The value of a business is the sum of its future cash flows discounted to present value. A business’ long-term value is entirely dependent upon the ability to invest in projects that increase the expected value of future cash flows. The process of deciding how to raise and spend cash in a business is called capital allocation.
Capital Allocation is Critically Important
Capital allocation skills are one of the most important skills the management of a business can have. With excellent capital allocation skills, a business will compound value well in excess of overall market returns. Poor capital allocation results in value destruction. Even a business with a strong competitive advantage can see its profits squandered and growth brought to a standstill through inefficient use of capital.
“The root of my success is acting rational about capital allocation”
– Warren Buffett
Management obtains capital by divesting parts of the business, selling debt, issuing new shares, and through earnings. The formula for cash raised by management is:
debt issuance + share issuance + earnings + business unit sales = total capital
For example, From 2004 to 2013, IBM issued $18.25 billion in new shares not counting share repurchases. Over the same time period IBM issued $121.81 billion in debt. The company had $125.81 billion dollars in earnings over the 10 year period from 2004 to 2013. The company did not have any notable business divestitures over the 10 year period. Total investable cash for the period is:
debt issuance of $121.81 billion + share issuance of $18.25 billion + earnings of $125.81 billion
= $265.87 billion in total capital
Management can spend capital in several ways to reward shareholders and grow the business. A company can repurchase shares, reducing the overall share count and increasing the earnings per share for remaining shareholders. A company can pay out capital as dividends, simply distributing cash to shareholders. Management can also pay down debt, which increases financial stability by reducing risk from being overleveraged. Paying down debt also increases future earnings by reducing interest expense. Finally, management can invest in various projects to increases future earnings.
Management & Valuation Ratios
Management has complete control over how they generate capital and on what they spend capital. What a company cannot control is its valuation multiple. The valuation multiple of a business is separate from the underlying business. IBM’s P/E ratio has bounced around from around 10.7 to around 15.7. These valuation changes represent enormous shifts in the value of the business. A move from 10 to 15 is a massive 50% change in market capitalization. To effectively score management’s effectiveness at capital allocation, you cannot include arbitrary shifts in valuation metrics.
Normalized Debt Adjusted Value per Share (NDAV/S)
How do you measure management’s effectiveness at capital allocation? By examining the change in normalized value over a time period. The value of a business is its future cash flows. If you were to own a business outright, it would be worth the sum of its discounted future cash flows plus any cash currently in the bank, and less any debt you would have to pay back that the business owns.
Value of Future Cash Flows – Debt + Cash = Debt Adjusted Value
The problem with debt adjusted value is determining the value of future cash flows. The historical average multiplier for the future value of $1 of current earnings is 15. The S&P 500’s historical average P/E is about 15, which is where this number comes from. Normalizing the future value of cash flows with the same valuation multiple of 15 allow you to value all businesses on an apples-to-apples basis.
Scaling Normalized Debt Adjusted Value by share count accounts for share repurchases over the period. Total shareholder valuation adjusted capital gains are best reflected by scaling by share count.
Enough theory, let’s see how NDAV/S works with IBM. In 2004, the company had the following:
Earnings per share: $5.05
Debt per share: $13.93
Cash per share: $6.11
EPS of $5.05 x 15 = $75.75 – Debt/Share of $6.11 + Cash/Share of $6.11 = NDAV/S of $67.93
By 2013, the company has the following:
Earnings per share: $14.94
Debt per share: $37.67
Cash per share: $10.16
EPS of $14.94 x 15 = $224.10 – Debt/Share of $37.67 + Cash/Share of $10.16 = NDAV/S of $196.59
IBM grew NDAV/S at a compound rate of 12.53% per year. But IBM did even better than that. The company paid dividends over the 10 year period of $20.53 per share. Adding dividend payments to NDAV/S shows the company compounded shareholder capital at 13.78% per year. Now you can see why Buffett was such a large purchaser of shares in 2011!
Capital Allocation Reexamined
From the 10 year period 2004 to 2013, IBM grew NDAV/S from $67.93 to $196.59, for a net gain of $128.67. Adding in dividends of $20.53 per share over the 10 year period, the company gained $149.20 in value for shareholders over the 10 year period.
How much capital did IBM spend to make these gains? The company had $265.87 billion in total capital to spend over the 10 year period (see obtaining capital section above). On a per share basis, this comes to $252.15 per share.
IBM spent $252.15 per share to generate $149.20 per share in value for shareholders. The company only increased shareholder value by about $0.86 for every $1.00 the company had to spend. You can measure management’s skill by comparing the ratio of shareholder value created to total capital.
Other Examples of Business & Capital Allocation
The higher the investment ratio, the more effective a company’s management is at turning cash flows into shareholder value. Apple’s extremely impressive run will not continue. If it did, the company would quickly become larger than any most countries. IBM has managed to compound value quickly, while Walmart’s management has done an excellent job of efficiently deploying capital.