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The Five possible Uses of Free Cash Flow—an Introduction to Shareholder Yield
In addition to being the most useful metric for investors, free cash flow is also the metric that enables a company’s management team to review and select the best possible options for the generation of shareholder value in light of the firm’s cost of capital.
Therefore, when engaged in the process of security selection, it is necessary for investors to look not only at the quantity and quality of the company’s Free Cash Flow, but also the manner this free cash Flow is deployed by management.
From the perspective of a company’s management team, there are only 5 possible uses of Free Cash Flow:
1. Cash dividends
2. Stock repurchases
3. Debt reduction
4. Acquisitions
5. Reinvestment in company capital projects.
Every conceivable option for the allocation of a dollar of Free Cash Flow use falls into one of these 5 applications. Often management will employ some of each, but we see a distinction between the first 3 uses and the latter 2. We believe that unless the return on incremental capital is superior to the firm’s cost of capital, (Bank’s Interest Rate), there is little point in pursuing option 4 (making acquisitions) or option 5 (reinvesting in the business beyond maintenance capital expenditures.)
So, when and if acquisitions and reinvestments fail to generate sufficient returns, free Cash Flow should be returned to shareholders via one of the first 3 options.
These first 3 possible uses of Free Cash Flow (cash dividends, stock repurchases and debt reduction) are all effectively dividends payable to shareholders. Therefore, we refer to these 3 options collectively as Shareholder Yield.
The Sources of Equity Return
The Components of Shareholder Yield – Three Options, One Strategy
The three components of Shareholder Yield are:
1. Cash dividends
2. Stock repurchases
3. Debt reduction
We have grouped these three cash flow deployment options together into one overall concept because they are all strategies by which a company can enhance shareholder value. In other words, each of these three uses of free cash flow has the potential to positively affect the return on a shareholder’s investment. Therefore, they can all be seen as different ways in which to create a dividend.
The first cash flow deployment option on our list – the cash dividend – is perhaps the most obvious way of creating shareholder return in the manner just described.
The second option – stock repurchase – is also a clear method for value creation. However, a stock buyback will only boost shareholder return when the shares are cancelled or held in treasury but not used
as a device to make up for dilution from option issuances to management and others.
Finally, debt reduction can also be used to create shareholder value and, therefore, to produce a de facto dividend. To understand why this is the case, it is helpful to consider the famous finance paper by Franco Modigliani and Merton Miller.
These two Nobel laureates proved that a firm’s value is independent of how it is financed, provided that one ignores the tax effect of debt interest. If Modigliani and Miller are correct, the use of free cash flow to repay debt results in a wealth transfer from the debtor to the shareholder. Since the value of the firm remains the same, shareholder wealth is increased as debt is reduced. And this, according to our methodology, can be considered a type of dividend.
The ability to provide a return to the shareholder (i.e., a dividend) is therefore the uniting factor that joins cash dividends, share repurchases, and debt reduction, under the conceptual umbrella of Shareholder Yield. But before we continue our discussion of Shareholder Yield and its role in today’s stock market, we should first revisit the other two uses of cash flow that are not included in our definition of this concept, acquisitions and reinvestment. It is important to remember that acquisitions and reinvestment are perfectly viable, and often very desirable, ways to deploy free cash flow. However, to use cash in these ways, a company must follow the rules. As mentioned earlier in Chapter 1, the rules state that acquisitions and reinvestments should only be undertaken when the return on incremental capital is superior to the firm’s average cost of capital. If this is not the case, the three cash flow deployment options comprising Shareholder Yield should be utilized instead.
A good way to think about this is by grouping acquisitions and reinvestments into a concept called
Firm Growth, as opposed to
Shareholder Yield. Firm Growth can be thought of as a growth concept, whereas Shareholder Yield is a value concept in the sense that, when this strategy is utilized, excess capital in the firm is returned to the shareholders. Apple Computer provides a current example of a growth company that has been deploying free cash flow via Firm Growth as opposed to Shareholder Yield. For Apple, it has paid for the company to use its cash flow for internal reinvestment in R&D projects. In this way, Apple has been able to generate the innovations necessary to maintain a rising return on the capital employed within the business. Other companies in other industries, however, will not realize such a dramatic pay off from reinvestment or acquisitions. For these companies, cash flow should be utilized according to the three components of Shareholder Yield. The lodging industry includes several companies such as Marriott, Starwood, and Intercontinental that have exhibited a historical tendency toward cash deployment in the form of dividends, share buybacks, and debt pay downs. While each of these companies has also invested in the development of new hotel formats or expansion into new geographies, they have not used all their cash in the manner because of the heightened costs of acquiring and building new properties within the hotel industry. As a result, Marriott, Starwood, and Intercontinental have elected to return a meaningful portion of their cash flow to shareholders, rather than spend in through acquisitions or reinvestment. In fact, over the past five years, these companies have channeled approximately $18.6 billion into cash dividends, share buybacks, and debt pay downs, thereby illustrating their awareness of the Shareholder Yield philosophy.
Shalom.
NB:-
Investment is hard, isn't it? So many things to consider even after you know the company has "Super FCF".
The second option – stock repurchase and keep as Treasury stocks is not really safe i think. These stocks can be used later as
"used as a device to make up for dilution from option issuances to management and others." Isn't it possible?
Anyone any sharing?
Shalom.
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