Market-leading companies not only achieve success through their business results but also by properly allocating capital in a �ꦿ�way that is most beneficial to shareholders.

Often overlooked as a central theme, 澳洲幸运5官方开奖结果体彩网:capital allocation decisions are vital in determining the future of the company and, as such, are some of the most important responsibilities of company m📖anagement. This article will examine some of the metrics that help us evaluate management's ability to effectively allocate capital in any set of market conditions. Read on to learn how to use these metrics to facilitate stock research and find companies poised to succeed over the long haul.

Capital Allocation Decisions

Should the company issue or increase 澳洲幸运5官方开奖结果体彩网:dividends? Should it build that new factory or hire more workers? These are the dilemmas facing🌱 managers of today's publicly-traded companies.

Every company follows a life cycle; in the early stages of life, capital allocation decisions are pretty simple – most of the cash flows will be poured back into the growing business, and there probably isn't going to be much money left over. After many years of strong, steady earnings growth, companies find out that there is only so much market out there to be had. In other words, adding the next product to the shelf, or adding the next shelf for that matter, is only half as profitable per unit as the first things that were put on that shelf many years ago. Eventually, the company will reach a point where cash flows are strong, and there is extra cash "lying around." The first discussions then can begin about such things as:

• Entering a new line of business – This requires higher initial outlays of cash, but could prove to be the most profitable course in the long run.
• Increasing capacity of the core business – This can be confidently done until growth rates begin to decline.
• Issuing or increasing dividends – The tried and true method.
• Retiring debt – This increases financial efficiency, as equity financing will almost always be cheaper.
• Investing or acquiring other companies or ventures – This should always be done cautiously, sticking to core competencies.
• Buying back company stock.

Mana🍸gement makes these kinds of decisions by using theไ same metrics available to investors.

Return on Equity

A stock's 澳洲幸运5官方开奖结果体彩网:return on equity (ROE) reveal♈s the growth rate of the company in "shareholde🐓r dollars."

When looking at a company's ROE, there are a few considerations to take into account, such as the age of the company and what type of business it operates. Younger companies will tend to have higher ROEs because cash deployment decisions are easy to make. Older firms and those operating in 澳洲幸运5官方开奖结果体彩网:capital-intensive businesses (think telecom or integ⭕rated oil), will have lower ROEs because it costs more up front to generate the first dollars of revenue.

ROE is very specific to the industry in🎐 which the company operates because each has unique capital requirements; therefore, comparisons should only be made to similar companies when reviewing this valuable metric. A ROE above the industry average is a good sign that management is wringing the most profit possible out of every invested dollar.

Return on Assets

澳洲幸运5官方开奖结果体彩网:Return on assets (ROA) is similar in theory to ROE, but the denominator of the equation has changed from stockholder equity to total assets. The ROA number tells us what kind of return management is get♔ting on the assets at its disposal. As with ROE, ROA figures will vary greatly within different industries and should be compared with this in mind.

ROA performance will, over the long run, provide a clearer picture of profitability than ROE will. Why? Because in the ROE calculations, current 澳洲幸运5官方开奖结果体彩网:net income and last year's net income are major variables; they also happen to be much more volatile than long-term growth rates. When ROA is calculated, most of the denominator is made up of long-term assets and capital, which smooth out some of the short-term noise that ROE can create. Essentially, ROE can vary widely for a company from year to year, while ROA figures take longer to change si💝gnificantly.

Capital Requirements and Cash Management

Let's say that Company X has averaged an 18% ROE for the first 10 years of its existence. This represents a strong record of growth, but it was achieved during a time when there were ample new markets to get into.

With a leading market share, Company X can already see that it won't be able to keep up this rate of growth and must begin looking at other ways to increase shareholder value. The capital requirements to keep up the business are known and set aside, and the 澳洲幸运5官方开奖结果体彩网:free cash flow that is left over can be assessed f▨or its durabilityꦑ and consistency.

Once this has been verified, management can sit down and decide the best use of the funds. One or more of the options mentioned above may be used, and once this process begins investors can really start to evaluate the company's effectiveness outside of simply running the core business.

Dividend-paying stocks are attractive to many investors. Dividends are an effective way of returning free cash flow to shareholders and encourage long-term investment in a company. By looking at the 澳洲幸运5官方开奖结果体彩网:payout ratio for a stock's dividend, an investor can easily tell what percentage of net income is being used to pay dividends. The smaller th🦩e payout rati🅠o, the more room management has to increase this amount in the future.

The most mature dividend-paying companies are paying out 80%, or more, of all the net income to shareholders, which provides for a nice yield, but leaves very little cash behind to generate future earnings growth. These stocks end up resembling 澳洲幸运5官方开奖结果体彩网:real estate investment trusts (a securi꧑ty where at least 90% of net income must be distributed to shareholders annually). As a result, investments in companies with very high dividend pay🅰outs will experience little price appreciation.

Stock buybacks are another common way to allocate excess capital within an organization. When is this in the shareholders' best interests? If the company truly feels that its🐭 stock is undervalued, buying back stock could very well be the best use of the funds. This will increase the percentage ownership of all the other shareholders and is generally seen as a positive sign that management believes in the future of the company.

The Bottom Line

For the individual investor, part of any effective 澳洲幸运5官方开奖结果体彩网:due diligence should include understanding the history of, and expectations for, the capital allocation abilities of a company. When looked at along with the 澳洲幸运5官方开奖结果体彩网:valuation and growth, management's ability to allocate capital effectively will determine whether it is destined tܫo have a front-running stock ﷺor an "also-ran."