Warren Buffett (Trades, Portfolio) has frequently written about the crucial significance of the capital allocation skill for corporate managers. Capital allocation skill referst to the ability to decide what to do with the cash available in order to generate the most long-term earnings for shareholders. Their decisions today will impact business returns far into the future.
Generally, management has the following options for allocating their capital:
1) reinvest into the business (e.g., new products, new markets)
2) acquire or invest in other businesses
3) pay off debt
4) repurchase shares
5) pay a dividend.
Now here comes the question: how should shareholders judge the capital allocation skill of the management that they invest with? While there are various approaches to this matter, we at Urbem often use a simple calculation of the return on retained earnings as a shortcut measurement.
Take Microsoft (MSFT, Financial) as an example. Between 2015 and 2019, the software giant increased its annual earnings per share by $3.58 (from $1.48 to $5.06) while the company retained an aggregate of $3.64 per share after paying out dividends. This produces a return on retained earnings of roughly 98% over the period. This is a superior track record of capital allocation for CEO Satya Nadella since taking over from Steve Ballmer in 2014. His team is making fewer but bigger bets focused on cloud and artificial intelligence. The per-share basis is because we like to take into account the impact of share buybacks.
In recent years, some other capital allocation superheroes we have noticed include account software maker Intuit (INTU), which had a 52% return on retained earnings over the last five years, pizza restaurant chain Domino’s Pizza (DPZ, Financial) with a 40% return and payroll & HR services provider Paychex (PAYX, Financial) with a 54% return. For the purpose of comparison, Apple (AAPL, Financial), Church & Dwight (CHD) and PepsiCo (PEP) earned five-year returns on retained earnings of 9%, 17% and 19%, respectively. Some of these are still good capital allocators, but are just not as great, despite their high return on capital.
It should be noted that no single formula fits all. The return on retained earnings may require some special considerations, especially when it comes to situations like a change of management or strategy and one-off profit or loss (e.g., a tax cut). Furthermore, investors should be aware that this metric may be far less illustrative if the company conducted large mergers and acquisitions, divestitures and investments in long-cycle projects.
Lastly, profit is not cash, leaving this metric prone to accounting manipulation. In this regard, an alternative form of evaluation can be the free cash return on retained free cash flow.
Disclosure: The mention of any security in this article does not constitute an investment recommendation. Investors should always conduct careful analysis themselves or consult with their investment advisors before acting in the stock market. We own shares of Domino’s Pizza and Paychex.
Read more here:
- Softcat: An Easy-to-Understand Technology Story
- Urbem’s ‘Quality Strategy’ Series: Cash Is King​
- The Compounding Superheroes
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