It is freely accepted by investors as fact that U.S. corporate balance sheets are stronger than ever before in history. This view is largely driven by the significant amount of cash (checking deposits, savings deposits, money market funds, commercial paper holdings) on corporate balance sheets. Our difficulty with this view is that no single line item on a balance sheet is a sufficient indication of "strength." Most useful measures are derived from ratios at the very least, and ideally calculations across a variety of dimensions.
The best line item on corporate balance sheets today is typically "Cash and Equivalents." But while the amount of cash and cash-equivalents on U.S. (nonfinancial) corporate balance sheets has increased significantly, particularly relative to the cash-strapped lows of 2009, corporate cash is certainly nowhere near historical highs relative to debt. As a side note, probably the dumbest use of balance sheet data that we hear from time-to-time is when analysts talk about the P/E multiple of a stock "after you back out the cash," as if the cash line item can meaningfully be subtracted from the market cap of the equity. Really? If a company issues a billion dollars of debt, and then holds the proceeds in cash, does that suddenly make the stock "cheaper" because we can now back out that cash from the company's market cap? Um, no.
While cash holdings are relatively high compared with total assets and net worth, even those figures are in the range of 5-10%, only about 3 percentage points above historical norms. Cash levels are "high" in the sense of being a larger percentage of total assets than normal, but the "excess" cash amounts to roughly $700 billion, versus total assets of non-financial corporations of about $28.6 trillion. The excess is fairly second-order from the standpoint of overall balance sheet "health."
The best that can be said is that corporations are fairly liquid here, but this is a much different statement than saying that corporate balance sheets have "never been healthier in history." In evaluating overall balance-sheet health, it is important to consider the overall debt burden of corporations.
As the following chart shows (based on Federal Reserve Flow of Funds data), the debt burden of U.S. corporations is near all-time highs, having retreated only modestly since 2009. Debt burdens are elevated regardless of whether they are measured against total assets or net worth. Certainly, corporations are presently benefiting from very low interest rates on corporate debt, which substantially reduces the servicing burden of these obligations. But the combination of high debt levels and low servicing burdens does create a potential risk to corporate health in the event that yields rise in future years. Overall, the picture is fairly stable at present thanks to low yields and high levels of cash-equivalents, but it is important for investors to keep in mind that cash can burn fairly quickly during economic downturns, and debt is not spread evenly across corporations.
The bottom line is that at an aggregate level, corporate balance sheets look reasonable, but are certainly not "stronger than they have ever been in history." Cash levels are elevated, but this is at best a second-order factor (with excess cash representing only a few percent of total assets), while debt remains near record levels relative to total assets and net worth. In any event, balance sheet risks should be evaluated on a business-by-business level, rather than accepting the blanket notion that cash levels are so high that nobody needs to worry about corporate credit risk.
In going through the Flow of Funds data this week, I thought a few other features of the data were interesting. First, was the profound decline in tangible assets as a percentage of total corporate assets since 1980. This decline goes hand-in-hand with an increase in financial assets held by non-financial companies. At present, more than half of the total assets held by non-financial companies in the U.S. represent financial assets such as debt securities and equities. This is striking, in that we presently have a menu of prospective returns on financial assets that is among the most dismal in history. While the move toward zero interest rates has certainly been excellent for bonds when we look in the rear-view mirror, the fact that prospective rates of return are now so low suggests that a large portion of corporate assets are unlikely to achieve very much in the way of future returns, barring a decline in those asset prices. Something to think about.
Finally, the Flow of Funds data include two handy series, one representing the total net worth of nonfinancial companies, and the second representing the market value of the equities (stocks) of those companies. Intuitively, if those calculations are any good, one would expect the ratio of equity market value to total net worth to be a reasonable valuation indicator.
In fact, that's just what we see. Though the Flow of Funds data isn't as useful as one would like in practice (since it is only reported quarterly with a lag), it turns out that a low ratio of equity market value to total net worth is a very good indicator of high subsequent total returns for the S&P 500 over the following 10-year period. In contrast, a high ratio of equity market value to total net worth is predictably followed by weak 10-year total returns for the S&P 500.
Let's call this the price-to-net-worth ratio. As of the latest data, the market value of the equities (.21 trillion) for non-financial companies was nearly equal to the total net worth of those companies (.05 trillion) for a price-to-net-worth ratio of about 1.01. Note that this is NOT fair value - rather, the historical median and average of the price-to-net-worth ratio is just 0.75. The present level of about 1.0 has historically corresponded to a subsequent 10-year S&P 500 total return averaging only about 5% annually, which is fairly close to the estimate we get from a variety of other historically reliable methods, though the recent decline has improved our expectations a bit. Note that the right scale on the following chart is inverted, so higher levels of valuation on the left scale (blue line) correspond to weaker levels of subsequent return on the right scale (red line).
