5 Things Companies can do with Money

There is essentially 5 things companies can do with the money they make.

These 5 things are:

1. Invest for growth or in projects
2. Pay dividends to shareholders
3. Buyback company shares
4. Acquire/Buy companies
5. Repay debt

Using these 5 options one can potentially figure out whether a company is allocating their money reasonably. Some of the options are deemed to be more important than others, but each of the 5 have merit in certain circumstances.

1. Invest for growth or in projects

This is a favourite among investors especially growth investors as the company can potentially reinvest all the profits back into the company. 

If a company can invest in highly profitable projects and they can use most of their profits towards such projects then, over the long term, the company should do well. A classic example of such a company is Amazon.

However, when a company spends a lot of money, but have little to show for it, investors should stay away.

From Buffett's 1983 Shareholder Letter:

"We test the wisdom of retaining earnings by assessing whether retention, over time, delivers shareholders at least $1 of market value for each $1 retained."

One can assess whether a company is doing a good job by, for example, taking the change in profits over a 10 year period and dividing it by the change in market value. If it is above 1 then the company meets Buffett's "$1 Dollar" criteria.

Other times it is more obvious, for example, Colgate launching a lasagna line in th 1980s (a very bad idea).

2. Pay dividends to shareholders

Paying dividends to shareholders are quite popular among investors because of the return of cash. 

Dividend paying companies are usually more stable with proven business models. Identifying companies that pay a stable growing dividend over time might not be a bad idea as research have shown that these type of companies generally outperform.

https://www.simplysafedividends.com/world-of-dividends/posts/36-5-reasons-to-be-a-dividend-growth-investor

However, a company with a unsustainable dividend (paying out too much of their profits) should be avoided. New dividend investors tend to invest in companies with high dividend yields which is more often than not 'dividend value trap' companies.

https://www.dividend.com/dividend-education/how-to-spot-a-dividend-value-trap/#:~:text=A%20dividend%20value%20trap%20occurs,much%20more%20than%20its%20peers.

If a company do not really have new profitable project to invest in then paying a dividend makes sense.

3. Buyback company shares

Buybacks are also a popular way to deploy cash. If a company buys it's own shares then the equity ownership of the shareholders increases because there is fewer shares outstanding. Buybacks are more efficient than dividends because the shareholder is not taxed by this decision dividends of US companies are usually taxed at 15%.

How companies buyback shares are important. If the share price is very high then buying shares make less sense since the company can buy relatively fewer shares with the same amount of money. 

Another thing to be aware of is stock based compensation i.e. giving shares to employees as part of their compensation package. This can be misleading since some companies might announce they are buying back shares while simultaneously issuing shares to employees which, taken together, might actually dilute the shareholder.

4. Acquire/Buy companies

CEOs, in general, likes dealmaking since it is an exciting endeavour. To be able to buy another company maybe even an international company can be very alluring. 

Acquisitions are mostly difficult because companies generally pay a premium to acquirer another company and to merge two entities is not always seamless exercise or experience. 

However, there are a cohort of companies that have implemented this strategy successfully over the years.

Notable examples include:
Constellation Software 
Berkshire Hathaway 
Danaher 

The three things I would try to assess when it comes to an acquisitions include:
Price 
Deal structure (is the company using cash, shares, debt or a combination to finance the deal)
Synergies (will the merged company be stronger combined or is the companies somewhat disjointed)

5. Repay debt

Ideally you don't want a company to have too much debt. Although it might seems like a waste for companies to focus on their debt load, it can still provide a catalyst for a company. A good example of this is when rating agencies upgrade a company's credit rating leading to cheaper financing options in the future.

The recent Bed, Bath and Beyond bankruptcy debacle is another illustration of when it is better to pay down debt instead of using cash to buy back shares.

If a company can display discipline in tough times and repay debt to clean up the balance sheet, potentially leading to a credit rating upgrade, then identifying such companies could result in a favourable investment outcome.

In sum, whether a company is deploying cash sensible depends on the environment and thinking through each option will hopefully help you to reach a good conclusion.