Hi guys:
What financial ratios would you look at to decide what is a firm’s most optimal capital allocation strategy? Is it to compare free cash flow yield per share (for repurchasing stocks), to ROIC (reinvest in business), to the company’s weighted average yield on debt (to pay down debt)? What about dividend yield, do you use that?
Thank you!
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My 2 cents. A company has 5 options to deploy its FCF. (1) buy back stock. (2) return cash to shareholders through a dividend. (3) Pay down debt. (4) Invest organically through increased capex. (5) Invest inorganically through M&A.
For stock buy backs you just need to have a view on the fair value of the company and calculate the upside from buying back stock. If a company trades at 100/share and you think fair value is 120/share there is 20% upside from deploying capital in a buy-back. I also tend to look at the EBIT/EV yield on this.
For dividends, it's more a case of management having the balls to say that they can't deploy the cash any better than you can so they will return it to you....If the market yield from investing in the S&P 500 is greater than (a) the company's own ROIC (b) the yield from buy-backs (c) there is little or no debt to pay down, and (d) there are no attractive M&A deals to be had, the company should return cash to shareholders via dividends.
For debt repayments I just look at the yield on the debt and compare that to the ROIC and yield on buy-backs.
For organic investment I try to split capex into replacement and growth capex. I assume replacement capex just equals depreciation and all additional capex is growth capex. I then look at how much incremental FCFF is generated from the growth capex. So for example if total capex is 100 and 80 is maintenance capex, that leaves 20 as growth capex. If that 20 investment generates 5 in incremental FCFF, the ROIIC is 25%. There may be a lag between investment and returns so you may want to look at this over rolling 3-5 year periods.
For M&A it's basic accretive/dilutive analysis, typical M&A analysis.
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