Do Corporate Cash Holdings Predict
Stock Returns?

Abstract

Stockholders’ returns, in finance theory, are independent of a firm’s cash holdings. However, there is widespread belief among Wall Street practitioners that firms’ cash holdings do affect future returns. We examine the data to obtain answers to several questions that are germane to the investment community. For example, should investors pay attention to a firm’s cash holdings when they invest in stocks? For what kinds of firms are cash holdings particularly informative about future returns? Are there particular time periods when cash holdings have more predictive power? In this regard, we create a simple cash measure by scaling a firm’s cash holding by a measure of its investment opportunities and show that this cash measure has significant power in predicting future stock returns. We also show that this predictive power is stronger for small firms. Evidence from the period of the recent financial crisis indicates that firms’ cash holdings matter more during dramatic market upswings than during sharp-down markets.

TOPICS: Fundamental equity analysis, portfolio theory, portfolio construction