An Insider’s View of Capital Allocation (Corporate Finance and Valuation Case Studies)

This is includes an important reading found here:  Also in the Value Vault.

The 58-page document will start with buy backs from a corporate finance (an insider’s) perspective as described by Mr. Louis Lowenstein, the CEO of Supermarkets General and a Law Professor at Columbia University. Then you will read what the masters, Buffett and Graham had to say on the subject. If, when and how a company buys back its shares says a lot about the business and capital allocation skills of management as the Case Studies of Teledyne Corporation and others will show. You will learn the importance of context and circumstance as the principles of good and bad capital allocation are applied. I hope you find the lessons instructive.

From the introduction

Whether the business is a franchise or not, management has two major jobs: operate the business efficiently which is critical in a non-franchise business since earning the company’s cost of capital is the best outcome and allocating capital effectively. Growth is only profitable in a franchise business, therefore capital allocation is critical for shareholder returns.  If a franchise’s core business is unable to grow, often free cash-flow can’t be redeployed at the same high returns. Capital might need to be returned to shareholders but how much and in what way?

Thinking about what management will do with excess cash is important for your valuation work. Should the excess cash on the balance sheet be discounted heavily because management tends to make poor choices (Greenblatt) or will management buy-in shares, causing the per share value to rise (Duff & Phelps valuation case study)?  You will be given a corporate insider view on these issues.

Share repurchase programs should be an integral part of a company’s capital allocation process, one in which management weighs reinvestment opportunities not only against the alternative of cash dividends but also both of those alternatives against a third alternative, the buyback of common stock. Management has several capital allocation alternatives:

Business Needs: Working capital, Capital expenditures, and Mergers & acquisitions

Return Capital to Shareholders: Dividends, Share buybacks, and Debt repayment

You will gain many insights from your reading.

Supplementary materials from a reader:

Dividends from an investor’s perspective:

10 responses to “An Insider’s View of Capital Allocation (Corporate Finance and Valuation Case Studies)

  1. I can’t seem to find it in the Value Vault. Is it listed under a different name? Thanks.

  2. John, I spent a few hours going through your case study on WD-40. Based on the information I reviewed, I would say that the company does have an appropriate dividend policy. The company is paying out roughly 50% of cash flow as dividends. I went back and tracked the change in retained earnings to market value over the last 5 and 10 years. MVE in 2001 was approximately $366 m and in 2006 it was $540 m compared to about $636 today. Since 2001, the company’s RE has increased by $136 million and $73 million since 2006. MVE today is above the MVE + RE from the dates listed. What is the company doing with the cash? 1. Paying dividends, 2. Reinvesting cash in the business, and 3. Recently repurchased shares. The share repurchase was at an average cost of about $40 per share, doesn’t seem that cheap to me. One concern I have is the company’s declining operating and net profit margins since 2000. My understanding is that the company began to expand internationally in 1999. I’m wondering if this overseas growth is as profitable as it is in the home market? Also, the core business in the US was down slightly in FY 2011. The decline was offset growth in overseas revenues. Also, the home and cleaning products categories have been losing market share. I wonder if this has been dragging down the results? Does management discuss dividend policy with shareholders explicitly? I did not see any place in the most recent annual report where management discussed dividend policy. In terms of capital requirements, the company doesn’t need to spend much on fixed PPE each year and WC requirements are not very high. I would classify this company as having a consumer franchise (cash cow) which low growth opportunities. I wonder if management’s decision to retain a part of cash flow and reinvest in overseas markets is a profitable one? What do you think? Thanks.

    • Good work. If you would like, I will try to dig out the shareholder letter I sent to management of WD-40 protesting their “diworsification” strategy seven years ago.

      You have hit the nails on the head. Their crown jewel (WD-40) is funding crappy businesses that may not even make their cost of capital–so growth is worthless. It may, in fact, be harmful.

      There is no discussion of dividend policy with shareholders.

      wd-40 has a dominant (90%) position in the US. Their strategy to be (all things under the sink?) hurts the company. I would simply invest in the core, crown jewel, and buy in shares when appropriate or pay out excess cash. Notice that the company doesn’t break out the margins by product for the shareholders!?

      Go on the conference call and ask these questions or call the CFO / IR (the company is small enough) and say you are thinking of buying a sizable position (2 shares could be a huge position for my 5 year old niece) and find no discussion of capital allocation in the 10-K or conference call transcripts.

      That said, I have bought and sold wd-40 because it is a bond in my eyes. The question is what interest rate do you wish to receive?

  3. Sure, if it’s easy to find I would like to read it. Thanks again John.

  4. Interesting post, and it confirms what I’ve read elsewhere. Now, the question is, if companies have massive cash piles on their balance sheet, does that make them bad investments?? i am thinking of firms like Google, Microsoft, Apple and probably a few others.

    • Well, just like the market seems to be doing, you have to discount the cash and separate the cash fro the operating business. If you valued the cash at $0 (very draconian) what is the operating business worth?

  5. John, on the Capital Structure and Stock Repurchases pdf (page 6) shouldn’t the growth rate be (20% ROE) * (1 – 40% tax) * (1 – payout ratio) instead of (20% ROE) * (1 – 40% tax)? Of course I might have misunderstood something and that would not surprise me! ; )

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