Session 6: Alternatives for Capital Allocation
Session 6: Alternatives for Capital Allocation
OBJECTIVE: The degree of your success through growth will depend on how good you are in making capital allocations from your retained earnings. This session will teach you how to financially analyze various acquisition opportunities....which to pursue and which to shun.
- What are retained earnings?
- How to calculate retained earnings
- Managing retained earnings
- Options for utilizing retained earnings
- Retain the cash
- Distribute to shareholders
- Reinvest the cash
- Buy back shares
- How to evaluate return on retained earnings
- The value of retained cash
- Investing in the business to keep pace
- Expanding your business
- Acquire your real estate
- Acquire businesses
- Top Ten Do's and Don'ts
What are retained earnings?
The purpose of this session will be to provide you with some different options on how to invest your retained earnings and how to evaluate these alternatives.
Retained earnings are the cumulative result of a firm's operation from the start-up through the current operating statement. It is the earnings which have stayed in the business rather being taken out. If the business has lost money, it's called retained losses. Retained earnings and losses are cumulative from year to year with losses offsetting earnings.
A growing business will need capital to undertake expansion plans. Expansion capital can come from either retained earnings or from borrowing or a combination of both. Keep in mind that "retained earnings" means that adequate amounts are being spent on maintenance, repairs, research, and taxes. Your retained earnings is the cash remaining after all these expenditures.
Some business can build up retained earnings more readily than others. A business requiring frequent replacement of expensive machinery will probably have less remaining cash left as retained earnings than a service business that operates with little or no machinery or equipment.
How to calculate retained earnings
Throughout this session, we will use "Nifty Nail Salons" as our operating business example. Nifty Nails consists of ten operating stores with total annual sales of $2,000,000. Their beginning retained earnings (from previous periods) is $3,000,000.
Retained earnings will be the cash at the end of the year after provisions for all expenses including some accounting effects, depreciation, and taxes. Retained losses and earnings are netted out and carried forward from year to year.
Here's Nifty's year-end income statement to show how retained earnings in a profitable company are calculated:
|Nifty Sales for the year||$2,000,000|
|Total operating costs||$1,000,000|
|Income before taxes||940,000|
|Less income taxes @30%||282,000|
|Retained earnings from previous periods||$3,000,000|
|Total retained earnings||$3,658,000|
Managing retained earnings
In most cases, a growing company will manage retained earnings by investing back into the business or by buying other businesses. In either case, there is a two-step standard test you can use to objectively evaluate the prospects of a business.
- Does it have a durable competitive advantage?
- Is it reasonably priced with an attractive ROI or intrinsic valuation? Intrinsic valuation will be covered in Session 12 Buying Businesses. If a potential business does have a durable competitive advantage, it will be possible to make a more accurate evaluation.
Businesses with a competitive advantage, as a rule, are in unique products or services where the advantage lies with the product rather than the people running the business. Examples include Hershey's Chocolate and Coca-Cola. For smaller growing firms, the goal could be to grow into products or services which could be built into important brand names.
Not all businesses, even widely admired ones, possess a durable competitive advantage. Here are two examples:
- Airlines are now a commodity service, where the lowest price gets the customer. In other words "you are only as smart as your dumbest competitor."
- In spite of high tech's rapid expansion into worldwide applications, some high-tech companies are at risk due to the industry's nature of frequently reinventing itself and, therefore, subject to the risk of overnight obsolescence.
So your business plan for managing retained earnings could be to grow your business by investing in situations that possess durable competitive advantages and are attractively priced. Products or services with wide moats around them are the ones that will deliver the greatest results. Here are some business characteristics to look for when investing retained earnings:
- The product or service has had years of experience
- They can be expected to make the same product in the future
- They spend little money on research and development
- Their product or service has a long life span
- They serve a repetitive need (think razor blades)
- They are fairly simple
Options for utilizing retained earnings
Retain the cash
During periods of financial uncertainty such as the global economic collapse of 2008, corporations experience uncertainty and fear. As a result, retained earnings were allowed to build up until the expression "hoarding cash" became appropriate. In July of 2010 companies in the Russell 3000 index had hoarded $2.9 trillions of cash. In many cases, cash is hoarded in order to provide funds for potential acquisition opportunities.
Distribute to shareholders
Withdrawing retained earnings by making dividend distributions to the owners or stockholders of the company is an option. But be aware that there are different state and federal restrictions on dividend withdrawals as well as tax consequences, so you will first need to consult with your attorney.
Reinvest the cash
Well managed companies reinvest retained earnings in a way that the cash is used wisely to grow the business. Possibilities for reinvesting retained earnings could include:
- An Internet technology firm might invest in research and product development with a long-term goal of avoiding technological obsolescence risks.
