The Bible On Capital Allocation plus His Checklist – Michael Mauboussin

Johnny HopkinsMichael Mauboussin, ResourcesLeave a Comment

There are a number of metrics that we use here at The Acquirer’s Multiple to establish a company’s valuation, quality and shareholder returns.

One of my favorites, provided by our Deep Value Stock Screener, is Shareholder Yield.

Shareholder Yield tells us what’s being returned to shareholders through a combination of dividends and share buybacks. Often investors only look at the Dividend Yield which is really only half the picture. To get the full picture its important to include Buyback Yield.

We calculate a company’s Buyback Yield as follows:

(trailing twelve months share repurchases / market capitalization)

When you add the Buyback Yield to the Dividend Yield you end up with the Shareholder Yield.

As an example, we currently have a company in the All Investable Screener. The company is in the Tire & Rubber Industry. It only has a Dividend Yield of 1%, which by itself seems pretty poor, but it also has a Buyback Yield of 11%.

For the investor simply looking at Dividend Yield they would have missed out on the overall picture, a Shareholder Yield of 12% (Buyback Yield 11% plus Dividend Yield 1%).

It’s important to remember that a company should only buyback its shares when its stock is trading below its expected value and when no better investment opportunities are available.

I was hunted around to find a piece on capital allocation covering dividends, buybacks and Shareholder Yield when I found what I consider to be the Bible of Capital Allocation, by Michael Mauboussin.

It’s an awesome paper on everything you need to know about Capital Allocation titled, Capital Allocation – Updated Evidence, Analytical Methods, and Assessment Guidance. I’ve provided a link below.

Mauboussin even provides the following Checklist for Assessing Capital Allocation Skills:

Past Spending Patterns

  • Have you analyzed how companies have spent money in the past, separating operating uses from return of capital to claimholders?
  • How has the company funded its investments?
  • Identify the prime use of capital. Do you know if management thinks about that use of capital properly?
  • Have there been shifts in the pattern of spending?
  • If there is new management, has spending changed?
  • Who makes which capital allocation decision?
  • How does the company conduct its budgeting process?

Calculate ROIC and ROIIC

  • Have you calculated ROIC over time and observed a trend?
  • Examine composition of ROIC through a DuPont analysis—does this suggest a consumer or production advantage?
  • Have you compared the company’s results to those of its peers?
  • Have you calculated ROIIC for one, three, and five-year rolling periods?

Incentives and Governance

  • How is the company’s incentive compensation structured?
  • How much stock does senior management own?
  • Is total shareholder return calculated on a relative basis?
  • Have you examined the company’s incentive score?
  • Are the measures in place to encourage management to think for the long term?

Five Principles of Capital Allocation

  • Does the company use zero-based capital allocation or is it dominated by spending inertia?
  • Is the company focused on funding strategies or projects?
  • Does the company have a “scarce but free” attitude about capital, or “abundant but costly?”
  • Does the company prune businesses with poor prospects for creating value?
  • Does the company know how to calculate the value of its assets and does it act accordingly?

To read more about Mauboussin’s thoughts on Capital Allocation you can find his full paper here, Capital Allocation – Updated -Evidence, Analytical Methods, and Assessment Guidance.

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