U.S. corporations are more profitable than ever, leaving many firms flush with cash. Deciding what to do with that excess cash is a good problem to have.
Companies have several options when it comes to deploying their extra dough. They can make acquisitions, fund organic growth, pay down debt, or return it to shareholders through dividends or stock buybacks.
Of course, a company can just let that money sit in the bank and grow its cash hoard. But with interest rates near record lows, they’re generating very low returns for their shareholders.
Ideally, a company should use its capital to maximize long-term value for its shareholders. But clearly some managers understand this concept better than others. Many corporate executives are more concerned about empire-building than producing high returns on capital and often make reckless decisions with shareholders’ money that destroys value over time.
If you own a company for the long-run, make sure you know how it is managing its cash.
Shareholder Yield
It’s not uncommon for companies to distribute more and more cash to shareholders as they mature. Bigger companies have less growth opportunities and compete in crowded markets, so they plow back less of their earnings into the company and more into shareholders’ wallets. And dividends, along with stock buybacks, are the quickest and surest way to return value to shareholders.
The total amount of cash a company spends on dividends and share buybacks as a percentage of its market cap is referred to as shareholder yield. While many growth investors might scoff at companies that return a lot of cash to shareholders, history shows that, on average, stocks with high shareholder yield significantly outperform stocks with low shareholder yield over the long run.
Buyer Beware
When a company actually buys back its shares, it has a direct benefit in that it reduces the number of shares outstanding. This means that earnings are divided among fewer shares. In other words, your piece of the pie just got bigger.
