What Business Owners Should Do With Their Business's Earnings
Business owners and managers have only five ways to use the earnings from their business.
They are:
- Reinvest capital into the business
- Buy back shares
- Pay a dividend
- Pay down debt
- Acquire another business
How to determine what do to with business earnings:
Determining what to do with earnings is a simple calculation for shareholders. Management should choose the option that will produce the highest post tax rate of return.
Before a decision is made however, opportunity cost must be properly considered. Assuming risk levels for each option are roughly equal, the five options should be evaluated against their return and the capabilities of management over an appropriate time horizon.
Opportunity cost applies most heavily to internal and external investment. If the business has no immediate prospects of an acquisition or internal investment, management must ask the question if it would be more efficient for the firm to wait to deploy capital. Management activity to expand the firms opportunity cost and capability determines the course of action.
At the same time, managers should consider ongoing liquidity requirements and any increased capital spend necessary to retain the businesses’ competitive position and unit volume. Increases to working capital should factor into this capital equation as well. For all considerations, required after tax capital spend should be subtracted from the net capital deployable.
Only after these options and their associated opportunity costs have been properly considered should business owners and managers determine how to deploy capital.
A rough exercise would should look something like the following:
Below is a detailed analysis of each of the available options for capital deployment.
Reinvest Capital Into The Business
It is important to clarify the difference between what qualifies as business investment and what does not.
The vast majority of businesses require some additional capital investment to retain their competitive position in the market. This spend can include maintenance expense for equipment, inflationary costs for marketing and cost of living adjustments to retain talent. It can also include spend to maintain inventory at appropriate levels.
There are two kinds of businesses: The first earns 12%, and you can take it out at the end of the year. The second earns 12%, but all the excess cash must be reinvested -- there's never any cash. It reminds me of the guy who looks at all of his equipment and says, "There's all of my profit." We hate that kind of business.
Charlie Munger
Nondiscretionary spend does not represent funds available for reinvestment in a business. The capital available for reinvestment must be fully discretionary. If a company has no ability to redeploy capital favorably into the business, the other options should be considered.
For simplicity, the criteria that determines if a reinvestment opportunity is valid is the ability of the company to reinvest a dollar and generate more than dollar of value in return in todays dollars. Projects that do not lead to additional post tax dollars that themselves become discretionary fail to qualify.
The ideal business is one that generates very high returns on capital and can invest that capital back into the business at equally high rates. Imagine a $100 million business that earns 20% in one year, reinvests the $20 million profit and in the next year earns 20% of $120 million and so forth. But there are very very few businesses like this. Coke has high returns on capital, but incremental capital doesn't earn anything like its current returns. We love businesses that can earn high rates on even more capital than it earns. Most of our businesses generate lots of money, but can't generate high returns on incremental capital -- for example, See's and Buffalo News. We look for them [areas to wisely reinvest capital], but they don't exist.
Warren Buffett
Invest In Another Business [Or Acquire]
Price is what you pay and value is what you get. A common quote of Buffett's means pay less and get more, and pay more and get less. Managers who can acquire cashflows for significantly less than their future value may be able to take advantage of investing in or acquiring other businesses.
A company may have limited internal opportunities to deploy capital favorably. Similarly, the rate of return on investment in external business may be far superior. One of the key responsibilities of management is to constantly expand the firm’s opportunity cost by continually screening for investment opportunities outside of the firm. For the purposes of generating a return, public and private market opportunities are no different beyond liquidity considerations.
Acquisitions present perhaps one of the greatest opportunities for growth for a company. With a well structured transaction, a company can more than double its size in relatively short order. But, they also present one of the greatest risks for shareholders especially when debt is used.
CEO managers without material ownership take in a company may exhibit a natural desire to grow via acquisition. By using the firm's money and not their own, they increase the relative size of their ownership in the larger firm. Proper independent corporate governance, board members, should act to prevent a CEO from overreaching.
Companies that are able to compound capital at extremely high rates for extended periods of time are rare birds. Any company looking to do an acquisition should be wary of any investment which will not eventually return capital to shareholders.
Acquisitions should be evaluated based on the eventual return of capital to shareholders. Cashflows of acquisition targets should be examined on the basis of post-tax and post maintenance capital spend. At the end of the day, the money that goes into an investment must eventually go back to the investor, or in this case, the business.
Reduce Debt
Perhaps the simplest option to understand, many companies employ some form of leverage to enhance returns. When interest rates are low it may be favorable for companies to borrow more capital in advance of need rather than pay it down.
Debt, in contrast to the other available options, typically introduces a level of systematic risk to equity holders. For long dated issues, most firms are benefited by inflation and by holding affordable notes through maturity or extended periods of time.
When high yield debt is used within a company’s capital structure, the opportunity cost of paying down the debt early becomes more apparent. Reducing interest burdens produces a real return for the business. Paying down debt may have the double benefit of freeing up future cashflows and creating new opportunity for combination with new financing at better terms.
Importantly, the added risk of debt does not supersede the imperative to utilize the capital towards the highest return activity.
Buy Back Shares
Share buybacks may not apply to a small or a private company with limited ownership. But for lager private and public firms with varied ownership structures, share buybacks are a valid use of the company’s available earnings.
Buying back shares requires that management communicate honestly with shareholders about the intrinsic value of the shares of the firm. To be effective, management must have a very clear understanding of the value of the underlying business. If a company’s stock is selling or available far below its intrinsic value then the company can generate a significant return for owners.
Share buybacks are a powerful way to return cash to shareholders when the stock is selling for below intrinsic value. The tax treatment of a share buyback program may also be more favorable than dividends.
Managers of companies with outstanding shares should continually monitor the share price relative to the intrinsic value of the firm.
Pay A Dividend
Companies can pay out a portion of their earnings to shareholders in the form of dividends. Dividends should be considered only in relative attractiveness to other options previously mentioned.
Not realizing that smaller size increases total universe of available investments, most small businesses pay out some portion of their earnings at the end of the year. This is typically done without consideration as to the opportunity cost of other available options. It is common for private companies to have wildly differing dividends amounts year to year based on performance and opportunity cost.
The majority of public companies however, run into an expectation problems when issuing a dividend. When companies issue dividends, the expectation regularly becomes that it will continue those dividends in regular intervals for extended periods. The effect is that most management seek to ensure a regular dividend will pay out a conservative amount of capital.
Mistakenly, once the dividends are established, management teams are reluctant to pull back towards or stop dividends for higher return uses. The effect is a less than optimal use of the firm’s capital for extended periods of time.
In public markets, the total amount of money paid out in dividends is roughly equal to the amount lost in trading and investment advice. This is a very peculiar way to run a republic.
Charlie Munger
Depending on the entity structure. A reason to avoid dividends as a capital allocation mechanism may be the taxes paid by shareholders or the firm. After tax costs must be factored into the return calculation for owners.
Management must always consider if they retain a dollar, will it be worth more than a dollar in present value in the future as a result of other activities. If the answer is yes, then a dividend is not the best course of action.
Why Capital Should Always Go To Its Highest And Best Use
Money is the most fungible commodity there is. Strong businesses can generally create more of it by providing value to others via its goods or services but not indefinitely. Eventually, some disruption to future cash flows will occur.
Given the future is uncertain. Managers of a firm should aim to maximize value creation for shareholders and put the firm’s capital to its highest and best use.
When excess capital is available, the role of management is always to ask, “Can we use the money more effectively within our business or outside? How? And how does it compare to the other available options”.