News

Investment of Excess Corporate Cash

Business
0 min read

 


Share Repurchases have Surpassed Dividends – Four Uses of Excess Corporate Cash

 

Management is faced with several options when their company has excess cash.  They can invest the excess reserves in the hope that the investment will lead to higher growth. They can pay down debt. They may repurchase shares. Or they could distribute it by paying shareholders a dividend. Management’s decision is best if made by viewing each option as an investment with a different return profile. Each investment opportunity has its advantages and disadvantages.

 In recent years, share repurchases have grown in popularity. Treasury & Risk, an online magazine for corporate treasury professionals, reported that the amount of capital spent on share repurchases between 2014-2019 has increased at a compound annual growth rate (CAGR) of 10.4% versus a 7.1% rate for dividends and a 5.5% rate for organic investments. The investments may signify to the market management’s positive expectations about the company’s future performance. In this article, Channelchek looks at the four uses of cash and addresses the advantages and disadvantages along with the broader market implications.

Reinvesting Cash

Reinvesting cash into the business is a clear sign that management believes there will be a large return on the investment. The investment might be building a new factory, hiring employees, or raising the company’s research and development budget. These are steps usually taken when a company has the ability to grow but faces constraints preventing growth. Reinvesting cash, then, is expected to lead to higher earnings and cash flow growth. In comparing cash reinvestment to other forms of investment, management may look at its historical return on invested capital (ROIC) and adjust it to reflect the outlook for specific investment projects. Management should also be wary of the risks associated with the investment and factor these risks into investment considerations. Cash reinvestment is not as obvious as paying down debt, repurchasing shares, or raising a dividend. Often reinvestment is lumped together with normal capital expenditures in an investor’s mind and has little impact on the stock price. However, reinvesting capital is a good indication that management believes its best investment opportunities lie within the company. Companies with high levels of cash reinvestment tend to be associated with early-stage, fast-growing industries.

Paying Down Debt

When a company retires debt, it frees itself of the obligation to pay interest on the note. Therefore, paying down debt can be viewed as an investment as the excess cash deployed will provide future benefits. The return on investment will be equivalent to its cost of debt. A company’s cost of debt is typically less than its implied cost of equity or return on invested capital. With this in mind, the investment return on paying down debt may seem low relative to other cash options. However, there are other factors to consider. Reducing debt improves the company’s balance sheet. This may allow the company to issue debt in the future if favorable opportunities arise. An improved balance sheet may also lower the cost of the remaining debt. It could even have the effect of making the stock more attractive to equity investors. On the other hand, debt reduction may be viewed as management, sending a negative signal about future performance. Is the company shoring up the balance sheet to weather an upcoming negative environment?

Cash Dividends

Paying a cash dividend has long been the easiest way to return funds to shareholders. Investors appreciate the utility of cash assets. Some use dividends to pay for living expenses. Others will reinvest the dividend but enjoy the ability to direct where the proceeds are invested. Measuring the level of cash return is easy. Almost every investor knows what a dividend yield is and that a higher yield reflects a larger return on investment. Changed expectations of investors is also a consideration; before management opts to raise dividends to help lift up its stock’s yield, they should consider the company’s ability to make future dividend payments. The stock market is full of examples of investors punishing companies that cut their dividends. Retirees depend on certain dividend levels to pay for expenses. Others view a dividend cut as a sign that management believes future results will not be as favorable as previously expected.

Share Repurchase

Since 1997, share repurchases have surpassed cash dividend payments. According to Treasury & Risk, $3 trillion was spent on repurchase programs between 2014 and 2019. The return on investment of repurchasing shares depends on the implied return required by investors. By determining a company’s stock price, the market has, in essence, set a required rate of return based on the company’s risk profile and prevailing expected risk-free and market returns.  Repurchasing shares has several advantages. It is inexpensive. It can be done quickly and timed to reflect management’s opinion about the stock price. It can also serve to offset panicked selling that might be unjustified. On the negative side, repurchases weaken the balance sheet leading to more expensive debt financing. Many management teams have been increasing debt levels to fund share repurchases. Such a strategy takes advantage of current low-interest rates but leaves the company susceptible to interest rate increases. As far as signaling goes, share repurchases are usually viewed as a sign that management thinks its stock is undervalued. However, it can also signal that management believes it does not have attractive investment options internally.

Take-Away

There are many factors to consider when deciding what to do with excess cash. We examined the four common uses of unused company funds. Rather than attempt to determine which “investment” is the best, individual companies face different circumstances; Channelchek examined the side effects and the signaling implications of each investment. In the end, it is up to management to determine which method makes sense for their individual company. Likewise, investors should be aware not only of the investment but the implications of the investment. Raising a dividend, for example, maybe a signal of improved management confidence in future performance. Or, it could be a signal that management has run out of attractive internal investment opportunities.

 

Suggested Reading:

Alternative Investments and 401K Plans

Is Gridlock Good for the Stock Market?

Interest rates Impact on Investment Sectors

Tomorrow – Meet Neovasc (NVCN) President and CEO Fred Colen at Channelchek’s online Virtual Road Show.

Learn more and register HERE

Enjoy Premium Channelchek Content at No Cost

Sources:

https://www.treasuryandrisk.com/2020/06/04/corporate-stock-buybacks-hit-record-levels, T&R Staff, Treasury & Risk, June 04, 2020

https://www.jstor.org/stable/3094520?seq=1, January 4, 2020

https://www2.deloitte.com/us/en/insights/economy/spotlight/economics-insights-analysis-03-2019.html, Deloitte, March 26, 2019

 

Comments

0
No comments yet...
Share

Inbox Intel from Channelchek.

Informed investors make more money. And it’s all about timing. Get it when it happens.

By clicking submit you are agreeing to the Terms of Use and Privacy Policy
© 2018-2022 Noble Financial Group, Inc. All Rights Reserved. Channelchek is provided at no cost to be used for information purposes only and not as investment advisement.