Friday, May 28, 2010

Cash and Cross holdings

I am sorry about the long break between posts but I was on the road for much of the last two weeks and grading exams prior to that. I started my road trip with sessions in Slovenia and Croatia and continued on to India to make a presentation to the Tata Group, one of India's premier family groups, with a long history of operating in every aspect of Indian business. As part of the preparation, I did value a Slovenian pharmaceutical company (Krka), a Croatian tobacco company (Adris Grupa) and four Tata companies (Tata Chemicals, Tata Steel, Tata Motors and Tata Consulting Services). The presentations and the spreadsheets containing the valuations are online and can be accessed by going to:

Without belaboring the details, there were two key issues that came up when valuing Adris Grupa and the Tata Companies.

1. Cash holdings: Adris Grupa, as a tobacco company with significant operating cash flows, has accumulated a very large cash balance; it amounts to 20% or greater of the overall value of the firm. Adris is clearly not the only company that accumulates cash and it is not a phenomenon just restricted to emerging markets. Technology companies in the United States, such as Apple and Microsoft, have also been avid cash accumulators. While the conventional valuation practice with cash has been to add the cash balance to the value of operating assets, thus adopting the common sense rule that a dollar in cash has to be worth a dollar, there is substantial evidence that markets do not always treat cash as a neutral asset. In particular, markets seem to view companies that generate poor returns on their operating assets (less than the cost of capital) and accumulate cash with disfavor, while being much more sanguine about companies with good investment track records and substantial cash. Apple, for instance, is clearly not being penalized (and may be even be rewarded) for its large cash balance; after the most recent decade, investors trust the company to find good uses for the cash. In the Adris valuation, one of the concerns I raised was that the company's return on capital has lagged its cost of capital.It is therefore possible that the market may be discounting the cash holdings; a Croatian kuna in cash may be valued at less than a kuna.

2. Cross holdings: The Tata companies that I valued, with the exception of Tata Consulting Services, shared a common feature. A third to half the value that I estimated for each company came from  holdings in other Tata companies. In effect, investing in any Tata company is a joint investment in that company and a portfolio of 25-30 other Tata companies. While one reason for this cross holding structure is corporate control - it allows the family to preserve its control of the group companies - there are also more benign reasons, rooted in history. In the decades before the 1990s, Indian investors had little access to financial information from the company, let alone analyst reports or investment analysis. In that period, these investors had to essentially buy companies based on how much they trusted the promoters of the company, and a trusted family name became a proxy for research. In addition, when capital markets are undeveloped, having an internal family group capital market, where excess cash at some companies can be redirected to other companies that need the cash can be a competitive advantage.

The Indian equity markets today are different. While Indian companies have their own share of scandals and investment advice/ equity research can be tainted, the market is wider (thousands of publicly traded companies) and much deeper (more investors both from Indian and from outside). The cross holdings at family group companies can now become a valuation problem for two reasons:

1. To value one company, you have to value dozens:  Consider a firm with holdings in 25 other companies. Even if we could access information on these companies (because they are public), a thorough analysis of the firm would require a valuation of 26 companies. (Using the book value of these holdings, which are not marked to market, will yield skewed estimates. Using the market values of these holdings risks feeding any market mistakes into your valuation).
2. Some cross holdings cannot be valued: With many family group companies, some of the companies in the group are privately owned and never go public. As a consequence, there is little or no information that can be used to value companies. We have no choice but to use book value.

If you carry these concerns through to their logical conclusion, it is possible that investors either unconsciously (by using book value) or consciously (by discounting the market value of the cross holdings) will reduce the values of family group companies below what they would have been worth as independent companies. In effect, the sum of the parts will be greater than the whole. I have a paper on valuing cash and cross holdings that explores the technical details of this discount:

In my next post, I hope to examine the link between corporate governance and the phenomenon of cash and cross holdings.


Mahesh Sethuraman said...

Not sure if you had read this article by Emmanuel Derman in Edge.

He offers an interesting insight into the financial transactions tax and liquidity that we had discussed at great length in you earlier post.

Michael said...

Your URL lacks "index.html".

Gaurav Mehta said...

Hi Sir,

I was going through the presentation and valuation for Tata steel, you have used the consolidated numbers when you were taking the Historical Aggregates but use stand alone numbers when doing the valuation.

Please could you clarify on how and when do we take stand alone and consolidated numbers and also what numbers do we use for calculating cross holdings (method you use i understand).


Aswath Damodaran said...

You are right. I should have used the stand alone numbers for both but ran into a bit of a data problems. Bloomberg is the source I used for the historical data and it carries only the consolidated numbers. I could have pulled up five annual reports but was too lazy to do so.

Gaurav Mehta said...

Thanks Sir, this clarifies my doubts regarding what numbers to use. I assume we should always just use the stand alone numbers to value a Company.

However what does one do when you have the stand alone company making a profit while the consolidated financials making a significant loss. How do we discount for that. One example i can think of currently is Punj Lloyd (india) in this quarter.

Aswath Damodaran said...

I think I will take up the question of stand alone or consolidated financials in one of my next posts.

Gaurav Mehta said...

That would be really helpful. Thanks again.

Michael said...

I would also be interested in this important question. I have the impression that it seems usual to use consolidated figures when it comes to valuing a listed company; e.g. different multiples. Which often seems to be a simplification. Also, rating agencies quite often only look at the consolidated figures.

Gaurav Mehta said...

On a similar topic....i was looking at the financials of Bhushan steel another steel company in India, their financials look all good until i looked at the debt and interest cost. The company has a debt of close to 8000 crore, Interest cost on the income statement is just 200 crores, however the cash flow statment shows that the comapany paid interest of close to 950 crores. The difference between the two 750 crores as per the notes to the financial statements has been capitalized as the corrosponding debt has been taken for a production unit that is still not ready and hence not generating revenues. If one was to be valuing this company using FCFE, the Net Income would be overstated and so would the valuation and how would the valuation change if we were to be valuing using FCFF method. The equity in the company is close to 2500 crores and has little cash.