Key Points:
- Corporations have significantly reduced costs and increased liquidity in response to the COVID-19 pandemic.
- US non-financial companies currently hold $2.6 trillion in cash, equivalent to over 5% of total assets.
- As earnings growth and the larger economy recover, companies are expected to deploy their cash through capital expenditures, mergers and acquisitions, and cash givebacks to shareholders.
- Cash givebacks, such as dividends and buybacks, can be significant drivers of stock returns.
- Analysts can evaluate the appeal and utility of cash givebacks by assessing a company’s prospective projects, cash flow, and leverage profile.
- Determining whether to distribute cash givebacks as dividends or buybacks depends on factors such as FCF generation, growth stage, industry cyclicality, employee stock options, and tax rates.
Corporations responded to the onset of the COVID-19 pandemic by slashing costs and raising liquidity. In the United States, non-financial companies currently hold $2.6 trillion in cash, which is equivalent to over 5% of total assets. This is a decrease from the all-time peak of 6% set last summer. Additionally, net debt-to-EBITDA ratios are lower than those seen in previous decades.
US Corporate Cash/Assets
Sources: US Federal Reserve and Wealth Enhancement Group, as of 31 March 2021.
As earnings growth and the larger economy start to recover, companies are poised to deploy their cash through capital expenditures (capex), mergers and acquisitions (M&A), and cash givebacks to shareholders in the form of dividends and buybacks. According to Bloomberg consensus projections, S&P 500 earnings will grow over 50% in 2021. Goldman Sachs predicts increases of 5% and 35% in dividends and buybacks, respectively.
Cash givebacks should be a significant driver of stock returns, especially amid such low interest rates. Indeed, dividend and buyback stocks started outperforming the S&P 500 in early 2021.
Buyback and Dividend Stocks vs. The S&P 500
Sources: Bloomberg, S&P, Goldman Sachs, and Wealth Enhancement Group, as of 14 May 2021
While shareholders generally benefit from cash givebacks, the appeal and utility of such transactions vary by company.
To determine if a particular giveback contributes to a firm’s intrinsic value, analysts can follow a multi-step evaluation framework that answers three questions:
1. Does the company have prospective capex, R&D, or M&A activities on which to deploy its cash?
Assessing the outlook for a firm’s projects is challenging, as the investment details are often not transparent or public. However, historical performance can provide useful insights. If a company has struggled in the past to generate return on capital (ROC) above its cost of capital (COC), it is likely to continue unless the prospective projects differ significantly. In such cases, cash givebacks become more appealing. For companies with short histories, analysts can examine key capex projects or M&A. Positive net present value (NPV) for capex projects and synergies with an NPV higher than the premium paid for M&A indicate potential value creation.
2. How much money can the firm afford to allocate to givebacks?
Free cash flow (FCF) generation and financial leverage are important metrics to consider when determining the size of cash givebacks. A higher FCF margin indicates greater capacity to distribute cash to shareholders. FCF variability should also be assessed, considering the company’s growth stage and sector cyclicality. Additionally, analysts can use comparables, downside operating profitability, and minimizing the cost of capital to evaluate the company’s debt level and determine an optimal leverage level.
By evaluating a firm’s projects, cash flow, and leverage profile, analysts can inform an appropriate giveback strategy.
3. Should those givebacks be dividends or buybacks?
Determining the best form of cash giveback depends on factors such as FCF generation, growth stage, industry cyclicality, employee stock options, and tax rates. Dividends are suitable for firms with strong and stable FCF generation and those that have shifted beyond their fastest growth stage. Market interpretation of dividend changes can provide insights, and benchmarking against similar firms’ yields and payouts can be helpful.
Buybacks are suitable when a company’s stock is undervalued, it is past the early growth stage, the industry is cyclical, employee stock options are important for talent retention, and tax rates on capital gains are not significantly different from dividends. Tax rate changes on capital gains or corporate taxes can influence the buyback vs. dividend decision.
With corporate cash balances at record high levels, companies are likely to continue increasing their cash givebacks to benefit shareholders. However, investors should be aware that not all givebacks are equal in terms of value creation.
All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
Image credit: ©Getty Images / champc
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