps. [COST stock price might temporarily increase but if you don't want to hold the acquirer you have a tax issue now. Perhaps this is minor or irrelevant.]

But I disagree with Roark more because if COST's cost of capital was significantly higher, the cash should be more of a 'waste' and vice versa. Firm A and Firm B are sitting on the same amount of 'excess' cash but Firm A got it thru issuing cheap AAA-debt and Firm B had to issue expensive equity. That must affect their valuation somehow.

I guess the 'How?' is the question. But I'm deeply suspicious of those who say it has no affect, [or at least their models. :)]

Just my two cents.

Naj
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Which seems to me that the risk would be increased right back to the pure equity rate, perhaps

Well, you're entitled to think that a bank account in corporate form run by okay people has the same required return as a typical business, given agency and change of control risk. I don't think it's even close.

But I disagree with Roark more because if COST's cost of capital was significantly higher, the cash should be more of a 'waste' and vice versa.

But "cost of capital" isn't determined in a vaccum. A company that holds nothing but a bank account run by decent people doesn't have the same cost of capital as Charlotte Russe -- you don't need to calculate Beta or survey its equity investors to know that. Leverage or negative leverage significantly affects a companies cost of capital, and when you build up excess cash you are in most cases lowering your overall cost of capital, which offsets the lower return you are getting from those lower risk investments.

Discarding the jargon for minute, it seems clear, at least to me, that a Costco with a bunch of cash and and owned real estate has a much more attractive downside on average than a Costco with no cash and operating leases. You can describe this as the expected standard deviation of its stock returns or the likely covariance of its stock returns with the market return, or you can just say the investment is safer. And a safer investment is worth more than a riskier investment, all else equal. While the benefits of safety may not quite translate one for one for every dollar of capitalization added, because of tax inefficiency and agency risks, there are still enormous capitalization-based difference in risk and cost of capital.

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Leverage or negative leverage significantly affects a companies cost of capital,

A company may appear to have a high cost of capital, not because it is leveraged, but because investors in the company are leveraged. Short squeezes and margin calls can accompany a pristine corporate balance sheet.

jkm929
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A company may appear to have a high cost of capital, not because it is leveraged, but because investors in the company are leveraged. Short squeezes and margin calls can accompany a pristine corporate balance sheet.

Could you elaborate? I don't understand.
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My initial strategy would be to sneak in the thread, hiding between the differing views of two great posters (wasn't that quote 'I accomplish more by hiding behind the shoulders of giants'?).

It seems I took too long and will have to openly disclose my limitations in undestanding some aspects of a Damodarian-like valuation of cash, which at first seems quite obvious when he states that the present value of cash is cash.

It becomes easier (for me, that is) to explain/understand the issue if we contrast it to a more Buffetesque thinking and instead of thinking of a discount rate in terms of risk free, historical premiums, bottom up betas; consider it to be the required rate of return on an investment (with risks considered at the cashflow level).

A company has all this cash earning 1% at a bank, you are looking to make 10% on the investment so you get the apparent contradiction that the present value of cash is less than cash (which sounds even worse if you think in terms of risk free rates and risk premiums, instead of required rates of return). In reality all that the DCF is showing is what you should pay for tied up cash considering what you are expecting to make (and not that $1 in the bank is worth less than $1). There's an implied assumption that cash will be stuck making a sub-normal rate of return when you use a straight DCF. In my view the present value of cash is not cash when you expect to make more than what cash is yielding, specially when it's not under your control.

The major problem is that management at Costco, Microsoft and Debs have basically full control of the situation, while for someone analyzing the company it's one more impossible variable to guess. But between the assumption that excess cash will be stuck at the business forever, and the assumption that excess cash is readily available to any shareholder as implied in the cash-is-cash, probably neither is a very realistic assumption... (which just shows that I can beat anyone in repetition and redundancy even when I review my posts).

The corollary of this would be that a business with excess cash would have a different value for a small shareholder versus someone that could induce change in the company's policy (which brings an uninteresting disgression of how there's nothing intrinsic about 'intrinsic value')...

