Capital Allocation Decisions

Why this matters

Management and Capital Allocation listed what a company can do with its cash and compared the options by their returns. This lesson adds two things. The first is the standard those returns have to beat, which the last three lessons supplied: the cost of capital. The second is a method for checking what a management has really done with the money over several years, as opposed to what it says.

The test for keeping a dollar

Profit belongs to shareholders. When a company keeps it, shareholders are in effect investing it again without being asked. That's a good deal for them only if the company can earn more on it than they could earn themselves at similar risk, which is the cost of equity from Cost of Capital in Depth.

A company keeps $100 million and invests it. Shareholders require 9.8%, STU Corp's cost of equity. To keep the arithmetic simple, assume the investment earns the same return every year indefinitely.

Return on the investment	Profit each year	Value at a 9.8% required return	Value of each dollar kept
15%	$15 million	$153 million	$1.53
9.8%	$9.8 million	$100 million	$1.00
5%	$5 million	$51 million	$0.51

The value in each row is the yearly profit divided by 9.8%. At a 15% return, keeping the money turns each dollar into $1.53. At 5%, it turns each dollar into 51 cents. In all three rows the company's profit goes up. Only in the first are shareholders better off than if they'd been handed the cash.

This is why growth isn't a goal in itself. A company that keeps all its profit and earns 5% on it will report rising profit every year and still be worth less than if it had paid the money out. The required return is sometimes called the hurdle rate, because an investment has to clear it to be worth making.

What each choice earns

Two points about using the table. First, the returns aren't equally certain. Repaying debt earns a modest return with no risk, and an acquisition promises a high one that may never arrive. A sensible comparison weighs both. Second, no ranking is permanent. Buybacks are a good use of cash at a low share price and a poor one at a high price. Expansion is the best use in a business with room to grow at high returns and the worst in one that's already saturated. Good allocators change what they do as prices and opportunities change. A company that follows the same formula every year isn't making decisions.

Auditing a five-year record

One year's choices say little. Five years, added up, show a pattern. Everything needed is on the cash flow statement.

	Five-year total
Cash from operations	500
Capital spending	(220)
Acquisitions	(130)
Dividends	(60)
Share buybacks	(120)
New borrowing, net of repayments	50
Increase in cash	20

What the investment earned. Depreciation over the five years was $150 million, a rough guide to what it cost to keep the existing business running. That leaves about $70 million of capital spending aimed at growth. With the $130 million of acquisitions, the company put about $200 million of new money to work. Over the same period, operating income rose from $100 million to $116 million. An extra $16 million a year on $200 million is 8% before tax and about 6.3% after tax at 21%. That's well below the 9.8% cost of equity this track has used.

What the buybacks did. The company bought 4 million shares at an average of $30. It also issued 3 million shares to employees. The share count fell from 50 million to 49 million, or 2%, for $120 million. Three quarters of the spending offset new shares. The shares now trade at $24, so the average purchase was made at a higher price than today's.

Where the money came from. The company paid out $180 million to shareholders while borrowing $50 million. Part of what it returned was borrowed.

Nothing in that record is a scandal. It's an ordinary company that grew, paid a dividend, and bought back shares. But each dollar it reinvested earned about 6%, most of its buyback went to cancel out shares it had just issued, and debt rose to pay for it. A shareholder reading only the headlines would have seen rising profit and cash returned.

The measure used in the first step, the extra profit divided by the extra capital, is the return on incremental capital. It's rough. Profit can rise for reasons unrelated to the new investment, and new projects can take years to pay off. Used over five or more years, it's still the most direct evidence of what reinvestment has earned.

Where to find it

• The cash flow statement. The investing section shows capital spending and acquisitions. The financing section shows dividends, buybacks, shares issued, and borrowing.
• Management's discussion in the 10-K. Companies must describe their material cash requirements, including commitments for capital spending, the expected source of the money, and its general purpose.¹
• The share count. Compare the shares outstanding at the start and end of the period with the amount spent on buybacks.
• Past letters and presentations. What management said an acquisition or project would earn, set against what happened.

Signs of good and poor allocation

Key takeaways

• Keeping a dollar creates value only if it earns more than shareholders require.
• Growth funded at a return below the cost of capital raises profit and lowers value.
• Judge every use of cash by what it earns, how certain that is, and what the alternative was.
• Five years of the cash flow statement show where the money went. The change in profit shows what it earned.
• Check buybacks against the share count and the prices paid.

Check your understanding

A company keeps $200 million of profit and invests it in projects that earn 6% a year indefinitely. Investors require 10% from a business of this risk. Roughly what is that investment worth to them?

1. $200 million, since money that's invested keeps its value whatever it earns.
2. About $120 million, since $12 million a year is worth that much at 10%.
3. About $333 million, since the 10% required is higher than the 6% earned.

Over five years a company put $400 million into acquisitions and expansion beyond upkeep. Its operating income rose by $20 million a year. The annual letter celebrates record revenue. What's the fairest reading?

1. The new money earned about 5% before tax, likely less than its cost of capital.
2. A success, since revenue and operating income both reached record levels.
3. Impossible to judge, since the returns on new investment are never disclosed.

What's next

The next three lessons take the main choices one at a time, starting with the cash a company hands back. Dividend Policy looks at how companies decide what to pay and what a change in the dividend signals.