looking deeper into capital allocation

Looking Deeper Into Capital Allocation

Share |

By Investopedia.com | 23.07.2012

Market-leading companies not only achieve success through their business results, but also by properly allocating capital in a way that is most beneficial to shareholders. Often overlooked as a central theme, capital allocation decisions are vital in determining the future of the company and, as such, are some of the most important responsibilities of company management. This article will examine some of the metrics that help us evaluate management's ability to effectively allocate capital in any set of market conditions. Read on to learn how to use these metrics to facilitate stock research and find companies poised to succeed over the long haul.

Digging Deeper Into Mutual Fund Names
6 Common Misconceptions About Dividends
Valuing Firms Using Present Value Of Free Cash Flows
Reverse Engineering Return On Equity
Due Diligence In 10 Easy Steps

"Thanks, Keep the Change"

Should the company issue or increase dividends? Should it build that new factory or hire more workers? These are the dilemmas facing managers of today's publicly-traded companies.

In the past, for example, Microsoft came under increasing shareholder scrutiny for holding onto more than $48 billion in cash and equivalents. Investors rightly asked when Microsoft was going to start sending some of the shareholders' money back their way. In March of 2003, Microsoft finally answered that question by issuing a dividend (worth 8 cents per share) for the first time. Recently in 2012, it issued a 20 cent dividend.

Every company follows a life cycle; in the early stages of life, capital allocation decisions are pretty simple - most of the cash flows will be poured back into the growing business, and there probably isn't going to be much money left over. After many years of strong, steady earnings growth, companies find out that there is only so much market out there to be had. In other words, adding the next product to the shelf, or adding the next shelf for that matter, is only half as profitable per unit as the first things that were put on that shelf many years ago. Eventually, the company will reach a point where cash flows are strong, and there is extra cash "lying around." The first discussions then can begin about such things as:

Entering a new line of business - This requires higher initial outlays of cash, but could prove to be the most profitable course in the long run.
Increasing capacity of the core business - This can be confidently done until growth rates begin to decline.
Issuing or increasing dividends - The tried and true method.
Retiring debt - This increases financial efficiency, as equity financing will almost always be cheaper.
Investing or acquiring other companies or ventures - This should always be done cautiously, sticking to core competencies.
Buying back company stock.

Management makes these kinds of decisions by using the same metrics available to investors. These include:

Return on Equity
A stock's return on equity (ROE) reveals the growth rate of the company in "shareholder dollars."

When looking at a company's ROE, there are a few considerations to take into account, such as the age of the company and what type of business it operates. Younger companies will tend to have higher ROEs because cash deployment decisions are easy to make. Older firms and those operating in capital-intensive businesses (think telecom or integrated oil), will have lower ROEs because it costs more up front to generate the first dollars of revenue.

ROE is very specific to the industry in which the company operates because each has unique capital requirements; therefore, comparisons should only be made to similar companies when reviewing this valuable metric. A ROE above the industry average is a good sign that management is wringing the most profit possible out of every invested dollar.

Return on Assets
Return on assets (ROA) is similar in theory to ROE, but the denominator of the equation has changed from stockholder equity to total assets. The ROA number tells us what kind of return management is getting on the assets at its disposal. As with ROE, ROA figures will vary greatly within different industries, and should be compared with this in mind.

ROA performance will, over the long run, provide a clearer picture of profitability than ROE will. Why? Because in the ROE calculations, current net income and last year's net income are major variables; they also happen to be much more volatile than long-term growth rates. When ROA is calculated, most of the denominator is made up of long-term assets and capital, which smooth out some of the short-term noise that ROE can create. Essentially, ROE can vary widely for a company from year to year, while ROA figures take longer to change significantly.

Capital Requirements and Cash Management
Let's say that Company X has averaged an 18% ROE for the first 10 years of its existence. This represents a strong record of growth, but it was achieved during a time when there were ample new markets to get into. With a leading market share, Company X can already see that it won't be able to keep up this rate of growth, and must begin looking at other ways to increase shareholder value. The capital requirements to keep up the business are known and set aside, and the free cash flow that is left over can be assessed for its durability and consistency. Once this has been verified, management can sit down and decide the best use of the funds. One or more of the options mentioned above may be used, and once this process begins investors can really start to evaluate the company's effectiveness outside of simply running the core business.

Dividend-paying stocks are attractive to many investors. Dividends are an effective way of returning free cash flow to shareholders, and encourage long-term investment in a company. By looking at the payout ratio for a stock's dividend, an investor can easily tell what percentage of net income is being used to pay dividends. The smaller the payout ratio, the more room management has to increase this amount in the future. The most mature dividend-paying companies are paying out 80%, or more, of all the net income to shareholders, which provides for a nice yield, but leaves very little cash behind to generate future earnings growth. These stocks end up resembling real estate investment trusts (a security where at least 90% of net income must be distributed to shareholders annually). As a result, investments in companies with very high dividend payouts will experience little price appreciation.

Stock buybacks are another common way to allocate excess capital within an organization. When is this in the shareholders' best interests? If the company truly feels that its stock is undervalued, buying back stock could very well be the best use of the funds. This will increase the percentage ownership of all the other shareholders, and is generally seen as a positive sign that management believes in the future of the company.

The Bottom Line
For the individual investor, part of any effective due diligence should include understanding the history of, and expectations for, the capital allocation abilities of a company. When looked at along with the valuation and growth, management's ability to allocate capital effectively will determine whether it is destined to have a front-running stock, or an "also-ran."

>> Click here to read other articles from this week's newsletter