There are two key leadership functions that successful CEOs must execute well: efficiently directing cash-generating operations, and effectively allocating cash that's generated by said operations and capital market transactions. Most management texts focus primarily on operations, but the capital-allocation function demands equal skill and senior management attention.
There are several capital-generation aspects that need to be examined in order to determine if there is significant capital within the company to ensure its profitability for shareholders. These elements are grouped as follows:
Key Capital Generation Elements
1. Free cash flow -- what’s left after paying the bills, taxes, and debt payments.
2. Debt issuance, such as bank loans and corporate bonds.
3. Initial and secondary public equity offerings.
How capital is allocated is another important aspect to examine while valuating a company. There could be enough capital generated, however if that capital is misallocated, the value for shareholders will definitely decline.
Key Capital Allocation Elements
1. Organic growth of existing lines of business using retained earnings.
2. Mergers & Acquisitions -- buying growth externally.
3. Debt reduction -- less debt means less interest expense and a better liquidation position for shareholders.
4. Stock buybacks, which enriches remaining shareholders, especially when stocks are purchased below their respective intrinsic values.
5. Cash dividends -- a bird in the hand is worth two in the bush. A long history of steadily increasing dividends is a great discipline for management teams.
Quantifying "Shareholder Friendly" Companies
We can use publicly available information gleaned from quarterly and annual financial reports to rank stocks by shareholder yield, which is an objective measure of how well a given management team is taking care of shareholders.
To calculate these numbers, employ the following formulas to give you the shareholder yield:
Dividend Yield = Trailing 12 month (TTM) cash dividends / market capitalization. You can’t easily massage this number.
Net Buyback Yield = TTM stock repurchases (actual, not just announced, buyback programs) -- stock issuance (often in the form of lucrative stock options given to management) / market capitalization.
Net Debt Paydown Yield = TTM net changes in short and long-term debt / market capitalization.
Shareholder Yield = Dividend Yield + Net Buyback Yield + Net Debt Paydown Yield.
After we have calculated shareholder yield for all the companies in our universe of interest, such as the S&P 500 Index
(INDEXSP:.INX) or the Top 100 most liquid Vietnam stocks (with available room for foreigners), we can rank them on an ongoing basis at quantile or decile points, and focus our qualitative research efforts on the companies that have proven themselves to be friendlier than their peers in improving the lot of the investor class. In addition, we can reduce or eliminate exposure in our portfolios to companies that are wealth-destroying adversaries of shareholders as measured by negative shareholder yields.
Companies that have a higher shareholder yield often offer larger dividends as they have more capital to go around. AmTrust Financial Services
(NASDAQ:AFSI) has increased its cash flow substantially over the last year. In turn, it issued a 40% increase in dividends last March, bringing it up to $0.14 per share, while in September it paid out a 10% stock dividend. At a 19% dividend payout ratio, AmTrust will likely continue to increase its payouts, and currently has a yield of 1.6% at the current prices.
Buybacks are another way for companies to become more shareholder friendly as seen with GNC Holdings
(NYSE:GNC). In March the company bought back $61 million in stock under a $250 million buyback authorized in February of the same year. It was no coincidence that in the same month, management authorized a 36% increase in dividends, bringing it to a whopping $0.15 per share.
Growth Over Dividends
High dividends are often very attractive to investors, but it is important to not take a higher dividend at the cost of slow growth. Companies that offer a modest dividend but are still reaching growth expectations are a far better investment than those that are stagnate with higher dividends.
Digital Reality Trust
(NYSE:DLR) is one such company. It is offering a modest dividend yield of 5.5%, but is showing steady growth as the global demand for "anywhere" data access increases. This makes it a potentially good investment for not only steady growth, but higher dividend yields as well.
While the goal of every investor is to make a great profit, how that happens does matter. And whether you look to the long or short term, a fair-sized dividend and steady growth are the true markers of a viable investment.
No positions in stocks mentioned.