The first call on the company’s capital is whatever funds are required to provide for the business such that it can maintain its current normalized level of profits, adjusted for inflation, over the long-term.

There are three general categories of such maintenance expenses that must be considered:

Economic maintenance capital. Let’s suppose that a competing casino across the street just spruced-up its interior and hotel rooms, installed all-new slot machines and opened a fun new restaurant that everyone is raving about. Sure, technically you don’t have to do anything the next day, and in the short-term your business will be just fine. However, if you do nothing then longer-term there is a good chance that you will lose market share to your competitor as customers learn that there is now a more enjoyable option for the same service than you are offering. You may need to invest additional capital into the business just to maintain your company’s profits, even though technically nothing is “broken” at your casino. This is still maintenance capital – the competitive landscape is forcing your hand as this capital will not produce growth in your profits, but may only serve to prevent declines.

What that level is will vary widely from company to company based on its cyclicality, the fixed vs. variable nature of its costs, capital intensity and a number of other factors. Don’t substitute some credit agency’s rating or the opinion of bankers at the peak of a credit cycle for your own, first-principles, assessment of what levels of debt are safe. If you find yourself not being sure if a level of financial leverage is safe – assume it is not and reduce it a bit further.

Any capital needed to return the balance sheet into a safe state. A safe balance sheet is one which can withstand temporary adversity due to the economy or company-specific set-backs and avoid landing the company into bankruptcy, causing it to violate its credit agreements or forcing it to issue highly dilutive equity securities while in distress. This is measured at the lowest point, since, as the saying goes, many a person has drowned in rivers that were on average only 6 inches deep. So if the company’s current debt levels are unsustainable, then the first call on capital after #1 needs to be reducing financial leverage to a sustainable level.

The bare-bones maintenance capital. Imagine that you are running a casino in Las Vegas. You need to fix the structures to comply with the zoning code and ensure customers’ safety. These are the obvious expenses as they are urgent and cannot be deferred, since otherwise the business will immediately suffer or cease to operate.

Of the three categories above the first two are mandatory. The third category is not. In the above example, if the return on invested capital from matching the renovations of your competitor across the street is below the company’s cost of capital, it would be wiser to accept market share losses than to make these maintenance investments at a poor rate of return. This is an important point when thinking about capital allocation – a bigger business is not better than a smaller one if getting there involves investments below the cost of capital.

So the corollary to the Zeroth Law of Capital Allocation is to only make investments that are either a) absolutely forced or b) hold a reasonable expectation of a return in excess of the company’s cost of capital.

There are five ways in which the company can deploy its capital once maintenance requirements have been taken care of:

