Mar 11th, 2007 by Martin Lee
Intrinsic Value and Capital Allocation
When managers make capital allocation decisions, it is important that they act in ways that increase per-share intrinsic value and avoid things that decrease it.
For example, in considering business mergers and acquisitions, many managers tend to focus on whether the transaction would be immediately dilutive or anti-dilutive to earnings per share. This is insufficient.
Consider our previous example on college education. If a 25-year-old first year MBA student were to merge his future economic interests with that of a 25-year-old laborer, it would enhance his near-term earnings since he isn’t earning anything at the moment.
But such a deal would be downright silly for the MBA student.
Similarly in corporate transactions, it is important to look not just at the current earnings of the prospective acquiree, but to look at the effect on the intrinsic value of the acquiree.
Unfortunately, with the way many major acquisitions are done, they only serves to benefit the shareholders of the acquiree and increase the income of the acquirer’s management, but reduces the wealth of the acquirer’s shareholders.
A really good business will always end up generating more cash than it can use after its early years. While this money could be distributed to shareholders by way of dividends or share repurchases, often the CEO will engage some consultants or investment bankers for acquisition advice.
As Warren said, “That’s like asking your interior decorator whether you need a $50,000 rug.“
In Berkshire, the managers of the individual businesses will first look for ways that they can deploy their excess capital in their own businesses. The balance that is left will be sent to Warren Buffett and Charlie Munger, who will use those funds in ways that build per-share intrinsic value.