Cash, Risk, and Return: Decoding Precautionary Motives

ABSTRACT We study the relationship between corporate cash holdings and expected stock returns through the lens of precautionary savings. Building on Palazzo, which predicts that firms more exposed to aggregate risk hold more cash and earn higher returns, we introduce a forward‐looking measure—Cash‐to‐Market Equity (Cash‐to‐ME). Unlike the traditional Cash‐to‐Assets ratio, Cash‐to‐ME consistently predicts cross‐sectional returns. The premium is conditional, concentrated among small and R&D‐intensive firms facing financing frictions. In R&D firms, it is largely subsumed by R&D‐to‐ME, consistent with cash serving as a buffer for innovation. In non‐R&D firms, cash‐to‐ME overlaps with book‐to‐market and cash‐flow‐to‐price, reflecting value‐like precautionary savings. Empirical tests show that the premium strengthens with cash‐flow betas and low profitability, and that cash‐rich firms gradually deploy reserves when constrained. These findings extend Palazzo's framework by providing long‐horizon empirical validation and establishing Cash‐to‐ME as a priced proxy for precautionary savings.