Part 2 – Lesson 13

### Overview

As you listen to earnings calls, you will often hear analysts ask management teams to provide color on how they plan on allocating capital to get a better understanding of the company’s priorities with regards to where they are looking to invest.

This is an important concept because most public market investors are minority investors with little voting power and control over the company.  Without a large controlling shareholder, the Board of Directors and the management team are essentially in control of the fate of the company.  As a small shareholder, investors generally don’t get to dictate strategy to the company.  Instead, investors try to understand what strategy the management team is pursuing.  If investors agree with this strategy, they buy the company’s stock, but if they don’t agree with the strategy, investors vote by selling the stock.

One of the key components of the management strategy that investors like to understand is how the management company plans on allocating capital between the following primary uses: 1) internal growth, 2) acquisitions, and 3) dividends and stock buybacks.

To judge the attractiveness of these various uses of capital, management teams may look at the internal rate of return (IRR) on capital deployed.  If the IRR of investing in internal growth is higher than the IRR of doing an acquisition or buying back stock, then, this management team will invest in internal growth before other uses.  However, if acquiring another company produces the highest IRR, then, the management team may decide to prioritize acquisitions over other uses of capital.

Let’s review IRR and how to calculate this metric.

### Internal Rate of Return (IRR)

Mathematically, IRR is the discount rate that would result in zero net present value (NPV) for a project.  It essentially calculates the “average return” for a project.  For example, let’s assume Company A invests \$10,000 into a project, which is expected to generate 10 years of positive cash flow.  The IRR of this project is the rate at which we must discount these 10 years of cash flow to arrive at a present value of \$10,000.  The \$10,000 initial cash outlay (which is a negative cash flow) summed together with the positive \$10,000 present value of all the future cash flows equals zero.

1. In the above example, Company A has projected their cash flows of their project. Company A knows that they will have to deploy \$10,000 today as the initial investment.  In Excel, we show the initial investment as a negative number since it is a cash outflow.  The cash outflow occurs at “Year 0” which is understood to reference the present day.

2. After the initial investment, Company A projects the 10 years of cash flow that they expect to receive from this project. Calculating IRR in Excel is very simple as we can use the =IRR(values) function.  Using the IRR function, we calculate that this project will yield a very healthy 36% IRR.

3. As we’ve mentioned, this 36% IRR represents the discount rate that would have to be used to discount all the future years’ cash flow to arrive at a present value of \$10,000. In other words, if we discounted the year 1 cash flow of 2,500 by 36% and then discounted the year 2 cash flow of 3,500 by 2 years at 36% and then discounted the year 3 cash flow of 4,500 by 3 years at 36% and so on, we would end up with a present value of 10,000 when adding all 10 years together.  Let’s see this math in action:

4. In the above chart, we can see that once we discount each yearly cash flow by 36% and then add it together, we end up with 10,000. Adding this to our initial cash outflow of 10,000 yields a zero net present value.  Therefore, we know our IRR calculation is working properly.

5. Now, let’s assume that this is the “upside case” for this project. In other words, these forecasts represent Company A’s most optimistic expectations regarding the returns of this project.  Company A wishes to forecast a “base case” and a “downside case” to see what the IRR would be if the cash flows come in lower than they expect.

6. In the above chart, we added base case projections and downside case projections. The base case projections assume that the project achieves 60% of the cash flow level of the upside case, and the downside case assumes a disaster scenario where the project only achieves 30% of the cash flows of the base case.The resulting IRRs are 20% and -4% for the base case and downside case respectively.  This brings us to an important point: IRRs can be negative!

How do management teams use IRR metrics?  After calculating an IRR of a project, management teams compare the IRR to their cost of capital and then decide to invest in the project accordingly:

IRR > Cost of Capital This creates value, so the company should invest in this project

IRR = Cost of Capital → This creates zero value

IRR < Cost of Capital → This destroys value

Let’s assume Company A’s cost of capital is 10% and calculate the present value of the cash flows from this project:

We can draw the following conclusions from this:

1. Upside Case – assuming a 10% cost of capital, the present value of the future cash flows of the project is 25,901, which significantly exceeds the 10,000 that Company A will have to deploy today. If the management team moves forward with this project (assuming the upside case cash flows are correct), they will have added 15,901 in value to the company.

