Capital allocation: Intangibles, CAPEX, R&D, NWC, Dividends & Buybacks
Capital allocation: Intangibles, CAPEX, R&D, NWC, Dividends & Buybacks
Author: Joris Kersten, MSc
Kersten CF: M&A advisory and Valuations @ The Netherlands. www.kerstencf.nl
Training: Business Valuation & Deal Structuring, 5 days @ Amsterdam. 4th – 8th November 2024, registration & manual @ www.joriskersten.nl . 130 recommendations @ https://www.joriskersten.nl/nl/reviews
Source used: Morgan Stanley Investment Management, Counterpoint Global Insights. Capital allocation: Results, analysis and assessment. 2022. Michael J. Mauboussin & Dan Callahan.
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Introduction
Intangible assets are non physical.
They can be divided in three categories:
1.????? Computerised information: e.g. software development, database development;
2.????? Innovative property: e.g. R&D, mineral exploration, creating entertaining and artistic originals, design and other product development costs;
3.????? Economic competencies: e.g. training, market research and branding, business process reengineering.
Measuring internally generated intangible investments is a challenge.
This because they are mixed with maintenance spending within selling, general & administrative (SG&A) expenses in the income statement.
In 1974 the FASB (financial accounting standards board) decided that companies should expense R&D.
This is a prominent form of intangible investments.
Reason was that there is normally a high degree of uncertainty about the future benefits of individual R&D projects.
So by expensing them you are conservative, and it will reduce equity straight away through the P&L.
Nowadays academics are actively researching methods to isolate investments from SG&A, and to estimate useful lives (this for setting the “amortisation”).
The most common approach is to assume that:
·???????? All R&D is an intangible investment;
·???????? 30% from SG&A (excluding R&D) is an tangible investment.
(please see the source I have used for this article, this for the original studies on isolating these intangible investments)
Aggregate SG&A, excluding R&D, was in 2021 for companies in the Russell 3000 1.3 trillion USD.
This up from 170 billion USD in 1985.
This went from 5.8% of sales in 1985 to 7.1% of sales in 2021.
It was estimated that in 2021, for companies in the Russel 3000, investment SG&A excluding R&D, and net of amortization, was about 1.9% of sales.
This is a little lower than 30% of 7.1%, cause it is a "net number", so taking amortisation into account.
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Capital expenditures (CAPEX)
Companies in the Russell 3000 allocated about 1.1 trillion USD to CAPEX in 2021.
This is about 5.7% of sales.
And CAPEX are investments in tangible assets.
Similar to intangible investments, CAPEX are less cyclical than M&A.
CAPEX can be divided in two parts:
·???????? "Maintenance CAPEX" and "growth CAPEX".
Growth CAPEX were roughly 35% from total CAPEX, over the period 1985 – 2021 for the Russell 3000.
Maintenance CAPEX is often underestimated, since often it needs to be larger than depreciation.
This because there is “inflation” (not taken up in depreciation) and there can be “technological obsolescence” within the assets.
As a rule of thumb, depreciation understates maintenance CAPEX by about 20% overall. (check the source I have used for this article)
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Research & Development (R&D)
R&D is largely an intangible investment.
US businesses spend 20 – 25 % of their R&D budget on research, and 75 – 80 % on development.
Investment R&D was 1.3% of sales in 1985 and went up to 2.3% in 2021, for the Russell 3000.
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This was mainly the result of a change in the composition of the market.
Since the sector weights of “technology” and “healthcare” have doubled since the mid-1980s to now.
Concerning amortisation on R&D, the weighted average asset life is about 4.4 years.
Net working capital (NWC)
NWC has lost significance as a factor in capital allocation in the last decades.
NWC was nearly 30% from assets in the 1970s, and NWC is less than 10% of assets today.
Reason is the mass reduction in inventory levels.
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Dividends
Dividends, once set, are considered equivalent to investment decisions such as capital expenditures.
Buybacks are seen more as a way to disburse residual cash after the firm has made all suitable investments.
Nearly 75% of the companies (in the US) paid a dividend in the late 1970s.
And just 39% of the companies did this in 2002.
It went back up to 48% in 2014, and went down again to 35% of the companies in 2021.
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Share buybacks
The percentage of net income that companies are paying out in buybacks was significantly higher in the last 10 years (about 2010 – 2020), compared to 1985 – 1995.
Very rough estimate is 60% of net income during 2010 – 2020, and 30% of net income during 1985 – 1995.
This is a “gross number”, so equity issuance is NOT netted out.
And this for companies of the Russell 3000.
While buybacks have surpassed dividends in overall corporate payouts, the aggregate payout has been very steady.
When we look at the “shareholder yield”; ( buybacks + dividends ) / equity capital of the market, this is quite stable.
Ranging roughly in between 4 – 6 % during 1985 – 2021 for the Russell 3000 (gross number, so equity issuance NOT netted out).
This is ( very roughly ) in line with the “cost of equity”.
Cost of equity & buybacks
This cost of equity comes down from about 12 – 13 % in 1985 to about 8 – 9 % from 2000 on to now.
The total shareholder yield went from 47% of the cost of equity in 1985 to about 62% of the cost of equity in 2021.
One could argue that a company should repurchase its shares ONLY when its stock is undervalued.
AND when no better investment opportunities (than the buybacks) are available !
I have mentioned "EPS accretion/ dilution" before.
And also with buyback "accounting outcomes" (EPS accretion is an accounting outcome) can (potentially) improve.
(improvement is not necessary the case, since EPS accretion actually is a function of “multiples” and “additional interest”)
But there is no prove that "EPS accretion" increases shareholder value !
Another reason for the buybacks can be to offset “stock based compensation”, so offsetting "equity issuance".
The total “net payout ratio” is still significant for companies.
The definition is:
So here the ratio is “net of equity issuance”.
For the Russell 3000 this ratio was 50% in 1985, and went up to 64% in 2021.
Hope this was useful,
See you next week again with a new blog !
Best Joris????
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Source used: Morgan Stanley Investment Management, Counterpoint Global Insights. Capital allocation: Results, analysis and assessment. 2022. Michael J. Mauboussin & Dan Callahan.