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How To Allocate Capital

|Includes: Apple Inc. (AAPL), KO, MCD, MO, PEP, TGT

The biggest fallacy out there is that each dollar reinvested by companies will automatically translate into more profits.

Unfortunately, real life does not work this way. There are issues with that. There is law of diminishing returns. There is the competitive nature of business and various physical constraints.

Most dividend investors intuitively understand this. For example, a company like Target (NYSE:TGT) is a better value at $62 than at $85. Therefore, it makes sense to invest dollars into Target at a lower valuation, since that provides better margin of safety and higher future dividend income potential. Buying a stock at 12.60 times earnings and 3.80% yield is better than buying at 18 times earnings and a 2.80% yield. Of course, as the company has not really grown its store base for several years, we may be seeing the limits to its growth. This is why paying a dividend may be the optimal capital allocation decision.

Most great companies that we talk about on this site have been able to grow dividends per share for decades. These companies have accomplished that because they are of high quality, have branded products, and are able to generate high returns on invested capital. These companies generate a lot of excess capital, that they do not know what to do with. This is how companies like Coca-Cola (NYSE:KO), Altria (NYSE:MO) and McDonald's (NYSE:MCD) have delivered substantial shareholder wealth over the past 50 years. Having too much cash is a good problem to have of course. It allows you to grow your business, and still shower your shareholders with cash. I will discuss a few examples below, which will provide more detail on my main thesis above.

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