2. Base Case – assuming a 10% cost of capital, the present value of the future cash flows of the project is 15,540. Since Company A only needs to deploy 10,000 today to achieve this value, the management team will have added 5,540 in value by pursuing this project (if the base case cash flows are correct).

3. Downside Case – assuming a 10% cost of capital, the present value of the future cash flows is 4,662. If the management team believes the downside case is likely, then, they will have destroyed 5,338 of value by pursuing this project.

IRR and cost of capital are two related but distinct concepts.  The cost of capital is the required return demanded by the equity and debt investors of the company, whereas the IRR is the actual return achieved from deploying the capital provided by debt and equity investors.  Therefore, if debt and equity investors on a combined basis demand a 10% return, then, a management team must only pursue projects that exceed this cost of capital.  For example, if a company finances a project with debt at 5% (cost of debt), then, the investor must earn a return higher than 5% (IRR) to create positive value.

In the next few sections, we will review the primary options that management teams evaluate when deciding how and where to deploy capital.

Internal Growth – “Organic” Growth

Management teams must continuously weigh the highest and best use of cash.  Many management teams prefer to invest cash back into their own business, particular when management judges IRR of investing in projects within the company to be higher than other uses.

Generating growth by investing in the business is referred to as “organic” growth.  Organic growth is growth that comes “naturally” from pursuing and investing in the core business of the company.  “Inorganic” growth is growth that comes from outside the company, such as through acquisitions.

Deployment of capital into organic growth can come in two forms: 1) operating expenditures and 2) capital expenditures.

Operating expenditures are income statement expenses.  For example, hiring new salespeople or hiring new R&D staff are investments into the business.  The challenge for many companies is deciding on the return on hiring new employees.  For example, the return on hiring a salesperson is usually straightforward to calculate.  If Company A hires a salesperson for a yearly salary of \$75,000, and the average salesperson in the company generates \$300,000 in annual sales, then, the company knows exactly how to calculate the IRR on hiring new sales staff.

However, hiring an engineer into your R&D department provides a return that is much more difficult to calculate.  In these instances, management teams must make a judgement call on their long-term outlook of the business and the likely returns of the overall project that the company is pursuing.

Organic growth can also come in the form of capital expenditures.  Many companies categorize capital expenditures into two categories: 1) sustaining capex and 2) growth capex.

Sustaining capex is the minimum level of capital expenditures needed to sustain the current revenue level of a company.  For example, Avis is a rental car company that must maintain a certain fleet level so that it can meet the demands of its existing customer base.  Avis must continually spend capex in the form of buying new cars to replace old cars in their fleet just to maintain their current level of revenue.  If Avis were to stop buying new cars, its fleet quality would deteriorate, and customers would ultimately go elsewhere.  Thus, Avis has a minimum sustaining capex level that it must spend every year to maintain the business.  An IRR is typically not calculated on sustaining capex because this is a non-discretionary expenditure.

Growth capex is capex that a company deploys above and beyond the sustaining capex level so that the company will grow the revenue of the business.  In our Avis example, if the company wants to grow revenue, it can spend growth capex on opening new rental locations and expanding the size of its fleet.  Based on its history of opening new locations, Avis should have a good sense for how much capex is required to open a new location and what level of revenue and cash flow a new location may generate.  Based on these numbers, Avis can calculate an IRR on opening a new location.  As long as that IRR is higher than their cost of capital, then, Avis may decide to pursue new location openings since it creates positive NPV for the company.

### Acquisitions – “Inorganic” Growth

Many large public companies employ business development teams that are continuously on the hunt for acquisition opportunities that will supplement their current business, whereas other companies may pursue acquisitions on a one-off basis as interesting opportunities arise.  Similar to capital deployed for organic growth, companies must evaluate the returns of acquisitions to judge whether or not it is financially attractive for the company.  Management teams may judge the attractiveness of acquisitions by evaluating the expected IRR.  Additionally, many management teams will calculate if the acquisition is “accretive” or “dilutive” to their current EPS or FCF/share.  This topic is covered in Part 2, Lesson 14.

