Constellation Software (TSE: CSU) is a company with an incredible long-term track record. Its founder and CEO, Mark Leonard, writes in his shareholder letters that a company should not hoard capital unnecessarily.
I completely agree. Money that a company cannot effectively invest should be returned to shareholders as soon as possible.
Capital hoarding dilutes returns
Here is an illustration of why capital hoarding dilutes returns.
Let’s say there are two companies: Company A and Company B. They will each generate $1 in free cash flow per share per year for 10 years before they cease operating. The difference is that Company A returns all its annual free cash flow to shareholders each year while Company B hoards its cash. Company B also earns negligible interest, and only returns all of the cash to shareholders in one go at the end of 10 years.
With the above as a backdrop, Company A’s shareholders will receive $1 each year as dividends. On the other hand, Company B’s shareholders will receive $10 as a dividend once, in the 10th year. While the total amount that is eventually returned to both sets of shareholders is $10, shareholders of Company A will be much wealthier after 10 years.
This is because shareholders of Company A can invest the dividends earned each year. A shareholder of Company A who is able to invest the dividends at 10% per year, will end up with $15.90 per share after 10 years if all the dividends are invested.
How this impacts the valuation
In the scenario above, investors should be willing to pay more for Company A’s shares.
We can calculate the values of the shares of Company A and Company B using a discounted cash flow model to get the present value of the stream of cash flows that will be returned to shareholders.
Using a 10% discount rate, Company A’s shares have a present value of $6.76 per share. Company B’s shares on the other hand, have a value of just $4.24. This makes sense as Company A’s shareholders will end year 10 with $15.90 per share, while Company B shareholders will end year 10 with just $10 per share.
As you can see, two identical companies that generate the exact same cash flow can have significant differences in their value simply due to whether the company is maximising shareholder returns by returning cash to shareholders appropriately.
Unfortunately, in the real world, I notice many companies that hoard cash unnecessarily. This is especially rampant in the Singapore stock market, where many companies are controlled by wealthy families who may not have minority shareholder interests at heart. These companies hoard cash and pay only a minimal amount of dividends each year, which ends up not maximising shareholder value.
But that’s not the most destructive thing. Spending the cash on investments that destroy shareholder value is even more damaging to shareholders. Some examples of poor capital spending include buying back overpriced shares, making poor acquisitions, buying lousy assets, or diversifying into poor businesses.
Proper capital management can have a massive impact on the value of a company’s shares. When building valuation frameworks, investors often assume that the cash generated each year will be returned to shareholders in that same year. But that’s not usually the case. Some companies may keep the capital and invest it well, thereby creating more value for shareholders. But some may hoard the cash or make poor investments.
We have to keep this in mind when thinking about how much we should pay for a company’s shares.
Note: An earlier version of this article was published at The Good Investors, a personal blog run by our friends.
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Disclosure: Jeremy Chia does not own shares in any of the companies mentioned.