As we noted in our last commentary, the intrinsic value of any investment rests on the free cash flow the business can generate over its remaining life, discounted back to present value at an appropriate rate. Obviously, one cannot actually know the precise timing and magnitude of cash flows even for the next few years let alone the remaining life of a typical business. Once we begin to focus on free cash flow, it also becomes apparent that it is critically important to determine what a firm does with such cash flows.

“In theory there is no difference between theory and practice. In practice there is.”

Yogi Berra

As we noted in our last commentary, the intrinsic value of any investment rests on the free cash flow the business can generate over its remaining life, discounted back to present value at an appropriate rate. Obviously, one cannot actually know the precise timing and magnitude of cash flows even for the next few years let alone the remaining life of a typical business. However, this is certainly the best place to start. Once we begin to focus on free cash flow, it also becomes apparent that it is critically important to determine what a firm does with such cash flows.

As Yogi Berra famously noted, there is a big difference between theory and practice when it comes to operating in the real world. Following a sound and principled capital allocation process is proven to enhance shareholder returns, though it may not always be possible due to long standing institutional biases and shareholder expectations. For example, a newly hired CEO of a long established business engaged in irrational capital allocation practices will be unable to change the approach immediately. Nevertheless, the approach to allocation should be sensible, even if certain aspects may not be strictly defensible.

Any MBA or investment analyst could recite the basic alternatives of capital allocation:

• Invest in internal expansion to widen the moat of the existing business as opportunities arise.
• Invest in external expansion to acquire another business, either to consolidate market share or expand entirely into a new area.
• Pay down debt either to change its capital structure or strengthen the balance sheet (particularly in cyclical industries).
• Return capital to shareholders either by paying dividends or through stock repurchases.

Returning capital or paying down debt are certainly the least intrusive to the business operations, though they could result in diminishing returns over the long term. For this purpose, we assume that stock repurchases are made at low valuation. It should also be noted that dividends are a tax‐inefficient method for generating total returns, because dividends are taxed twice, first at the corporate level and then at the personal level.

Organic reinvestment – the first option above – is likely the most simple and straightforward form of capital allocation. Instead of diverting funds away from a core business line to make balance sheet improvements, perform acquisitions, or return capital to shareholders, management opts to reinvest excess capital into the operating business that originally generated it. Of course, some businesses are so capital‐intensive that almost all operating cash flow must be reinvested just to maintain their current competitive position. These businesses are not generally fantastic investments. Since capital must be continuously reinvested to maintain the business, there is no excess capital to fund more aggressive growth projects or diversify the enterprise’s operations.

The business that requires very little reinvestment (although reinvestment is certainly an option if growth prospects are bright) is much more attractive. Capital‐light business models with minimal reinvestment requirements make good long‐term investments because they offer more optionality. In other words, it is up to the management team – rather than the economics of the business – to decide whether organic reinvestment is the path to building long‐term shareholder value.

Mergers & acquisitions – our second option above – can be some of the most transformative capital allocation moves that corporate executives can make. They can also be the most risky. For example, when markets are high, or there is plenty of competition in the industry, it is more likely that the acquiring company is overpaying for its purchases, which reduces future total returns. An acquisition that may make sense at one price will eventually become foolish if prices are sufficiently increased.

The CEO and management team should ideally be competent operational managers as well as skilled capital allocators. These skills are two sides of the same coin when it comes to achieving satisfactory returns on shareholder capital as, ultimately, capital allocation will drive the real returns of investors over long periods of time.