All my poorly structured post means is that while I see the advantages of separating excess cash from operations in judging performance; I can't see how doing the same thing in the valuation process properly accounts for the opportunity cost of holding high levels of cash (aren't there costs of carrying 'a loaded elephant gun', of the downside protection that cash affords, or of the easing of the fear of not meeting payroll?).

BTW, if the initial sentence sounds like a lame attempt to induce a Reciprocity like reaction it's due to the handicap of having English as a second language, not because a lack of sincerity. I always enjoy anything both of you have to say.
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Now, I don't want to overstate what I really think here. I do think there are some benefits to being more aggressively capitalized that don't necessarily come out in the risk-adjusted wash. There's that tax deductibility of interest loophole, for one. And of course others much less dignified than myself who mark to market every day might notice that the market in standard sub-30% VIX times tends to look askance at risk adjusted capital structure but can be wooed quickly with the fruits of a good recap. Plus, there is always agency risk. I'm not trying to turn this into a thesis on the irrelevance of capital structure. But I don't think it's optimal to see the underlying returns of the business adjusted for excess capital as only valuable if there is a catalys to take the capital out of the business. While there might be some benefit to that, the much of the value already exists in the form of a safer investment.

Yeah in the back of my mind I'm thinking, why would a retailer own their real estate to begin with? Owning leads to decreased returns on capital. The appreciation of the real estate is unlikely to be realized unless the company is Lampertized, which in the case of COST and MRD, seems unlikely (though anything can happen I guess). Purchasing locations seems like a way of socking away shareholder capital in a place that shareholders will never benefit from it.

T
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Could you elaborate?

I'm talking about a hypothetical company that is not itself in debt but investors in the company's common stock owe money because they borrowed it to buy the stock on margin or they borrowed shares to sell it short.

jkm929
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bank account in corporate form run by okay people has the same required return as a typical business, given agency and change of control risk. I don't think it's even close.


That bank account has the exact same agency and change of control risk as the rest of the firm's assets, no? Am I misunderstanding you?

When KKR acquired RJR Nabisco, they got control of all the assets, right? Including bank accounts? [of course, big premium there]
A better example might be the leveraged MBO of MonkeyWard?
Ohio Mattress as an example that didn't work out so well?

There are numerous firms that went through LBOs who had cash on the balance sheet that turned into NCAA* Champions before going bankrupt.

Discarding the jargon for minute, it seems clear, ...that a Costco with a bunch of cash and and owned real estate has a much more attractive downside on average than a Costco with no cash and operating leases...And a safer investment is worth more than a riskier investment, all else equal.

Okay, here's where I disagree, COST with little cash and operating leases is not 'all else equal' with a COST having lots of excess cash and real estate.
The 'riskier' one may generate more earnings, dividends, and revenues, and even after adjusting for some 'risk-factor' may be worth more than the cash-risk COST. I don't think you can even compare the two and say 'all else being equal.' The cash-poor firm has done *something* with that cash, invested, bought back stock, built more stores - that generate earnings and revenue and dividends of some measure. They are not firm C1 and C2, but rather firms 'C' and 'Q.'

A more attractive downside does not mean a more attractive investment, ceteris paribus. You have neglected half of the equation.

Finally, option theory and bi/tri-nomial option valuation modeling of a firm's prospects would often, often disagree that a 'safer' investment is worth more.

What was 'riskier' in 1980, poor MSFT or cash and land-rich IBM? What had better returns if you owned equal shares in each?

FWIW, I don't necessarily disagree with your assessment of COST, but I think your general theory here is not correct. Some firms need more cash than others, true, but if you don't have a valid reason to keep 'excess' cash on your balance sheet you are wasting shareholder money, and at the expense of satisfying debtholders [if any.]

enjoying reading your POV,

Naj

ps *NCAA Champion* - No Coupon At All - means firm LBOs, let's say, issues $400mm in debt on Jan 1 at 8%, means they owe $16mm on July 1, goes bankrupt before paying anything to debtholders. A junk bond term.


pps Did you hear about the high-yield desk in London that was mailed an envelope full of Anthrax?



The anthrax died.
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It seems I took too long and will have to openly disclose my limitations in undestanding some aspects of a Damodarian-like valuation of cash, which at first seems quite obvious when he states that the present value of cash is cash.


