Judge how well management has used the cash the business produced.
To judge how management allocates capital, add up ten years of a company's cash flow statements by use, then test each use against the cost of capital. Over a decade, what management does with the cash a business produces can matter as much as the business itself. The cash flow statements record every choice, and anyone who adds them up can see it.
At Larkspur's last annual meeting, a shareholder asked why the company was holding S$60 million of cash (an invented figure, like every Larkspur number here). The chief executive said the board was "keeping its options open for growth". Marcus has heard that line from other boards, each time before an acquisition that went badly. So he went back through ten years of Larkspur's statements to see what management had actually done with its cash.
Every dollar of cash a company produces ends up in one of the five uses of cash:
reinvestment in the existing business, such as machines, working capital or research buying another business repaying debt dividends buying back the company's own shares
Keeping cash in the bank is a sixth choice. It is temporary, and sooner or later the cash moves into one of the five.
None of the five is good or bad in itself. You judge each one by the same test, which is whether it earned more than the cost of capital. Reinvestment and acquisitions earn whatever the assets they buy go on to earn. Debt repayment earns the interest saved and also lowers risk. Dividends give the decision about the cash to shareholders. Buybacks earn the gap between the price paid and what the shares are worth.
Start by collecting ten years of cash flow statements. Add up where the cash came from, then add up where it went, by category: reinvestment, acquisitions, debt repayment, dividends, buybacks and cash added to the bank.
Over ten years, Larkspur took in 520 from operating cash flow and 10 from a property sale, so 530 in total, with all amounts from here on in S$ millions. On the other side, it spent 290 on capital spending and 55 on the coatings acquisition, paid 140 in dividends, made 20 of net debt repayments and added 25 to cash, so 530 out. Total cash in must equal total cash out. It is the same discipline as the cash check in lesson 7.7, Enter five years of history into your model. If your two totals differ, you have missed a line.
Then compare each line with the returns that followed. Larkspur's cost of capital is about 9%, from lesson 8.2, Cost of capital: equity, debt and a WACC you can defend.
Almost all of Larkspur's reinvestment went into the parts business. Lesson 9.4, Competitive position: Five Forces and moats, found that business earning about 19% on its capital, well above 9%, so most of Larkspur's spending created value.
To test an acquisition, value its annual profit as a perpetuity at the cost of capital and compare that value with the price. Larkspur paid 55 for coatings, and 30 of that is still on the balance sheet as goodwill. In its best year, coatings earned about 6% on the price, or 3.3 a year after tax. Valued at 9%, 3.3 a year for ever is worth about 36.7. Measured on its best year, the deal lost about 18 of the 55 paid. In FY5 coatings was near break-even, so the real loss is larger than the best-year figure. Lesson 6.5, Management incentives, ownership and related-party deals, found that the chief executive's bonus is tied to revenue and EBITDA, and the coatings deal raised both on day one.
A company with no investments that clear its cost of capital should pay out more in dividends. Larkspur did have such investments in the parts business and still paid a steady dividend. In FY5 the dividend was 18 against underlying profit of 42, a payout of about 43%, which looks like a balanced split.
The debt repayment lowered risk and saved interest. Net debt is now about a quarter of a year's EBITDA, so repaying more would add little.
Companies that buy businesses often need a sharper test, because one good deal can hide several poor ones. Track goodwill and intangible assets against operating profit over five or ten years. If goodwill is climbing far faster than profit, the company is buying revenue rather than returns.
Suppose a different company saw goodwill rise from 100 to 400 over five years while operating profit rose from 50 to 70. It paid a premium of at least 300 above book value, and profit rose by 20. Divide the profit increase by the premium: the return is under 7% a year before tax on the premium alone, which is below most companies' cost of capital. Also watch for impairments that arrive a few years after each deal. An impairment of this kind is the company admitting, late, that it paid too much.
Lesson 5.5, Corporate actions: rights issues, placements, buybacks and splits, showed that a buyback moves value between the holders who sell and the holders who stay. A buyback below value makes the remaining holders richer, and the same buyback above value makes them poorer. When a buyback is announced, ask what a share is worth and what the company is paying for it. The announcement never answers either question, so you need your own valuation.
Larkspur's cash pile makes this a live question. The model from lesson 7.8, Build the forecast and balance the model, forecasts its cash rising to about 136 by FY10. Marcus tested a hypothetical buyback of 30 million shares, a tenth of the 300 million in issue. On his DCF, equity value is about 538.6, or S$1.80 a share. At today's price of S$1.60, the buyback costs 48. Value left is 538.6 - 48 = about 490.6, spread over 270 million shares, which gives about S$1.82 a share for the holders who stay, a modest gain on S$1.80. Now suppose the shares run up to S$2.10 first and the company buys the same 30 million. It spends 63, and value per share falls to about S$1.76, so the remaining holders are poorer. The general formula is (equity value - cash spent) / shares remaining, compared with value per share before the buyback.
A good allocator's ten-year record shows most cash going into investments that earned well above the cost of capital. Its acquisitions kept earning after the first year, its dividend is set at a level the business can sustain through a downturn, and its buybacks are concentrated in years when the shares were cheap. Larkspur's record is mixed. Its reinvestment was good and its dividends sensible, but one acquisition destroyed value and its cash pile keeps growing with no stated plan.
Now gather the cash flow statements for your own company for as many of the last ten years as you can find, so you are ready to total each use of cash.
Add up how your company used its cash over the last ten years, by category. Decide which uses earned their cost of capital.
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