Capital allocation is vitally important to the success of an enterprise. If an acquisition-hungry CEO convinces the Board of Directors to acquire another company at fifty-times earnings, the transaction has essentially doomed shareholders to earn two-percent, less than the historical long-term rate of inflation, on their capital. Instead of entering into the transaction, management would have been wiser to find an alternative use of the capital or pay it out to shareholders via dividends.
Is the company maintaining a responsible level of debt, or has debt relative to equity increased with little or no explanation?
If you notice a significant increase in the debt-to-equity ratio with little or no explanation from management, you may want to be concerned. An increase in liabilities is not necessarily bad. Indeed, in some cases it can maximize earnings per share with little additional risk to the company. However, as an owner of the business, you have a right to know the motivation behind such moves.
Are employee perks reasonable?
While under the direction of former-CEO Scott Livengood, Krispy Kreme [KKD] had reported earnings of $33.5 million in 2003. Yet, after he was forced out, the corporate turn-around specialist appointed in his place, Stephen Cooper, found that Livengood and several other executives at the company had access to a Dassault Falcon 900EX private jet. Cooper got rid of the aircraft; a move which is expected to save the company $3 million dollars per year. This expense essentially amounted to a ten-percent “jet” tax on Krispy Kreme’s shareholders. Had the company reinvested those funds into the business and managed to earn an average return on equity of only twelve percent per annum, this would have resulted in $52,646,205 additional net income over the course of ten years. The lesson: if a management team is regularly dining on filet mignon and sleeping in $5,000-per-night hotel suites on shareholders’ tab, the odds are substantial their priorities are out of line. (Note: The same test can reveal extraordinary fiscal responsibility: despite overseeing a company with half-a-trillion-dollars in revenue, Wal-Mart executives are known for their bus-station-like headquarters, and insistence upon sharing rooms at $50 per-night hotels. Here, management is truly looking out for the interest of shareholders.)
Are management’s communications open and honest?
As an owner of a business, you have the right to expect a management that is open and honest about the challenges the company is facing. If the CEO’s letter to shareholders sounds more like a public relations document, or if you have difficulty understanding the footnotes, reconsider your investment. At the very best, they don’t have a proper respect for your role as owner. At worst, they may have something to hide.
5. Large potential dilution
Dilution, either in the form of convertible bonds or preferred stock, or outstanding stock options can result in otherwise stellar-increases in earnings-per-share coming in substantially lower than anticipated. For this reason, it is extremely important that investors delve into the financial reports and attempt to uncover any potential source of share issuance. By factoring this into his valuation calculation, the investor can help ensure he does not overpay.
