Add it's hard capital allocation is deploying capital to yield the highest returns. As co with cash in the bank has the option to hold cash for a rainy day reinvested organically in the existing businesses or acquire another business. Those are the obvious choices. Financing strategy also comes into play because the CEO could also decide to reduce debt levels with this cash or return some of this cash to the shareholders, which has the effect of increasing financial leverage. It's the return of cash to shareholders, which many companies fail to optimize properly. A company with surplus cash can return capital for the benefit of shareholders in a number of ways.

Here the valuation and tax professionals on the finance team have their moment to shine. Dividends are the most obvious mechanism however, dividends may be the least efficient from a tax perspective for the shareholder and the reason is is that dividends are typically paid out of after tax profits earned inside the business. Shareholders then take those dividends into taxable income. And for certain shareholders, those dividends may get taxed again at the personal level. Dividends also come in two varieties, they can be regular dividends or special dividends. Regular dividends are attracted to investors who seek yield on their investment.

So think of the little old ladies. This feature makes your shares appealing to this segment of the investor population. However, you can piss off this segment of the investor by reducing or canceling the dividend, which puts your share price in the doghouse for years to come. So regular dividends must be sustainable. Special dividends can be paid when the company has a big lump of cash for which you cannot find a purpose. Perhaps the company is like Microsoft or Apple just hoarding cash for years on years, or maybe the company sold off a significant line of business and is now sitting on a pile of cash.

Special dividend can be paid to the shareholders to put capital back into the shareholders hands for reinvestment. Special dividends tend to transfer cash from the company to the shareholder, but they don't tend to get you very much in terms of attracting new types of investors or providing another basis of valuation for your stock. Regardless of whether the dividends are regular or special, the underlying message is somewhat the same. The company's businesses don't need cash, or the CEO cannot find opportunities to deploy cash to generate a return. Berkshire Hathaway has never declared a dividend, even though it's sitting on a mountain of cash, likely because that was sent entirely the wrong message about Mr. Buffett's ability to allocate capital. So that's the story with dividends.

Let's turn our attention to repurchasing our own shares. This is where the valuation guys get their moment in the spotlight. Let me emphasize done properly, this activity alone can distinguish a great CEO from a good one. Pay attention. companies should always maintain a view as to their intrinsic value. It's misleading to simply assume the markets digest public disclosures and perfectly attribute value to your shares.

They simply don't. Capital Markets rise and fall like tides and industries come in and out of favor, multiples expand and contract. So maintaining this long view of what the company is worth is important. This value should look at the long term cash generating potential of the underlying business. Ignore indicators that are too fixated on a moment in time. So for instance, earnings make it messy because of impairments.

Cap rates tend to fluctuate based on the level of interest of current buyers and sellers in the market. This is where you can use a little bit of valuation expertise to help formulate this long term view for the CEO. But it doesn't need to be complex. In fact, you can use rule of thumb such as EBITDA multiples or some of the part calculations To determine your net asset value or nav, the CEO will need a strong CFO to help them in maintaining this view. And typically, there's only a handful of strategic drivers for each business unit that will impact this long term view of intrinsic value. But once we know what we're worth, it opens up an entirely new outlet for deploying capital and generating a return.

By having the company buy back its own shares, you're investing in yourself. How does this work for the shareholders? Well, certain shareholders will desire liquidity, that is the ability to sell their shares and take their money off the table by offering to purchase their shares. That company can satisfy those shareholders seeking an exit at a given price for the shareholders who retain their shares. Obviously, we now have fewer shares outstanding and the same amount of earnings. So if you think about the earnings per share calculation, your numerator is earnings.

That number remains the same, but the denominator is the number of shares outstanding, and this decreases as you buy back shares. Thus, earnings per share will increase as the denominator gets smaller. When you apply the same earnings multiple to the business, the share price should increase if the market is behaving rationally. If your share price is trading at the same price as your view of intrinsic value, it's largely a zero sum game as portrayed on this screen. The repurchase of shares is simply a more tax efficient way to increase the value of the remaining shareholders investment, because in most jurisdictions, capital appreciation is not tax until it is realized. Pause the video for a moment and review the example on the screen, which compares the payment of a dividend to the repurchase of stock and look for these three things.

First, notice how the enterprise value doesn't change as a result of this capital allocation decision. Secondly, when the dividend is paid with the surplus cash The stock price should adjust to reflect the payout of this capital. The value of the shares plus the value of the cash received by the shareholder should be the same as the value prior to the dividend declaration. And third, when the shares are repurchase, the company buys the stock at the market price of $62, resulting in 19.4 fewer shares outstanding. However, the value of the shares should be the same before and after the repurchase, even though the company is now smaller. However, if you want to supersize your shareholder returns, consider buying back shares of the company when the shares are trading at a substantial discount to the intrinsic value.

