Companies can use profits to invest in the business, acquire other businesses or pay-out the profits as a dividend. Capital allocation is essential and requires CEO’s who know what is best for long-term business success.
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Capital allocation of companies
Let’s start with some notes about capital allocation before we begin describing the investment possibilities of companies.
Investing the profits is also known as allocating capital. Capital is the amount of debt and equity (the shares) that a company has to invest. A company basically starts with money and then makes a product and/or service that is sold to earn more money. The earned money is called the profits of a company. A good definition of capital allocation is:
“It’s what managers decide to do with the cash available to them. If a company has good allocators, even a mediocre business will prosper. If a company has poor allocators, the best business in the world will eventually founder.”Fortune.com
The profits of a company don’t tell you much, unless you look at the capital that the company needs to produce the profits (letters to shareholders 1987). Ideally, a company should use a minimum amount of capital (debt and equity) to produce the earnings. This leads to high returns on capital (see the best business according to Warren Buffett). The balance sheet of a company allows you to see the capital structure of a company.
How companies can invest profits
There are basically 5 things a business can do with the profits:
- Invest in the business (e.g. a new machine or IT)
- Invest in another business (buy another company)
- Reduce debt (less interest cost and reduces risk)
- Buy back shares (this increases the earnings per share)
- Pay a dividend (shareholders receive a part of the earnings)
Note that I’m defining profits as the cash that is available from operations minus the required capital expenditures. This is also called the free cash flow and gives a good picture of the cash that a company can invest after ensuring that the machines will still produce the same production quantities. You always want to ensure that you maintain your machines and infrastructure first to ensure the same level of service to your customers.
Investing is all about comparing opportunities
A good question would be “which of these 5 options should a company select?”. As we will later learn from the best CEO’s, this depends on where a dollar of profits will deliver the highest risk-adjusted return in the long-run. This is a concept called “opportunity cost”. A useful concept to the individual investor as well. You weight the assumed return on the investment with the risk of losing money over time. First you look at your own business or stocks and then compare that to outside opportunities.
So, a business should compare the investment options and this will depend on the maturity of a business or the economy for example. Having additional cash on the balance sheet could be prudent at this moment in time. A mature business will have less opportunity for profitable investing then a start-up company.
Investing profits back in the business is key
Investing in maintaining the competitive advantage (moat) of the business should be key. So, a part of the profits will always go to maintenance investments to simply making sure that a company can still make the same amounts of shoes or service quality.
Let’s take Google as an example. Google is getting most of its profits from Search via advertisements. This requires a lot of computing power and IT investments. Investing for Google will likely be aimed primarily at ensuring that Google Search can still function in the same way in the upcoming years. We know it works, so investing in extra IT capabilities is profitable and not very risky.
Google Cloud is another example of a pretty sure and profitable investment. Investing in Google Bets is more risky as it is unlikely that all the “moonshots” projects will turn into viable solutions. See for more information the Google (Alphabet) Investor Relations page: https://abc.xyz/investor/.
Why should a business invest profits?
The whole idea of investing profits should be growing the future earnings of the company by pursuing new opportunities or by improving the current business. If a company cannot invest the profits in something that adds value, then paying out a part of the profits in the form of a dividend or share repurchases is fine. Note that a company should not overpay for its own shares (just like an investor).
Paying dividends is not the most efficient way of allocating profits due to the tax. But, many investors use the dividends as income and strong dividend records are highly valued on Wall Street. Many strong mature businesses like Unilever, Coca-Cola and Johnson & Johnson pay-out dividends.
Focusing on the highest incremental return on profits is best for the shareholders. This means reinvesting the profits in opportunities that leads to higher free cash flow for shareholders. Apple’s iPhone is one of the best examples of smartly investing profits in new opportunities. Restructuring stories remind us of how investing can also go wrong. Management tries to increase sales by buying other companies for too much money. Restructuring takes place if the added earning capacity of the takeover is not adequate in respect to the price paid. Hence, investing discipline and skills are essential!
Books about capital allocation
Luckily, we have the opportunity to learn from the best by reading about successful businesses. Two excellent books about how companies should invest their profits are “The Outsiders” and “University of Berkshire”. The Outsiders describes how 8 superb CEO’s achieved their record.
