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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.
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.
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.