Acquisitions can generally be broken down into two categories: 1) transformative acquisitions and 2) tuck-in acquisitions.

Transformative acquisition – An acquisition that materially changes the business mix, geographic mix, size, or general outlook of the company is referred to as a “transformative acquisition.”  For example, in 2018, T-Mobile announced the acquisition of Sprint.  This is a transformative deal for T-Mobile and Sprint because it significantly increases the size of the company, creates significant cost savings, and combines large employee bases at each respective company.

Tuck-in Acquisition – An acquisition that is relatively small in comparison to the overall size of the acquiring company is generally referred to as a “tuck-in acquisition.”  Many of the large tech companies regularly acquire very small companies to fold into their larger organization.  Many of these acquisitions are simply to purchase a technology that a smaller company has developed.  For example, in 2012, Facebook acquired Instagram for \$1Bn.  At the time, Facebook’s valuation was believed to be around \$100Bn.  Instagram was a relatively small, tuck-in acquisition for Facebook.  In retrospect, this small tuck-in acquisition turned out to be transformative for Facebook due to the immense success of Instagram.  We don’t know if Facebook ran an IRR analysis on the acquisition of Instagram at the time of acquisition, but if we ran an IRR analysis on the Instagram acquisition today (in 2018), the IRR would be exceptionally high.

The Instagram acquisition is a perfect example of why investors are so focused on management teams’ priorities with respect to allocation of capital.  During the IPO roadshow for Facebook, many investors questioned the decision making around paying \$1Bn for Instagram.  It was rumored at the time that Mark Zuckerberg and the founders of Instagram reached an agreement privately in a matter of a few days.

It goes without saying that Facebook investors are no longer complaining about this acquisition.  But the takeaway is that acquisitions can make or break a company.  While Instagram was a home-run acquisition for Facebook, corporate America is also littered with the ruins of failed acquisitions that were detrimental to the acquiring company.  The classic example is the acquisition of Time Warner by America Online (AOL) for \$160Bn in January of 2000.  The acquisition occurred shortly before the popping of the Internet bubble, and the subsequent years revealed an ill-fated marriage between new media and old media assets.  Time Warner then spent the next 18 years de-consolidating (selling) businesses brought together by the combination.

For this reason, investors place more trust in management teams that have a disciplined and prudent M&A strategy and have demonstrated a positive track record in the past.  This increased trust level often manifests itself in higher valuation multiples.

### Dividends and Stock Buybacks – “Return of Capital”

Dividends and stock buybacks are the two forms of “return of capital” to investors.

Dividend – A dividend usually comes in the form of a regular quarterly cash payment that is made directly to the investor.  Companies will typically pay dividends when it generates more free cash flow than it is able to re-invest.  Companies may also pay dividends because they believe their shareholders prefer to receive regular cash payments.  For example, Verizon pays a regular dividend that is equivalent to about 5% of the stock price.  This is referred to as “dividend yield” which is calculated as the yearly dividend divided by the share price.

Some companies that have accumulated large cash balances may also decide to make one-time large distributions back to its shareholders.  This is referred to as a “special dividend” since it is not expected to re-occur.  Let’s calculate the dividend yield of Verizon:

1. In the above chart, we have calculated the current dividend yield (latest quarterly dividend was 59 cents) by taking the current dividend of \$2.36 and dividing it by the stock price of \$51

2. We have also projected that Verizon’s dividend yield will grow by 2% per year, which is consistent with its dividend history. This growth in dividend will boost the dividend yield to 4.81% by 2020 assuming an investor buys Verizon stock at \$51.

3. We have also calculated the dividend payout ratio of Verizon. Dividend payout ratio is measured as the dividend / FCF per share or dividend / EPS.  This metric provides an investor with a sense for the sustainability of a company’s dividend.  In Verizon’s case, the company is paying out roughly 52-53% of its free cash flow in the form of dividends.  This is a comfortable dividend payout ratio that most investors would not worry about.  However, once the payout ratio begins to exceed 80-90%, many investors worry that the dividend is too high to be supported by the underlying cash flow.

