Buying a great franchise that generates cash -- as evidenced by the stream of free cash flow -- is considered good investing. Wal-Mart (WMT), Home Depot (HD) and McDonald's (MCD), for example, generate surplus free cash every day in every quarter, year in and year out.
But it's not enough to invest in great franchises that generate a lot of cash. You need to take it one step further and analyze management's ability to allocate capital. In my view, a CEO's single most important function is allocating capital. Over seven to eight years, on average, a CEO will allocate
all of his or her company's capital.
Numbers Don't Lie
Disney (DIS) Chairman and CEO Michael Eisner, who leads one of America's great franchises, is busily lobbying shareholders to keep his job as "Allocator-in-Chief" of Disney's capital. However, if he's talking to shareholders who understand financial statements, he has a problem. Numbers are not malleable. Parse through 10 years of Disney's financial statements and the numbers tell the cold, stark truth about Eisner's capital-allocation record:
Nominal earnings have barely budged over a 10-year span. Annual earnings have increased from about $1.1 billion to $1.3 billion. Adjusted for inflation, there has been no growth.
The capital base was $8.3 billion 10 years ago; it now stands at about $37 billion. Despite deploying four times as much capital, Disney generates roughly the same amount of nominal earnings!
Debt has ballooned from $2.8 billion to $13 billion in 10 years.
Revenue growth has been paltry to nonexistent (adjusted for inflation) for many years, despite the four-fold growth in the capital base.