Let's say you and I own a lemonade stand and at the end of the year we have a profit of $100,000. We are now faced with a decision: We can either spend the money on one epic night at Dave & Buster's (PLAY, Financial), or we can reinvest it back into the business.
If we choose option No. 2 β let's say we buy an automated lemon squeezer β and profits increase as hoped, then the value of the business should increase as well. Similarly, the value of public companies should increase as wise allocation decisions are made.
Let's take a look at three tobacco giants and see who does a better job at this.
Altria β the maker of Marlboro, Benson & Hedges and Virgina Slim cigarettes β retained approximately $15 billion of earnings from 2006 to 2015. Was this a good move? To check, we look to market value. In Altria's case, the stock price increased by $57.5 billion from 2006 to 2015. In other words, for every dollar retained, $3.85 of value was created. Sorry, Dave & Buster's, a 285% return is worth many games of skee ball.
British American Tobacco PLC (ADR) (BTI, Financial)
Chief Altria rival British American Tobacco β the maker of the Lucky Strike, Pall Mall and Dunhill cigarette brands β retained approximately $14 billion in earnings from 2006 to 2015. During that same period, market value for the company increased by over $55 billion. For every dollar retained, $3.96 was created for a return of 296%. Again, this outweighs the skee ball.
A quick look at a third tobacco rival, Reynolds American Inc. (RAI, Financial) β the maker of Winston and Camel cigarettes β reveals that the company created $14.81 in market value for every dollar it retained from 2006 to 2015, a return of 1,381%. Bottom line β all of these companies did a great job at creating value, but Reynolds knocked it out of the park.
Both the managers of lemonade stands and public companies must decide what to do with profits: either reinvest them or dole them out. If high-returning options are available, then certainly, they should be kept. From a long-term investment perspective, the best businesses are the ones that can profitably reinvest earnings and snowball book value and market value. Otherwise the money should be used for all kinds of debauchery at Dave & Buster's.
Disclosure: The author does not hold positions in any of the stocks mentioned.