“An outstanding book about CEOs who excelled at capital allocation.”Warren Buffett
The book University of Berkshire Hathaway summarizes the shareholder meetings of Berkshire Hathaway and is filled with investing advice. The advice is given by Warren Buffett and Charlie Munger who are excellent capital allocators. Famous students include Jamie Dimon of JPMorgan Chase and I would recommend Jamie’s letter to shareholder to my readers as well!
Investing principles for corporate capital allocation
The investing principles of Benjamin Graham’s book “The Intelligent Investor” are very applicable when companies are considering how to invest profits. Let’s go over the four principles found in chapter 20 called “Margin of Safety”. According to Buffett, chapter 8 (The Investor and Market Fluctuations) and 20 are all you need to know for investing.
- Know your business (circle of competence)
- Do not let anyone else run your business (make sure you understand the facts)
- Do not enter upon an operation unless a reliable calculation shows that a profit can be made (don’t risk your investment)
- Have the courage of your knowledge and experience
Graham further says about point four that: “you are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right.” You can directly relate these principles to the investing style of Buffett and it would be sound practice for companies to allocate their profits in a similar fashion.
As Graham says in the summary of chapter 20: “investment is most intelligent when it is most businesslike”. Sound business principles of successful business owners are lost when they go to Wall Street. Hence, the need to think logically and rational and to believe in your own decision making capabilities! The margin of safety (don’t overpay for your investment) increases the chances of success dramatically.
How to best companies invest profits
The book “The Outsiders” offers a checklist that shows what CEO’s of companies think about when deciding about investing profits. I will list a couple of points of the list that can be found in the book. Interestingly, the points align partly with the principles of Benjamin Graham. Remember, that a lot of these CEO’s have read the book’s of Benjamin Graham and also listen to Warren Buffett. So, it’s likely not a bad thing for us to look at as well!
The CEO investing checklist for allocating capital:
- Determine the hurdle rate for investments (opportunity costs or minimum rate of return)
- Calculate the returns on internal and external investment opportunities (adjusted for the risk)
- Calculate the returns when buying back shares
- Determine the adequate debt and cash levels for the company (depends on industry and economy for example)
- Retain excess capital only if you can invest it profitably in the future (otherwise return in to shareholders)
Interestingly, the list is very similar to the points like opportunity costs that we mentioned at the beginning of this article. Looks like CEO’s who succeed found a working recipe to outstanding performance. The smart CEO incorporates the risk and certainty as always with investing (see DCF). The idea of investing capital is to earn more profits in the future. So, you want to ensure a high return on invested capital for you business.
Buffett on investing for companies
One of the best CEO’s when it comes down to investing profits of companies is Warren Buffett. In his 1987 letter to shareholders we can find the following interesting opinion of Buffett about CEO’s and capital allocation.
CEOs who recognize their lack of capital-allocation skills (which not all do) will often try to compensate by turning to their staffs, management consultants, or investment bankers. Charlie and I have frequently observed the consequences of such “help.” On balance, we feel it is more likely to accentuate the capital-allocation problem than to solve it. In the end, plenty of unintelligent capital allocation takes place in corporate America. (That’s why you hear so much about “restructuring.”)Warren Buffett, 1987
Unfortunately, CEO’s are not always blessed with great investing skills. Many emerge to the top due to excellent performance in a specific area of the company like sales. This is no guarantee for successfully steering a company towards long-term out-performance.
Stock investing and business investing are similar
Hopefully, you see that the way a CEO must think about investing profits is similar to the way an investor must think when investing in stocks. The questions are always how much cash will I earn, when will it happen and what are the risks? Allocating profits has much in common with the simple way Warren Buffett thinks about investing in a business. The business must be understandable with good management and should earn high returns on capital.
A simple but very effective process is thinking about the certainty that the investment will deliver the minimum required return on investment and the likelihood of a loss. So, this has a lot in common with long-term stock investing!
Good investing of profits determines the future of companies
Finding a business with a good CEO that allocates capital well will greatly improve the chances of investment success. Focusing on the moat of the company is important to ensure that competitors don’t take away the profits. Additionally, investments should be made that benefit the shareholders over the long-term by pursuing new earning opportunities. Meanwhile, it can be prudent and fair to pay-out some of the profits in the form of dividends. Share buy-backs are also efficient as long as the company is not buying shares back at high prices above intrinsic value!