“When companies with outstanding businesses and comfortable financial positions find their shares selling far below intrinsic value in the marketplace, no alternative action can benefit shareholders as surely as repurchases.” ― Warren Buffett, Shareholder Letter 1984
Capital allocation is an important area when it comes to running a business, and it’s important to understand both sides of it, re-investing capital in the business versus distributing cash back to shareholders. The managers in charge of making these kinds of decisions have to have the knowledge to know the pros and cons, and thus be able to make the best capital allocation decisions possible to create the most value there is to create for shareholders of the business.
Also, as an investor you need to be able to understand the capital allocation decisions made by mangers and how it all affects the underlying value of the business, and if the capital allocation decisions made look reasonable and thus value creating or done mostly in the interests of the managers themselves, for example retaining earnings to build an empire that leads to bigger paychecks etc.
Disbursing Cash to Shareholders: Frequently Asked Questions about Buybacks and Dividends
A great way to learn more in this area is to read this recently published report discussing a few of the issues when it comes to disbursing cash to shareholders. This new report is written from Michael J. Maubosin and Dan Callahan, both currently at Credit Suisse. The report can be found here.
The following graph is found on the front page of the report, showing the historical growth in dividends, buybacks and the S&P 500 during 1982-2013.
The front page also contains the following summary points about the topic of buybacks and dividends addressed in the report. Have a look at them and then take some time to read the report itself.
- Corporate cash balances are building because Corporate America’s return on investment is high and its reinvestment rate is modest. The issue of disbursing cash to shareholders is a crucial and timely issue in determining shareholder value.
- Share buybacks and dividends are two methods to return cash to shareholders. Executives view the two very differently and are often unsure of the best way to proceed. Superficial media coverage and wide-ranging input from investors drives this confusion.
- This report answers frequently asked questions. This format allows us to cover the pertinent issues as well as address a number of canards that persist with regard to these topics.
- A company should retain its earnings if it can earn a rate of return that is above the cost of capital. But if shareholders can earn a higher rate of return on capital than the company can, the company should disburse the cash.
The report is well worth reading, so check it out here.