- A retail chain might add new stores. See the Start a Business session on creating successful profit centers.
- Retained earnings can be used to purchase businesses, either through making vertical integrations (see session on vertical integration), acquire businesses in their own field (see session on buying businesses) or buy businesses unrelated to their core activities (see session on The Berkshire Hathaway conglomerate model).
- Retained earnings can be used to acquire real estate. For example, mature chains such as McDonalds and Walgreen's own their real estate rather paying rent to landlords, thereby gaining a great advantage over smaller chains in occupancy costs.
- If a company cannot find ways to reinvest retained earnings profitably, it can use the cash to buy back shares. Existing shareholders favor this alternative because fewer shares remaining outstanding will result in a higher value per share of the remaining shares.
How to evaluate the return on retained earnings
The measurable value of holding cash is the earnings received from investments less the annual cost of living increases. The value of having cash to exploit opportunities or acquisitions is hard to measure.
Invest in the business to keep pace
Some businesses, notably manufacturing, find it necessary to spend their retained earnings just to keep up with their competitors who are installing more efficient equipment. It is not a good idea to be in a business that soaks up earnings just to stay alive.
Expand your business
The primary applications of retained earnings are to expand the business or purchase other businesses. In either case, the best way to measure success is to follow the guideline of renowned business manager Warren Buffett:
|"Unrestricted earnings should be retained only where there is a reasonable prospect - backed preferably by historical evidence or, when appropriate by a thoughtful analysis of the future - that for every dollar retained by the corporation, at least, one dollar of market value will be created for owners. This will happen only if the capital retained produces incremental earnings equal to, or above, those generally available to investors."|
While reinvesting in the business will most likely be your first consideration, calculations should be made to be sure that each dollar invested will increase the value of the company by at least one dollar and that a satisfactory return on investment is accomplished. Let's use Nifty Nails decision to open another salon to determine both the potential market value created and also the return on investment:
|Nifty Nail Salons is currently operating ten stores each of which produces $20,000 per year after tax net income. To open a new store will require a total cashoutlay of $120,000.
According to industry standards in the salon business, the value of the company is calculated as ten times its annual earnings. The annual income added by the new store, $20,000, increases the value of the company 10 times or $200,000.
The $120,000 investment will add $200,000 value to the company, or 1.6 times each dollar invested. This meets the Buffett criteria that for every dollar retained at least one dollar of market value is created.
The return on investment (ROI) will be: $20,000 (annual income) divided by $120,000 (your investment) or 17%.
Return on equity will vary from industry to industry. Consult with your CPA to determine the ROI history you business and industry has experienced. If you have a higher ROI than your competitors, it is an indication of effective management.
Acquire real estate
In the early phases of the Nifty Nails Company, owning its store's real estate was not an option because all available cash was being invested in equipment and fixtures for new leased stores.
But let's assume that over time Nifty Nails has grown to 200 stores. Now it is a large creditworthy business and can borrow money at 6% interest. Typically, shopping center landlords expect to receive a 12% return on their properties. Owning real estate rather than leasing becomes a desirable option. All major chains own the land and buildings where stores are located.
There is a session following that will give you some do's and don'ts when you're considering buying businesses. You will now have two essential tools to mathematically evaluate whether the use of your retained earnings is being put to most productive use:
- Every dollar invested will create at least one dollar of market value.
- The return on investment (ROI) will meet your established goal.
Top Ten Do's and Don'ts
THE TOP TEN DO'S
- Use retained earnings to build company value.
- Maintain a frugal budget to enhance retained earnings.
- Evaluate all investment options before committing retained earnings.
- Keep accurate and current records of retained earnings.
- Increase earnings by reinvesting retained earnings.
- Understand that one dollar invested should produce more than one dollar in value.
- Calculate return on investment before investing retained earnings.
- Avoid a business where retained earnings are required to keep pace.
- Consult your tax consultant when considering buying back stock.
- Consider purchasing businesses as a good option for use of retained earnings.
THE TOP TEN DON'TS
- Cut corners on maintenance and research to build retained earnings.
- Invest retained earnings without considering all options.
- Avoid keeping accurate and current record of retained earnings.
- Tie up cash on real estate until financial benefits are justified.
- Spend your retained earnings...ever.
- Automatically distribute dividends to shareholders.
- Buy back stock without checking all other options.
- Think "hoarding cash" is always a bad choice.
- Overlook the rule "a dollar invested should produce a dollar or more in value".
- Invest in real estate if you need operating cash for your business.