Corporations’ pandemic response of cutting costs and increasing liquidity has left them with hefty cash balances, and a recent CFA Institutearticle outlines ways to determine if corporate cash “givebacks” are boosting their intrinsic value.
According to the article, the process involves addressing the following three questions:
- Does the company have cash deployment opportunities in the form of capex, R&D or mergers and acquisition activities? While this can be difficult to determine, the article notes, “history can be a useful guide” in gauging whether the firm had past struggles in generating return on capital, for example.
- How much can the company afford to allocate to givebacks? This can be determined by looking at free cash flow generation and debt levels—the article outlines specific methods for assessing leverage. “Combining the outlook for a firm’s projects with its cash flow and leverage profile can inform an overall giveback strategy,” the article notes.
- Should givebacks be in the form of dividends or buybacks? This final step of the process requires addressing the following issues:
- Is the stock undervalued? It makes sense to buy back shares if an equity is trading below its intrinsic value.
- What is the firm’s growth stage? Buying shares may be appropriate if the company is past the early growth stage of heavy investment.
- Is the firm operating in a cyclical industry? If so, the “flexibility of buybacks make them preferable to dividends.”
- How important are employee stock options for attracting and retaining talent?
- Is the tax rate on capital gains different than dividends? Currently, the article notes, long-term capital gains are taxed at the same rate as dividends. Even given proposed legislation to increase taxes on the highest-earning individuals and corporations, the article argues that “increasing the capital gains rate on less than 1% of investors should not materially change the buyback vs. dividend decision.”
The article concludes that given high corporate cash balances, “firms are likely to continue increasing their cash givebacks to benefit shareholders. But investors need to be aware that while givebacks are generally a good idea, some are better than others.”