SERIOUS MONEY: Investors are paying a heavy price for the leading tech companies' low debt, extraordinarily inefficient balance sheets and scant regard for dividend policy

Large-cap stocks dominated market performance during the latter half of the 1990s and the "sacred cows" of technology led the charge. The sector's share of the S&P 500 by market capitalisation soared to more than 30 per cent by the decade's end and six technology stocks ranked among the index's top 10 names.

The technology bubble sowed the seeds of its own demise as the high expected returns, reflected in increasingly ludicrous valuations, attracted large amounts of new capital like bees to honey and the inevitable overcapacity was aggravated by a sharp economic slowdown in 2000 and beyond.

Stock prices collapsed and several names, including Cisco Systems, Lucent Technologies and Sun Microsystems, dropped by more than 90 per cent.

Seven years on and the share prices still languish more than 60 per cent below their all-time highs. The sector's weighting has dropped to 15 per cent and only Microsoft ranks among the market's top 10 names. Valuations are far more reasonable today and balance sheets are awash with cash, yet many names continue to lag. What measures can technology companies take to boost stock prices?

The technology sector is renowned for its financial conservatism, but investors are paying a heavy price for the increasingly unjustifiable capital inefficiency. Cash balances and short-term investments account for almost 30 per cent of total assets and more than 12 per cent of market capitalisation at leading technology companies.

The meagre returns on these assets place considerable downward pressure on returns on equity. Microsoft is a good example. It has generated an average return on the capital invested in its operating businesses of almost 60 per cent from 2001 to 2006 and looks set to return more than 100 per cent during the current financial year.

However, the paltry returns earned on cash have reduced these impressive numbers by more than 40 percentage points such that returns on equity have averaged 16 per cent over the past five years.

Apart from technology companies holding excessive levels of cash, several of these names carry little if any debt. The leading companies, excluding IBM, have outstanding debt amounting to less than 2 per cent of firm value and net of cash, the debt position is a negative 8 per cent.

The negative debt positions are particularly apparent at Apple, Dell and Microsoft, where the percentages are minus 14, 15 and 10 per cent respectively.

These extraordinary positions lead to a higher cost of capital as the companies' capital structure effectively consists of more than 100 per cent equity, with the surplus being lent to others as cash or short-term investments.

The firm's primary objective is to maximise shareholder value. Investment, distribution and financial policies are the means by which this goal is achieved. It is clear technology companies are focused almost exclusively on investment, with scant regard for dividend policy and capital structure.

Financial theory prescribes that firms should distribute all excess capital to shareholders and should adopt a capital structure that minimises the cost of capital. Companies should increase the level of debt as a percentage of firm value to the level where the marginal net tax savings equals the marginal increase in the expected costs of financial distress.

Senior management at technology firms will undoubtedly argue that companies whose value consists primarily of future growth opportunities should pay little if any dividends and have few borrowings, so that after-tax operating profits can be re-invested in the business.

Furthermore, companies whose assets consist mainly of intangible assets, such as human capital, will typically carry low levels of debt because, unlike the hard assets at electric power plants, hotels and railroads, human capital cannot be transferred to debt holders in the event of financial distress.

Additionally, even rumours of distress could cause key staff to leave.

These arguments only go so far. Many of the leading technology companies are no longer the youthful high-growth companies they once were and the free cashflows generated year-in year-out are more than adequate to support an appropriate capital structure.

Microsoft's operating businesses, for example, generate free cashflow of $1 billion (€740 million) every month.

Careful analysis suggests that net debt equating to roughly 20 per cent of firm value would reduce Microsoft's cost of capital by 75 basis points.

The return of cash to shareholders, combined with an optimal balance sheet could provide a once-off boost of almost 20 per cent to shareholder returns.

America's leading technology companies are some of the great success stories in recent decades, yet their balance sheets are extraordinarily inefficient. The adoption of appropriate capital structures would see more than $200 billion returned to shareholders.

Investors should pressure companies to return such excess capital and demand an end to the inefficient use of capital. The boost to returns could be substantial.