To create wealth in businesses (Public corporations), business should be able to generate and allocate (deploy) capital efficiently. In this article, I would like to highlight the ways in which businesses can generate and allocate capital. Although each category deserves an entire article on its own, this is just a highlight!
Capital Generation:
There are essentially 3 ways public corporations can generate capital.
1. Internal generation (Profits)
2. Issue stocks (Take money from investors)
3. Issue bonds (Borrow money from investors)
Lets take a look at each in detail with their advantages and disadvantages.
1. Internal generation (Profits):
Profits are generated when the company sells products/services above their costs after all taxes are paid. To continue to make a profit, the products/services of the company have to be needed or desired by the customers who are able and willing to pay more than the costs incurred to make it.
Advantage vs money from investors:
Limited risk and dilution of ownership.
Disadvantage vs money from investors:
Limited ability in generation relative to their products/services sales
2. Issue stocks:
When the business needs more cash than their own ability to generate, they can sell stocks to investors.
Advantages:
Business can and should do that when their stock is richly valued by the investors and deploy them into attractive opportunities.
Disadvantages:
Dilution of ownership for the existing shareholders.
3. Issue bonds
When the business needs cash more than their own ability to generate, they can borrow money from investors.
Advantages:
No ownership dilution for existing investors.
Lower cost of capital.
Interest expense is tax deductible.
Disadvantages:
Increased risk as the need to pay interest on the bonds.
Capital Allocation:
There are essentially 5 things public corporations can do with each dollar (Capital) generated:
1. Reinvest in the business
2. Acquire other businesses or assets
3. Pay down debt
4. Pay dividends and
5. Buy back shares
Lets take a look at each in detail and where each of them could be valuable and rational when they are applied.
1. Reinvest in the business
If the opportunity to get a return on invested capital is high, the business is best served by reinvesting in their products/services. This is by far the best option to increase the net worth of the business and shareholders.
2. Acquire other businesses or assets
If the opportunity to reinvest in their business where they can get high return on capital is not available, the next best option is to buy other businesses in same industry to achieve better economics and grow; or even other assets or businesses in unrelated industries (usually done by holding companies). Obvious disadvantage of this approach is usually companies tend to get 'diworsified'.
3. Pay down debt
If the opportunity is not available to reinvest in existing businesses or acquire other businesses, paying down debt makes the company debt free and less risky as a corporation. Disadvantage is that the business loses the low cost of capital and tax advantages.
4. Pay dividends
If the opportunity to reinvest/acquisition is not available and there is not a lot of debt, returning cash back to shareholders via dividends is a good idea. The disadvantages are double taxation(tax on the company level profits, dividend tax on the investor level) and value not accruing at the company level.
5. Buy back shares
If the opportunity to reinvest/acquisition is not available and there is not a lot of debt on their books, returning cash back to shareholders via buying back shares is a better idea when their shares are selling in the market for cheap multiples or attractive valuation relative to their cash flows. This will increase the existing shareholders' ownership and earnings per share in the company and no double taxation as in the dividend distribution. The value may not be great if the company is buying back their shares at any (high multiples) price.
Disclosure: Gobinath Balasubramanian is a Registered Investment Advisor Representative for GB Investments LLC (RIA).
