The Joys of Compounding by Gautam Baid
Author:Gautam Baid
Language: eng
Format: epub
Tags: BUS107000, Business & Economics/Personal Success, BIO003000, Biography & Autobiography/Business
Publisher: Columbia University Press
Published: 2020-06-01T16:00:00+00:00
One question I always ask myself in appraising a business is how I would like, assuming I had ample capital and skilled personnel, to compete with it.
—Warren Buffett
Capital Allocation
Capital allocation is the bridge between intrinsic business value and shareholder value. If a company has high-return investment opportunities internally, it should reinvest heavily. Maturing companies, however, often continue to invest despite declining or low returns on capital. (Aging is tough for companies as well as for people.) These companies should instead return capital via dividends or share buybacks. Dividends are important not only for the obvious reason of the use of idle cash but also because they act as a discipline—for a company to pay a dividend, the profits have to be real. Remember, dividends are not necessarily good if they are funded poorly (sometimes management takes on debt just because shareholders expect dividends) or if they are paid out in lieu of investing in high-net-present-value projects and represent a large opportunity cost.
Share buybacks always should be driven by an objective assessment of intrinsic value, but many times, they are done to offset stock option dilution and manage reported earnings per share. Note that buybacks do not create value; they simply redistribute wealth among shareholders. Buybacks transfer wealth from ongoing shareholders to former shareholders, if executed above intrinsic value, and vice versa.
Often, management teams that engage in empire building destroy value through extravagant merger and acquisition (M&A) deals. Always check to see whether company size, measured in terms of total revenues, with no mention of profitability, is a factor in management compensation. Managers who are paid handsomely to misallocate capital will do so. Incentives matter.
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