Capital Allocation: Course Guide

 

I’m going to be honest with you, if you have read the popular book, among investors and business owners, called the The Outsiders:Eight Unconventional CEOs and Their Radically Rational Blueprint for Success by William N. Thorndike, than you will know most of the core concepts of capital allocation taught within this course.

The lessons and stories are very important, and it is no surprise Warren Buffett is one of the eight CEOs covered in the book. And Warren Buffett has written much on the subject of Capital Allocation, for instance:

“Most bosses rise to the top because they have excelled in an area such as marketing, production, engineering, administration-or, sometimes, institutional politics. Once they become CEO’s, they face new responsibilities. They now much take capital allocation decisions, a critical job that they may have never tackled and that is not easily mastered. To stretch the point, it’s as if the final step for a highly-talented musician was not to perform at Carnegie Hall but, instead, to be named Chairman of the Federal reserve.

The lack of skill that many CEOs have at capital allocation skills (which not all do) will often try to compensate by turning to their staffs, management consultants, or investment bankers. Charlie [Munger] and I have frequently observed the consequences of such “help.” On balance, we feel it is more likely to accentuate the capital-allocation problem than solve it.

In the end plenty of unintelligent capital allocation takes place in corporate America. (That’s why you hear so much about “restructuring.”) Berkshire, however, has been fortunate. At the companies that are our major non-controlled holdings, capital has generally been well-deployed and, in some cases, brilliantly so. [p.99, The Essays Of Warren Buffett]

 

Identifying the CEOs who understand how to correctly allocate excess cash flows from operations, will allow you to earn extraordinary returns on our own capital.

If you put a gun to my head and said choose between understanding managements ability to allocate capital or understand the company’s competitive advantages, I’d choose capital allocation every time.

Identifying the competitive advantages of a company is more difficult and harder to measure. Whereas, capital allocation decisions made by CEO’s leave concrete clues, like a dinosaurs footprint in rock, you can see managements ability to allocate capital in the financial statements.

You will learn how to identify the specific transactions found on the Balance Sheet, Cash Flow Statement, Income Statement and Statement of Changes in Stockholders Equity.

But I could just buy the book, why attend this course?

The author William N. Thorndike provides the reader with awesome stories and examples of business leaders like Henry Singleton – the founder of Teledyne Technologies International Corp – who went on to produce extraordinary shareholder returns for their stockholders. And as I said earlier, yes you can learn the main concepts taught in this course by just buying the book, which I strongly recommend you buy and read the book.

This course is designed to build upon Thorndike’s book, using today’s businesses like Coca Cola, Intel, and Teledyne. Plus you will dig into the financial statements and learn how these core concepts can be identified on the Balance sheet, the Income Statement, the Cash Flow Statement and the Statement of Changes in Equity. 

 

Capital allocation decisions made by CEO’s leave concrete clues, like a dinosaurs footprint in rock.”

 

What Is An Example Of Capital Allocation?

Imagine you’re an entrepreneur, who in your spare time loves playing a video games on both Xbox and PlayStation with a friend, who we’ll call Mark. And Mark happens to be working on a new game.

You agree to help Mark market and distribute the new game for both Xbox and PlayStation. The game turns out to be an instant success, and you and Mark decide to go into business together, creating a Limited Liability Partnership company structure.

You both are now in business, you both split the equity 50/50 in the business. You both agree that you are the best person to manage the cash flow, marketing and distribution and you’re new business partner Mark is the best person creating and working on the games themselves.

Say the game brought in revenue of $10 million dollars this year, the total expenses were $2 million and tax payable of $2.8 million ($8 million x 0.35%) which leaves you with $5.2 million in net profit, or $2.55 million each per share.

You both agree that the video game can be made even better and Mark says it will cost close to $5 million to make and release. You come the conclusion that Mark is right, the game’s fan want more, so you release the funds to be reinvested back into operations to make the new updated video game.

Congratulations you just made your first official capital allocation decision. Reinvesting current cash flows back into operations is one of the six capital allocations decisions you will have to make.

You and Mark then work tireless on the new updated game, you both execute flawlessly and the game is a bigger hit then the previous old game with fans.

Next year’s revenues come in at $20 million! That capital allocation decision to reinvest back into operations and make the new updated game paid off. For every 1 dollar you spent, it created $4 dollars in revenue. A 400% internal rate of return.

After expenses and taxes, net profit is $10.4 million, which is an after tax return on capital of 208%. You now have $5.2 million per share, a doubling of equity over the year. Great Result!

 

And How You Can Profit From Understanding Capital Allocation! 

Our example is a simple explanantion of how the founder or CEO allocates capital, and inside you’ll learn the specific financial statement transactions, which will allow you gain unique insights and earn superior returns. 

As the old saying goes: ‘A stock price can be crazy in the short term, but stock prices are ultimately governed by the profits their underlying businesses generate.

Returning to our earlier example, now imagine that your business was listed on the stock market, that $5 million invested into operations producing $20 million in revenue and thus $10.4 million in earnings, will result in a skyrocketing share price due to investors suddenly learning after the fact.

But, our goal as investors is to able to spot the signs before hand, and you will be able too, by mastering this capital allocation course.

This is Intel’s stock chart from the depths of 2009.

Google Finance

Intel is a prime example of a stock price that has followed the businesses underlying earnings.  

“Two measures of success are especially important to me as a stockholder and your Chairman. Intel generated cash flow from operations in 2016 of $22 billion and return on stockholders’ equity of 16%. This caps five years in which cash from operations averaged over $20 billion and return on stockholders’ equity averaged over 19%. These figures indicate the intrinsic health of the business and the value created over time with stockholders’ money.”

– Andy D. Bryant, Chairman of the Board. Annual report 2016.

So, by understanding how management, in particular the CEO,  allocate the companies capital, you will gain a unique insight and blue print as to how management will either;

1. Create more shareholder value, thus allowing you to know in advance and buy before everyone else, or; 

2. Destroy shareholder value in the future, thus avoiding a losing money.

 

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