How Shareholder Friendly Companies Create Value for Investors
When looking at individual companies to determine whether or not they would make a good long term investment, one of the most important things to pay attention to is the company’s Free Cash Flow. Free Cash Flow, or FCF, is all of the excess cash profit a company has left after its paid expenses, taxes, and any amount reinvested back into the company in order to maintain growth. FCF is relatively easy to find but looking at that number alone isn’t enough to decide whether or not a specific company is a good investment. Not all companies use that cash wisely.
There are two ways that cash can be used in order to create additional value for its shareholders. The first and simplest way is to offer a dividend. A dividend may be paid in the form of cash, stock, or property but more often than not it is a cash payment of a portion of a company’s earnings. The value of this payment is easy to understand as it is cash paid directly to the shareholder. A truly great long term investment on the other hand, pays not only a dividend but also increases that dividend amount regularly over time.
Another method of creating value for shareholders is for a company to buy back their own stock. This is when a company uses its excess cash to purchase its own stock on the open market and then retires those shares. This decreases the total number of outstanding shares leaving you, the shareholder, with a larger piece of the pie. While not as straight forward as the cash dividend, this method still greatly increases value for current shareholders. As total outstanding shares decrease, the existing shares that remain increase in value proportionately. The following chart depicts the performance of a basket of companies with a disciplined buyback strategy compared to the S&P 500 since the financial crisis back in 2009:
David Ikenberry, a finance professor at the University of Illinois, researched more than 7,700 buybacks between 1980 and 2000 and found benefit to shareholders. Stock prices of companies that repurchased their shares outperformed by 15.6% over a basket of similar companies that did not buy back shares. This outperformance can’t be solely attributed to the fact that the companies were buying back shares but the bottom line is that companies that are able to reward shareholders through dividends and share buybacks are companies that are generating Free Cash Flow with management teams that know how to operate publicly traded companies. Of course these aren’t the only considerations that you should focus on when considering an investment but it’s a good place to start.