NEW YORK (TheStreet) -- Activist investors have been pressing U.S. companies to return extra cash to shareholders through dividends or stock buybacks, and companies have been obliging them.
Surely, individual investors may be asking themselves, "Is this really the best use of excess cash?" Reality Shares decided to investigate, and the results might surprise you.
Many investors consider stewardship of a company's free cash to be one the most important responsibilities of corporate management. For public companies in particular, the guiding principles to effective cash governance should all directly or indirectly enhance shareholder value. With this in mind, there are only four principal uses of free cash: direct reinvestment in the business for organic growth; accretive growth through acquisitions; paying down debt; or returning cash to shareholders through stock buybacks and/or dividends.
A company's stock price is ultimately driven by the successful deployment of its free cash. In this regard, earnings, the price-to-earnings ratio and aggregate dividends become key measures of a company's effective use of its corporate cash. In a perfectly managed corporate model, a company would always deliver a return on invested capital above its cost of funding. Corporations would only deploy free cash as working capital so long as they could earn returns over and above this target invested rate of return. Unfortunately we don't live in a perfect world. Many companies have inferior returns on invested capital, sometimes far below their cost of capital for sustained periods of time.
Increasingly, activist investors are combing through corporate income statements to identify these companies and seek changes in how they are run, often by compelling them to return more cash to shareholders in the form of dividends or buybacks.
The trend was illustrated in a May 27 article in The Wall Street Journal titled "As Activism Rises, U.S. Firms Spend More on Buybacks Than Factories," which called into question whether reduced capital investment might negatively affect economic growth.
The Journal said an S&P Capital IQ analysis conducted for the newspaper showed that companies in the S&P 500 index doubled their spending on dividends and buybacks to a median 36% of operating cash flow in 2013 compared to 2003. "Over that same decade, those companies cut spending on plants and equipment to 29% of operating cash flow, from 33% in 2003," the Journal said.
Few would argue against companies investing in their businesses to create innovation, growth and jobs, but what if every dollar invested is destroying shareowner value? Reality Shares conducted an analysis of the S&P 500 to determine which companies are doing exactly that.