The Proper Treatment of Cash Holdings in DCF Valuation Theory and Practice

Abstract The discounted cash flow (“DCF”) model is widely used for valuing corporate assets. But valuable assets that do not generate cash flows will be missed by the DCF approach. Because cash interest income is generally not included in the projected net cash flows of operating assets, the value of cash is regarded as a non-operating asset whose value must be added to the DCF enterprise value. Unfortunately, it has become standard practice on Wall Street and for the courts to exclude some amount of cash from non-operating assets on the basis that it will be used to finance the immediate operations of the business. The exclusion of so-called “operating” or “working-capital” cash is widely accepted as necessary and is recommended in virtually all valuation texts and treatises. We disagree and show that all cash should generally be added as a non-operating asset, except in unique circumstances where “wasting cash” is not earning a fair market return. We explain that excluding operating cash is correct only if either the interest income on cash is included in the net cash flows projections used to compute DCF value, or if the specific (near-term) operating expenses that will be covered by operating cash are excluded from the net cash flow projections. In either case, the full economic benefits of owning operating cash are fully reflected in the DCF enterprise value of the company, causing the DCF value to be higher by the exact amount of operating cash that is excluded. We call this the symmetry principle of operating cash. In practice, neither condition is normally met, so that all cash should generally be treated as a non-operating asset.