Dividends have historically been viewed as a signal that a company is entering a lower growth stage, so the management team is electing to return capital rather than invest the cash in low IRR opportunities.  While a management team does not calculate an IRR on a dividend payment, the management team will consider the IRR opportunities of investing its cash prior to paying a dividend.  For example, if a company earns \$100 in FCF, but is only able to invest \$60 of that cash flow into projects that generate an IRR above its cost of capital, then, a prudent management team should return that other \$40 in cash flow to the investor in the form of dividends or stock buybacks.

Stock Buyback – In addition to or in place of paying a dividend, some companies prefer to buy back their own stock as a form of returning capital to its shareholders.  A company executes a stock buyback by going directly into the open market and purchasing shares of the company.  After buying these shares, the company will typically “retire” the shares, which permanently reduces the share count of the company.  There are several reasons why a management team may choose to do a stock buyback:

1. Tax efficiency – Buying back stock is more tax efficient than paying a dividend. Investors must pay ordinary income rates on dividends.  However, with a buyback, an investor can realize higher value (assuming the buyback is accretive) through the reduction in the share count, which serves to increase the value of the stock.  In other words, dividends transmit value through cash while buybacks transmit value through a higher share price.  A higher share price is of course not taxable to the investor (until the investor sells stock).

2. Undervalued stock – Many companies will choose to buy back stock when they feel that the markets are not properly valuing the company. For example, if Verizon felt that their stock was worth \$100 vs. the \$51 stock price today, they may choose to repurchase their stock because they feel their stock is a good investment.  If Verizon feels that their stock could be worth \$100 in 3 years, then, buying that stock today at \$51 would be a 25% IRR investment.

3. Under-leveraged – If a company has little to no debt on its balance sheet and its stock is trading at an attractive FCF yield, the company may choose to borrow money to repurchase stock. For example, if Company A is able to borrow debt at 5% and repurchase their stock with a FCF yield of 10%, then, this is a value-accretive transaction for the company.  In Part 2, Lesson 14, we will learn to calculate accretion / dilution from a stock buyback program.

Stock buybacks have been particularly popular in the years following the financial crisis due to the low growth economic environment.  From 2009 to 2018, the economy has struggled to grow real GDP much faster than 2%.  Given the low growth rates in the economy, many companies have struggled to find attractive IRR opportunities to organically growth their cash flow.

With a lack of opportunities and with exceptionally low interest rates, many companies have found that they can create significant value by borrowing funds at low interest rates to buy their stock.  There are two ways to grow FCF/share: 1) grow the numerator or 2) reduce the denominator.  As such, many companies have chosen to reduce the denominator (share count) through share buybacks.

### Putting It Together

As we’ve discussed, companies are typically choosing between the three following options when deciding how to deploy their capital: 1) organic growth, 2) inorganic growth, and 3) return of capital.  A prudent management company will carefully evaluate the IRR of investing in their own business vs. acquisitions vs. buying back stock and will allow their yearly cash flow to “waterfall” between those opportunities.

For example, if Company A generates \$1Bn of yearly FCF, then, it must decide how to invest or return this cash flow to shareholders.  If the company identifies \$200mm of internal growth opportunities that it believes will generate a 30% IRR, then, the management company may prioritize this use of cash over other uses.  If the company identifies a \$500mm acquisition opportunity that will generate a 20% IRR, then, the company will prioritize the acquisition as the next best use of capital.  Finally, if any excess capital remains, the company may choose to return this excess capital to shareholders in the form of dividends or buybacks.

In practice, the timing and opportunities around deploying capital doesn’t always fit between the lines so neatly.  While a management team may have a pre-set formula or system for deploying capital, the timing of acquisition opportunities is irregular.  For example, T-Mobile has been wanting to buy Sprint for years, but never felt the regulatory environment was conducive to acquiring Sprint.  It was only after an administration change (to the Republican party) that T-Mobile felt comfortable taking the risk to acquire Sprint.

Good management teams will take an analytical approach in deciding how to deploy capital.  As an investor, it is our responsibility to understand management’s approach to allocating capital and commit investment dollars to the management teams that have demonstrated track records of creating shareholder value.