Cashcade

The “Why”

Why do companies make money? Lamplighter spends a lot of energy thinking about this. What do they do that creates value for customers? Before there can be value leftover for us shareholders, companies have to deliver it to customers first.

Lamplighter has invested in companies that make natural gas portable so customers can move it where they need it. That’s valuable. It invested in companies that lower the cost to run my hybrid car. It invested in companies that make it so advertisers can reach exactly the customers looking for exactly the right product. It invested in companies enabling their customers to accept any sort of payment, anywhere in the world.

All these companies deliver more value to their customers than they charge. That's one piece of how they create durable, profitable businesses.

But, where does that profit go? Once cash flows into a company, what does it do with it? Where should the money go?

These are very different questions. The answers depend.

The "Where?"

Shareholders live at the bottom of a long cascade of profits. Before value gets to shareholders, some goes to suppliers for things like raw materials, or server costs. Management has to get paid, of course. Employees too take a drink before shareholders. If the company's borrowed, its lenders take their cut. Once the waterfall has run through all these others, then, whatever's left pools to shareholders.

But, how does it get to shareholders?

The "How?"

Management's favorite way to get value to shareholders is to spend it to grow the business. Management’s like this, in part, because it increases their chances of getting paid more. This is true whether growth is profitable or not. Shareholders like growth too, but are pickier about it being profitable enough.

So, sometimes, it’s the right answer. Our payments company earns tidy profits. It's also growing rapidly. Management effectively uses the profits it earns to make the business better and expand. Shareholders get a bigger pool of profit.

The catch with plowing all a company’s capital into growth is that all the money stays with the company. It doesn’t really get to shareholders at all. And, with the carrot of higher pay nudging management to grow, shareholders ought to stay skeptical of all-growth capital allocation plans.

Tweeners — companies earning lots of profit, still growing, but that don't need all that cash for growth, can choose more balance. Our ad service also earns high profits and is growing, but its growth isn't quite as speedy as it was. It’s opted for a conventional three-part capital allocation plan. Some profit still goes to growth. Some goes to buyback shares. Some goes to dividends. Shareholders get a mix.

Companies cresting over the edge from growth to more limited or <gasp> falling prospects, like in natural gas or certain car parts, most cash should go back to shareholders through buybacks and dividends. This isn’t as exciting as growth, but it provides shareholders certainty, peace of mind and a fat wallet.

The End

There isn't one answer to "where should a company send its cash?" The key is to match the choices available with the chances in front of a business. And management has to agree to the plan. A plan should adapt as companies hit or miss their marks. Growthy companies should funnel all their resources back into the business. Tweeners should tend to both growth and payouts. Cresting companies had better return as much as they can to shareholders.

All this makes our job, investors, to figure out the value of a company and how we're going to get that value. When those things line up, returns flow freely. When they're out of step, result will likely be a trickle.

Disclaimer: None of this is investment advice. It's meant to illustrate ways LCM thinks about investing. Things that LCM decides are good investments for LCM and its clients are based on many criteria, not all of which are covered here. Some or all of LCM's ideas may not be suitable for other investors. LCM does not recommend investing either long or short any position mentioned. LCM may own positions in some of the companies mentioned. Some of its ideas will lose money — investing entails risk. See full disclaimer here.