Let's say your intrinsic value for the company is based on a long term historical multiple of 10 times earnings. For whatever reason, maybe the economy is soft or capital markets are going through a correction. You might find your stock trading at a lower multiple or realizing softer earnings because of the software. economy, any of these could result in your stock price falling below this intrinsic value that you have in the back of your mind. When this happens, you now have the opportunity to invest in a company you know better than any other and make a return based on this valuation discrepancy. The only thing different between this scenario and the zero sum scenario we just looked at is the fact that the shares are bought back at eight times earnings, which is below that long term average of 10 times earnings.

As time goes by the market corrects itself and the multiple returns once again to the 10 times earnings. Under the dividend option, the shareholders still get their $62 of value, split between the share value and the value of the cash received from the dividend. However, under the share purchase option, you'll notice that the total shareholder value has increased to $65 from $62 per share. Consistently arbitrage in this valuation differential is The key to maximizing long term shareholder value. Now, maybe you don't want to bother going through this exercise of building a model to support the analysis. Surely there's a formula for this, why Yes, there is.

Pause the video and read through the example on your screen to calculate how much return can be attributed to a share buyback. With the share repurchase option now on the table, you have another investment opportunity to throw into the mix with organic growth opportunities prepare by your business unit managers, and any acquisition opportunities you see in the market. As competing outlets for cash. Many companies will use a normal course buyback to give them the flexibility to buy back a small percentage of the float each year, typically in the range of five to 15% of the public float and possibly subject to rules of your exchange. These programs also helped bring stability and liquidity to the country. The stock price, particularly for small capitalization stocks, however, because we are talking about a small number of shares over a generally long period of time, the creative effects of stock buybacks using a normal course.

Issuer bid take a few years to gather some steam. Research has also confirmed that normal course buybacks provide a weak signal to the market that the company believes his shares are undervalued. It doesn't mean you shouldn't do it, it just means you should look to supplement it with larger buybacks from time to time when your shares are trading at a substantial discount. When the market conditions are right you can get a whole lot more aggressive by pursuing a tender offer to buy back a large quantity of your own stock. There are a few variations of how this can go. A company may pick a price and see what take up there is from there.

The company may also conduct what is called a Dutch auction, which allows the shareholders to indicate at what price they They will tender their shares, which allows the company to decide how many shares and at what price they get taken up. The key to pursuing a tender offer is the valuation of the shares. You ideally want the shares trading at a substantial discount to their intrinsic value using a conservative assumption to ensure that these buybacks are accretive to the shareholders. The end result should be that a large chunk of shares is taken out of the market, which will give the remaining shareholders a substantial lift in the years to come, as they will have a larger piece of the same pie. Some companies have even drawn on death facilities to capitalize on these sorts of opportunities. When the time is right, be bold and take action.

Finally, you'll often see companies split their stock as we know stock splits do not create economic value. However, there are legitimate reasons to consider stock splits, splitting a stock when the price per share gets large say $100 or more how Maintain retail investor involvement with the stock, as small retail investors sometimes find it awkward to deal with large share prices. The second advantage of splitting a stock is that it helps improve the liquidity of a stock. With two or three times more shares suddenly outstanding in the public float, it's easier to spread the shares among more investors. However, the opposite of a stock split is a stock consolidation. When stock prices become too low, brokerages will no longer provide margin on these shares, which reduces liquidity of the shares.

Companies will consolidate shares like Citigroup did, and it's 10 for one stock consolidation after the Great Recession to restore the stock price to a more familiar trading price. However, markets tend to look at stock consolidations on favorably so use it as a last resort. In this lesson, we covered three super important points. Number one, regular dividends are appealing to a certain a segment of the investor population, which can offer another reason to sustain your stock price. Secondly, knowing what your company is worth gives you another outlet for capital deployment. And thirdly, buying back your own shares when they're trading at a substantial discount can have a huge impact on long term shareholder returns with little effort and low risk.

Interestingly, Warren Buffett does none of the things discussed in this lesson. Berkshire Hathaway does not pay dividends, it does not repurchase stock, and it does not split his shares, which is why they're now trade for over $100,000 a share. However, other master capital allocator CEOs, such as Henry Singleton, who we discussed in the introduction, were actively using these sorts of capital allocation tools. Singleton bought back 90% of Teledyne shares between 1972 and 1984, which resulted in get this a 42% compound annual return for the Long Term Teledyne shareholders impressed Well, yes should be. In fact, most master capital allocators will place an extraordinary emphasis on these share buybacks at opportune times. So unless you have boundless ideas for investing as Mr. Buffett does, then you too should consider these tools from time to time.

In our final lesson, let's profile the traits of the master capital allocators to summarize what we've learned in this course. Till then