The 5 Capital Allocation Principles And How They Impact Intrinsic Value

by: Sure Dividend
Summary

One of the most important responsibilities of a company’s management team is capital allocation – the decision of where to deploy the firm’s excess capital.

There are exactly 5 ways that they can spend corporate dollars: organic reinvestment, mergers & acquisitions, debt paydown, dividend payments, and share repurchases.

In this video and article, we explain each capital allocation opportunity, with an emphasis on how they impact per-share intrinsic value.

One of the most important responsibilities of a company’s management team is capital allocation – the decision of where to deploy the firm’s excess capital.

As shareholders, it is our job to ensure that management is making intelligent decisions for capital allocation, as it can have a profound effect on our long-term investment returns.

In this video, I explain the 5 ways that management teams can spend money and how each impacts the intrinsic value of their businesses.

Each capital allocation option is explained in detail below.

Option #1: Organic Reinvestment

Organic reinvestment is exactly what it sounds like: investing excess cash back into the core business to expand its current operations. Organic reinvestment is likely the most simple and straightforward form of capital allocation.

The decision on whether or not to reinvest funds is completely dependent on two factors:

-Capacity: How much capital can reasonably be reinvested per unit of time before diminishing returns occur

-Business Unit Profitability: Generally measured by return on invested capital, this shows the return that can be expected on any reinvested capital

Ideally, companies will have opportunities with high returns on invested capital and large capital capacities. Wal-Mart in the 1970s is an example of this. The company could earn very attractive returns by opening new stores, and the capacity for new stores was almost unlimited. Of course, this led to remarkable returns for early Wal-Mart investors who recognized this opportunity.

It is also important to keep in mind that many businesses have no choice about whether or not to reinvest. This is best illustrated through a quote from Charlie Munger.

There are two kinds of businesses: The first earns twelve percent, and you can take the profits out at the end of the year. The second earns twelve percent, but all the excess cash must be reinvested-there’s never any cash. It reminds me of the guy who sells construction equipment-he looks at his used machines, taken in as customers bought new ones, and says, “There’s all of my profit, rusting in my yard.” We hate that kind of business.”

The key takeaway here is that organic growth opportunities should have three characteristics: they should have high returns on invested capital, large capacity to take in new capital, and the optionality to take cash out of the business if so desired.

Option #2: Mergers & Acquisitions

Mergers and acquisitions are some of the most transformative – and perhaps most risky – capital allocation move that corporate executives can make. Moreover, there is a great divide among investors about whether M&A actually creates real shareholder value.

We believe that whether M&A makes sense is highly dependent on the terms of the deal in question. More specifically, good M&A will have the following characteristics:

  1. A sensible purchase price (the lower, the better)
  2. Funded through cash on the balance sheet or debt – not equity

Mergers and acquisitions are complicated. Accordingly, we recommend that investor analyze M&A on a case-by-case basis for the companies that they own.

Option #3: Debt Repayments

Of all the capital allocation techniques employed by corporate executives, debt repayments are the most predictable. The return achieved by paying down debt is known in advance and equal to the interest rate on the debt being paid down.

You have to be careful here. Just because debt paydown is a predictable capital allocation strategy does not mean it is an attractive capital allocation strategy. In today’s low interest rate environment, there will almost always be a better way for corporate managers to spend their money than by paying down their low interest rate debt.

Option #4: Dividend Payments

Dividend payments are at the center of much of what we do at Sure Dividend. In fact, dividend yield is one of the ranking factors in The 8 Rules of Dividend Investing, our quantitative ranking system for dividend stocks.

This is because dividend-paying stocks have tended to outperform the broader stock market. In theory, this should not be the case. After all, dividends are subject to unfavorable double-taxation, and are inferior to share repurchases on paper.

We believe that the outperformance of dividend stocks does not actually come from their dividend payments. Instead, dividend payments are simply a sign of a high-quality business that is focused on acting in the best interests of its shareholders.

This is a belief that is corroborated by many influential investors. For example, Benjamin Graham wrote the following in his book “The Intelligent Investor”:

“One of the most persuasive tests of high quality is an uninterrupted record of dividend payments going back over many years. We think that a record of continuous dividend payments for the last 20 years or more is an important plus factor in the company’s quality rating. Indeed the defensive investor might be justified in limiting his purchases to those meeting this test.”

For corporate managers, the decision of whether or not to pay a dividend is highly dependent on the condition of their existing business. For companies that have high capital demands – such as Wal-Mart in the 1970s, which we mentioned earlier – paying a dividend would be foolish. For other, more mature businesses, such as Coca-Cola (NYSE:KO) today, we believe that paying a dividend makes a great deal of sense.

Options #5: Share Repurchases

Share repurchases are likely the most misunderstood capital allocation policy if adopted by corporate managers. They are also one of the most powerful if implemented properly.

Share repurchases occur when a company buys back its own shares, reducing the number of shares outstanding. This has the beneficial impact of improving important per-share financial metrics such as earnings-per-share or book-value-per-share.

The value-enhancing capabilities of share repurchases are highly price-dependent. Share repurchases made at a high price will destroy value, while cheap share repurchases build tremendous value.

One way to help understand share repurchases is through an analogy that uses a simple, privately-held business. Warren Buffett provided such an analogy in Berkshire Hathaway’s 2016 annual report, where we wrote:

“Consider a simple analogy: If there are three equal partners in a business worth $3,000 and one is bought out by the partnership for $900, each of the remaining partners realizes an immediate gain of $50. If the exiting partner is paid $1,100, however, the continuing partners each suffer a loss of $50. The same math applies with corporations and their shareholders. Ergo, the question of whether a repurchase action is value-enhancing or value-destroying for continuing shareholders is entirely purchase-price dependent.”

When a company’s stock is deeply undervalued, we believe that an aggressive share repurchase program is one of the best ways for it to deploy its capital.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.