When I discussed this exact topic with Aswath in Spring 1999 at a corporate-sponsored seminar on valuation, he freely admitted that wasn't exactly true and that sentence was written more for first-year students than actual practicioners. He agreed with the assertion that excess cash on the balance sheet was negative NPV.

He may have changed his mind but I doubt it.

And yes, he is seriously brilliant. Spending several hours with him on this topic was a pure pleasure.

Naj
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That bank account has the exact same agency and change of control risk as the rest of the firm's assets, no? Am I misunderstanding you?

Yes, but agency and control risks are not the only kinds of risks. Bank accounts have little other risk while operating assets not only have agency and control risk plus dozens of other often more serious risks.

The 'riskier' one may generate more earnings, dividends, and revenues, and even after adjusting for some 'risk-factor' may be worth more than the cash-risk COST.

I don't think you took "all else equal" as it was intended. I wasn't trying to say that "all things are worth the same risk adjusted amount." My point is that cash is less risky than most other assets (yes, even Microsoft in 1986) and thus requires a lower expected return than a riskier asset. This doesn't mean that "downside" is important and upside is not. You might have a $1 million bank account which you own in full with no downside and a known upside that is worth $1 million, which gives you a 3% expected return. You might also own stock in a biotech company run by crooks with $1m in spent R&D on a drug to cure message board addiction. There may be a 95% of a 100% downside but a 5% chance of selling it to Pfizer for $200 million in ten years. If you pay $1m for the thing your expected return is .05 * $50 = $20m in ten years, which would mean a 35% CAGR. You might think this is great and even be willing to pay $1.5m so your expected return is only 30%. So the upside can of course make the same asset more valuable than cash despite an infinitely higher downside. But you'd be a sucker to pay pay $15m for the thing, which would give you the same 3% expected return of your safer bank account, where it is acceptable. That is what I mean by all else equal. Similarly you would be nuts buy Microsoft in 1986 if your expected return was just barely above a bank account rate, but not such a fool to buy a bank account at that expected return.

What was 'riskier' in 1980, poor MSFT or cash and land-rich IBM? What had better returns if you owned equal shares in each?

Oh come on.

I think I've made my view clear enough that this is getting to be overkill, so my if willpower is up to it I'm going to try to leave it at that. For the record, as masturbatory as these discussions can seem, this isn't some abstract rumination about optimal capital structure, agency costs and risk adjusted return. I have made many investments over the years that rely on exactly this kind of thinking.





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There may be a 95% of a 100% downside but a 5% chance of selling it to Pfizer for $200 million in ten years. If you pay $1m for the thing your expected return is .05 * $50 = $20m in ten years, which would mean a 35% CAGR.

Yes, this is screw up central. I changed some of the numbers to make is simple and forgot to clean up the rest. Should be 5% chance of selling for $400m in ten years and thus .05 * $400 = $20m in ten years.
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Yes, but agency and control risks are not the only kinds of risks. Bank accounts have little other risk while operating assets not only have agency and control risk plus dozens of other often more serious risks.

Oh, okay, gotcha.

The 'riskier' one may generate more earnings, dividends, and revenues, and even after adjusting for some 'risk-factor' may be worth more than the cash-risk COST.

I don't think you took "all else equal" as it was intended. I wasn't trying to say that "all things are worth the same risk adjusted amount." My point is that cash is less risky than most other assets (yes, even Microsoft in 1986) and thus requires a lower expected return than a riskier asset


Agreed, now it makes more sense.

For the record, as masturbatory as these discussions can seem, this isn't some abstract rumination about optimal capital structure, agency costs and risk adjusted return. I have made many investments over the years that rely on exactly this kind of thinking.


I agree. When CAL had over $1bn of cash on the balance sheet, in a good economic environment, two people could argue very differently that is was a great 'value play,' or cash about to be destroyed in a horrid industry.

Also, excess cash can be used as a signaling mechanism to the market, even if it isn't going to be returned to shareholders anytime soon. I think of the homebuilders building up cash so they can go buy more land [because if you own one, you want them to do that.]


Oh come on.


I apologize for the overkill.

best,

Naj
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