- If a company invests $100 in something at the cost of capital of 10%, which in turn earns $7 in earnings forever, it would have a market value of only $70 ($7/10%), failing the $1 test.
- Earnings of $11 or more would pass the test.
- When companies make the decision to invest in M&A, CapEx or buybacks, they must make a conscious effort in evaluating if the potential returns would be meaningful and not capital destructive.
By The Fifth Investor on October 9, 2017
Companies small or big must make capital allocation decisions on a frequent basis to maximize returns for shareholders. But only a few companies in the world have excellent capital allocators at their helms, most companies are run by excellent operators who alone are enough to generate meaningful profits, which shareholders would find forgiving enough.
Before a corporation invests in machinery, equipment, property or securities, like us they must make comparisons of returns that they’ll get when they allocate capital. These decisions are far more complex than personal decisions as they often involve a giant leap of faith into the unknown.
- How did Google calculate that Android would be a massive hit when they decided to allocate millions of R&D to it?
- How did Google’s other failures not stop it from deciding to simply invest their monies in stocks or bonds or themselves (share buybacks)?
These decisions are of the highest risk, have a high potential for failure but if successful often give shareholders a multifold return. Although this may seem daunting to a budding retail investor, there are simpler ways to see if a company is allocating capital wisely: think top-down, think big.
1. Capital expenditures –
- Is the company spending its cash meaningfully in CapEx?
- What is the return on invested capital for the company?
- Has the company managed to earn healthy returns on the incremental invested capital over the years?
- What is their strategy?
- In CapEx intensive industries, sometimes CapEx is spent not to expand and grow the business, but to just survive. That is often not an ideal situation as there’s no buffer should the market turn.
- On the other hand, a CapEx-lite industry would see companies compete by spending in other areas that may not appear in the CapEx category.
2. Share buybacks –
- Is the company spending its precious money buying back shares at all-time highs?
- There’s a difference between mandated share buybacks and opportunistic buybacks. One is buying back shares no matter the price of the shares, and the latter is buying back shares only if the value of the company is worth more than its traded price (E.g. Berkshire will only execute buybacks when its P/B ratio is below 1.2).
3. Mergers & acquisitions –
- Is the company acquiring businesses to bolt on to their existing operations?
- How competent is the current management in the new industry where they’ve acquired a company?
- How much of a premium have they paid to buy a company?
- Does it even make sense?
- A wasteful merger or acquisition can be deadly to your financial health.
4. Cash –
- Is this company cash rich?
- Does the management not know what to do with it?
- What’s holding the company back?
- Companies that are cash rich often trade at a discount, making them appear cheap, the most famous example would be Apple (although there may be tax reasons why Apple has stashed such a huge pile).
- There’s a reason why companies like these appear cheap – the market deems the management to be incompetent in redeploying capital to earn a meaningful return for shareholders, and applies a discount to its shares.
Another way to look at it is the simple $1 test that Warren Buffett came up with in the 1980s:
“We feel noble intentions should be checked periodically against results. We test the wisdom of retaining earnings by assessing whether retention, over time, delivers shareholders at least $1 of market value for each $1 retained.
Unrestricted earnings should be retained only where there is a reasonable prospect – backed preferably by historical evidence or, when appropriate by a thoughtful analysis of the future – that for every dollar retained by the corporation, at least one dollar of market value will be created for owners. This will happen only if the capital retained produces incremental earnings equal to, or above, those generally available to investors.”
Buffett is essentially talking about return on invested capital. If a company invests $100 in something at the cost of capital of 10%, which in turn earns $7 in earnings forever, it would have a market value of only $70 ($7/10%), failing the $1 test. Earnings of $11 or more would pass the test. When companies make the decision to invest in M&A, CapEx or buybacks, they must make a conscious effort in evaluating if the potential returns would be meaningful and not capital destructive.
Companies that have heavy R&D spending as opposed to being CapEx-intensive like technology or pharmaceutical firms would require a more sophisticated understanding of their business models. That being said, the fundamentals of capital allocation are like the laws of physics – you can only spend so much cash on multiple failed ventures before the market realizes that you are incompetent.
The fifth perspective
Looking from the lens of an individual, companies are no different from investors at the very root – they’re in the business of making money. There will always be foolish investors and companies alike that waste their money in failed ventures or stupid decisions, and there will always be some rare, exceptional cases that earn outsized returns. Sticking to the basics in asking the most fundamental and simple questions can sometimes save your wealth and/or your company.