Two friends who often discussed investing over drinks faced off against each other as they argued which of the two brewing giants in Nigeria they need to invest in. Ivie preferred ABC Brewery because they liked to pay huge dividends year after year even though over the years it has left them far behind XYZ Brewery in terms of geographical spread and market share. However, Udoka thought XYZ was a far better company even though it hardly paid dividends but boasted a market share double that of ABC and had its products better spread across the country. XYZ Plc rapid expansion was basically a result of massive vertical acquisitions which it embarked upon over the years to the detriment of earnings per share and off course dividend payment. After all its share price would rise three fold in the last five years against ABC Ltd which grew at an annualized rate of just 15% over the last three years.
The way a company allocates its capital more than anything else is directly related to the survival of the company. Show me a company that has gone bust or bankrupt and you see how bad it has been able to manage its capital. As an investor in shares, it is important to study the effects of capital allocation (how companies spend their cash) of potential companies before investing in shares. To understand capital allocation let us first identify the common ways companies generate capital.
Companies can raise money via issuance of shares during an initial public offer, public offer or a private placement. They can also do so via rights issues. The effect of raising money via new issues typically reflects in its earnings per share. This is because the equity you raise would have created new shares which may impact negatively on shareholder values if it does not lead to higher EPS.
Another way a company can make money is via debts, which basically is obtaining loans from banks and other financial services companies. Loans attract interest rates and repayment terms that can determine whether a company is able to remain viable, honour its debt commitments and also pay dividends.
Internally Generated Funds (IGR)
IGR’s are funds generated by the business from its day to day operations. Cash flow generated from sale of goods or services can be used as a source of capital for the business and how it is deployed is critical to the success of the company as well.
So how does a company allocate the capital that it raises via the means above?
To invest in its current line of business
A company can decide to invest in its current business by acquiring fixed assets, investing in manpower, IT infrastructures or new product lines. It does this hoping that it will result in higher profits at the end of the day. But not all investments of this nature are worth it. A few years ago a lot of banks raised new equity in their race to meet the N25billion minimum capital. Most of them promised to use the money in building new branches (fixed assets), expanding IT infrastructure etc. But at the end of the day, they still went bust because they could not manage resources properly.
To Acquire Businesses
Some CEO’s are themselves investors and like to allocate their free cash flows towards acquiring new companies within their line of business (vertical integration) or buying companies that complement their line of business. The recent acquisition of Whatsapp by Facebook comes to mind in this instance. Whilst acquisition of business is a proven method for building shareholder value, not all acquisitions lead to success. In fact, research suggest three out of every four acquisitions probably fail.
To Repay Debts
Companies also use some of the money it has to repay its debts. Repaying debts for most CEO’s is a sin qua non while for some it is a continuous process. Whilst debt repayment is great with help boosting profitability, it within its period of payment affect the amount of money companies have available to repay shareholders as dividends or even finance new businesses. That is why it is very important to study the way companies raise and repay debts as its loan policy and positively or negatively impact on the value of your shareholding
To pay dividends
Companies also use some of its capital to repay dividends during the financial year. The way a company repays dividends can be found in its dividend policy which can mostly be found in annual reports of most companies. Whilst it is good to seek for high dividend paying companies it is also very important for companies to maintain a very efficient dividend policy that ensure money is also left behind to continue to grow the business. Without that, soon shareholder value will be eroded making the dividend payments somewhat useless.
Bearing all this in mind, it is thus important you study the way companies allocate capital when you decide to invest in them. A company with a very poor capital allocation policy can quickly erode your investments even when it is paying dividends. Also, a company that prefers not to pay dividends but invest in expansion can erode value if it makes the wrong decisions.