Unlike what happens with investors, the first decision a company has to make when managing its cash is whether it should distribute it to remunerate its shareholders or if that money should stay within the company so that it use it. In this article we will see what should be based on the decision of the management team to reinvest the profits in the company or not to do so and distribute it with the shareholders, and I will warn you about dangerous managers with an air of greatness at any price and the need to avoid them .
When should a company reinvest its money in the business?
In this case the answer is simple, when the relationship between profitability and profitability risk is adequate. In this case, proper financial management in the company is essential, since you must do a scenario analysis that provides you with the profitability that you could achieve by investing the money in improving the business.
In the absence of an adequate return on risk, managers should store it (if they think there are likely to be good investment opportunities in the future) or distribute it to shareholders in the form of dividends or buyback of treasury shares.
Internal profitability and external profitability
In deciding whether a company should invest its money in the company or distribute it among shareholders, the key is to compare its internal profitability with external profitability. Internal profitability is what the company can obtain by investing that money, while external profitability is what shareholders could obtain on their own. If external profitability is higher than internal profitability, the management team must distribute the money among shareholders in the most convenient way.
This idea, which seems simple and logical, is very difficult to implement in practice due to the problem that you will see below.
Beware of management teams with an air of greatness
As we have already seen, management teams have to manage the company's money by dedicating it to the alternative that maximizes the value to its shareholders. Sometimes, as we have seen, they will have to return them to their rightful owners, that is, to shareholders, either by distributing dividends or by repurchasing shares. However, many managers are reluctant to do so for selfish reasons.
One of the great problems that investors have are managers with an air of greatness, who prioritize their desire to manage large companies over their duty to maximize shareholder value. Our duty as investors is to identify them and keep them away from our investment portfolios.
How can we identify these types of managers? The truth is that it is not easy. They tend to have expansive company policies, paying exorbitant prices for the acquisition of their competitors. To identify these types of managers, it is best to know them thoroughly, reading their reports, interviews, statements and everything that comes our way. The truth is that it is not a perfect solution, but it can help us avoid falling into companies that, because of their managers, become value traps.