I'm so glad you decided to learn more. You're now embarking on a journey that most executives only spend very little time, if any at all considering that is what is my optimal capital allocation strategy right now. capital allocation is defined as a process of how a business divides their financial resources and other sources of capital to different processes, people and projects, the goal being to maximize shareholder value. I don't find this definition complete because it fails to recognize the importance and integration of finance strategy. So let me explain what I believe is a better description of capital allocation. And then I'm going to show you how you can evaluate management's capital allocation decisions in this lesson.
In my mind, a simpler definition of capital allocation is how a company sources cash and deploys it. There are essentially five choices sourcing cash, cash generated from operations, cash generated from reducing investment in working capital, cash from divestitures cash from the issuance of debt and cash from the issuance of equity. There are generally five ways to deploy cash as well, including reinvesting in existing businesses, acquiring another business, paying down debt, paying a dividend, or repurchasing shares. Are you serious? You mean to tell me that's it? Yes, that's it.
These are the tools of capital allocation. If you are a financial professional, you know full well what each one of these tools entails. However, the secret is developing the right mix and use of each of the tools in a way that maximizes shareholder returns. That part is extremely difficult to do, because this mix is constantly changing and often requires you to be contrarian in your thinking as much As you might think capital allocation decisions are made in secret behind closed boardroom doors. All you need is a set of financial statements to see half after the fact what decisions were made. To make this assessment I find the statement of cash flow is particularly useful because capital allocation is largely dependent on how management allocates cash flows.
Perhaps the only thing that might not be shown on the cash flow statement is if you use shares as currency to acquire another business, which is also part of capital allocation. For that you just need to give the statement of changes in equity a quick look. The best way to show you how to see capital allocation strategy is to work through a case study. Let's use GameStop Corporation as a real life example. GameStop is a global retailer of video games and consumer electronics. The purpose of this brief review is to simply show you how to review financial statements with capital allocation in mind.
I'm not going to spend any time discussing the business, its strategies or its operations, because in doing so, we'd be falling into the trap of evaluating operating performance and lose our focus on capital allocation. Let's just get some context by looking at the income statement from the 2014 10. k. The business does not appear to be growing, and most recently, it looks to be generating around $9 billion of top line sales. This suggests we have a mature business model. The recent earnings look a little bit lumpy with the loss in 2013. However, the company took a 620 $7 million dollar impairment charge in 2013. Excluding that charge earnings have been slowly growing the past three years from 340 million to 354 million in 2014.
That's growth in earnings of about 4% over two years. Not all that impressive, but stable. What's more interesting is the EP s number. It's grown from $2 and 41 cents to $2 and 99 cents on On a fully diluted basis, that's at 25% improvement my friends. The reason those per share numbers are growing faster than the actual earnings numbers themselves is because of the next line. The weighted average number of shares outstanding has declined on a diluted basis from 141 to 118 million.
Hmm, interesting. I want to find out more. Let's look at the balance sheet. A couple of highlights 530 $6 million of cash on hand with virtually no senior debt. In fact, a little historical research will tell you that the company has paid off the last of its remaining dead in 2012. The company has a nice thick $2 billion equity layer, which works out to about $20 a share in book value.
The company is well poised to capitalize on any strategic opportunities that emerge with this kind of financial capacity. So those metrics give us a little bit of context as we now look at the cash flow statement. The Cash Flow Statement kind of purifies the income statement in the balance sheet by separating him all the funny accounting adjustments to get back to what sort of cash this business generates. In the top section, we can see that the cash flow from operating activities has grown from 642 million to 763 million in the past two years, a nice 19% improvement. You can break this achievement into two components, cash from the business, excluding working capital, and cash created or use from the change in working capital. Notice how GameStop has done something different with the suppliers to get access to more credit.
Nice job GameStop using someone else's balance sheet to free up cash invested in working capital. The net of working capital management improves the freed up cash flow by about 150 million dollars in cash last year. Moving down a section the cash use from investing activities, we can see the company continues to reinvest in its own business to the tune of 120 $6 million. This is lower than historically spent on cap x two years ago and lower than the depreciation so the company may be running out of internal opportunities to grow its retail network. This is another characteristics of a mature business model and an indicator of a cash cow to use the Boston Consulting Group matrix lingo. The company has also undertaken some acquisitions of other businesses that cost $77 million of cash.
Back in the notes of the financial statements, you can determine whether any vendor notes or share considerations were issued in conjunction with these acquisitions. There was a bit of debt associated with them, but no shares issued. The company generated over a half a billion dollars of free cash which you can determine By taking the operating cash flow and subtracting the capital expenditures, a cash cow and deed, and better yet it has grown this free cash flow before debt repayment by 26% in the last two years alone. Finally, let's look at the cash flow from financing activities. Here you'll be able to determine how the company has used debt to finance either its operations, or its investment activities. And if it has any cash left over what it did with that cash in terms of dividends or repurchasing its own shares.
As we noted earlier, the company has virtually no debt. Debt issued on the acquisition was repaid during the year and a note for 250 million dollars was repaid two years ago. This still leaves the company with a tremendous amount of leveraged free cash flowed to do something with it appears as though in 2013. The company decided to start paying a dividend to its shareholders and that used up 100 and $2 million Last year, and then the company increased that dividend this year spending 130 $1 million are cross fewer shares. Remember, I'm sure that pleased a few shareholders. dividend growth is an attractive feature for yield oriented investors.
The company also has a sizable share repurchase program, the details of which you can learn more about in the notes to the financial statement. In the last three fiscal years GameStop has bought back approximately 37 million shares spending just over $900 million, which works out to be an average purchase cost of $24 per share, only slightly higher than the book value per share. The only other small item note is some shares that were issued for stock options. Watch out for companies that only use share buybacks to hide the dilutive effect of their option programs. This tactic has a tendency to give share buybacks a bad day so Now we know what capital allocation decisions have been made by the CEO and approved by the board of directors. What matters in capital allocation is not whether you're doing it or not.
It's whether you are increasing shareholder value. Let's take a look at gamestop 's stock chart for the last three years. Whoa, whoa, this stock has had one heck of a run in 2013 going into 2014 all the way up to $55 a share before falling back in early 2014 to $35. Prior to that the stock appear to be range bound between the high teens and the mid 20s. So what is the upshot of this analysis, the company is doing a great job of creating value for shareholders. Even in an environment where the business itself is growing.
Free cash flow is growing. Dividends are growing. Access cash flow is being used to buy back shares at a reasonable valuation. Note the average $24 per repurchase price. significantly less than the current $35 trading price, which made these repurchases accretive to the shareholders. So at this point in time, the company appears to be doing a great job of capital allocation.
But to be certain, it's difficult to evaluate capital allocation over a period of just a couple of years, you really need to stand back and make this assessment over the course of a couple of economic cycles. capital allocation is not an annual evaluation, because your share capital is not one year term financing. share capital is permanent financing, and capital allocation needs to be considered over a similar long term horizon. In this lesson, we learned three really important things we learned about the five sources of cash, we learned about the five choices a CEO has for cash deployment, and we also learned how to find out information about capital allocation by reading a set of financial statements. In the lessons to come. We're going to drill into each of these areas.
Until then