Reduce Debt. Your general goal should be to have a conservative capital structure that can easily withstand temporary adversity that the business might face either due to a recession or a company-specific issue. You also don’t want to live on the edge, so if you find yourself agonizing as to whether you have too much debt – just take debt down a notch. However, it is also usually a mistake to have a balance sheet on the other side of the continuum with no debt and cash sitting on the balance sheet for a business producing meaningful cash flow. If you are a CEO who has a balance sheet like that –no debt, plenty of cash, and copious free cash flow piling up (ehem, some West Coast tech companies come to mind), ask yourself this: if you were the CEO of a private company with one very business- and financially-savvy owner, would you be allowed to get away with this? If the answer is “no,” then you are letting the principal/agent problem combined with your shareholders’ lack of ability to prevent your overreach to cause you to not act in the best interest of your owners. Please don’t provide some weak, vague rationale that you are keeping dry powder for some theoretical use a few years down the road. That might be the right answer for Warren Buffett, who has proven himself to be the world’s best investor over many decades, but you aren’t him. Chances are you are just rationalizing what feels comfortable and favors you, the CEO, at the expense of your shareholders. You can almost always raise capital later if some really compelling opportunity comes along. It might actually act as good governor on your impulses to grow to have to convince your shareholders or the capital markets that your intended use of capital is a good one, rather than just have cash readily available for you to act quickly (and sometimes rashly) after earning a pittance for your shareholders for years. Remember – it’s your shareholders’ money, not yours. So what’s the right level of debt? This is very business-specific. Essentially, you are solving for a pretty bad scenario for the business in terms of profitability where most things go wrong. Then you want to be able to service your debt easily and avoid tripping your debt covenants even in that scenario. If your debt levels pass this test, reducing debt, especially in a low-interest rate environment, is an inefficient use of capital. If your company doesn’t pass this test, then by all means reduce leverage as soon as possible until you do. If you wake up in the morning as the CEO, read the Wall Street Journal, and some terrible news befalls the world, the economy or your industry, you want to go into work very confident that your balance sheet will be just fine. For many companies, a level of debt around 3x EBITDA is a good point of departure. Say you have a company with a 20% EBITDA margin and a 5% ratio of maintenance capital expenditures to sales. So if your EBITDA is 100, your debt would be 300 and your maintenance capital expenditures would be 25. If you average cost of debt is 6% (higher than most companies currently, but not unreasonable longer-term), then you have interest expenses of 18. You would have 75 available to service your interest, for ample interest coverage. Imagine that your EBITDA gets cut in half – a very drastic scenario for most companies. Now you would have only 25 in pre-tax cash flow available to service debt, which would still be more than enough to get through this tough stretch. Company characteristics that should make you want to have a lower Debt/EBITDA ratio are: Highly cyclical industry (with current profits at mid-cycle levels or higher)

High percentage of costs fixed in the short/intermediate term

High ratio of maintenance capital expenditures to sales

High exposure to major adverse regulatory changes

Other liabilities that may require mandatory payments (e.g. under-funded pensions, asbestos liabilities, large outstanding lawsuits against you) The average company would be fine at around 3x Debt/EBITDA assuming a mid-cycle, normalized level of EBITDA. If you want to feel a little extra safe, perhaps set 2x-2.5x as your normal upper bound. However, for the typical company going much below these levels is unlikely to reduce risk while almost certainly reducing shareholder returns. If you are below the upper bound of your debt levels, I would suggests eliminating debt reduction from your menu of capital allocation choices.

Internal Growth Projects. Many of these will be funded in the normal course of business as they will be too small to move the needle relative to your company’s free cash flow. Occasionally however you might face an organic investment opportunity that is large enough to use all or even more than all of your free cash flow. For many companies, this is the best use of excess capital. The risk associated with such investments is usually lower than with acquisitions. This is because you are typically investing within your company’s circle of competence/competitive advantage and are better able to estimate the future cash flows. There is also less risk of things like culture clash or distraction for the top management that frequently accompanies large acquisitions. This doesn’t mean that you should fund any internal project, but it makes sense to require a lower premium over your cost of capital than you would for a more risky acquisition. If you can, the best way to proceed is in stages. You and your organization has some thesis for why this internal project will generate high returns. To the degree possible, try to test out these ideas using well thought-out metrics that you set in advance before committing the full amount of capital. This isn’t always possible, but when you can do so without missing the opportunity, you can materially de-risk your investment. A nice benefit of such internal growth investments is that if they are done well they are likely to increase your competitive advantage and improve the company’s strategic position. If you, as the CEO, look at the projects that you are funding and can’t find any that, while hurting results over the next 3 years, are likely to benefit the company longer-term, you should question yourself as to whether you have a sufficiently long-term investment horizon for your decisions. If on the other hand all you see are projects long on hope and short on results/cash-flow, you should start to question whether you are being realistic enough with yourself. Vision without cash flow does not work. Cash flow without vision does not optimize your company’s opportunity. It’s not easy, but it’s your job as the CEO to balance these two extremes and find the right portfolio of internal projects to invest in.

Share Buybacks. Share buybacks are perhaps the most misunderstood and poorly executed aspect of capital allocation for the average company. Numerous conversations with CEOs of companies large and small over my two decades of investing have convinced me that the current corporate practice does not serve shareholders well. What’s more, it’s not hard to fix. They typical company buys back a lot of shares when the stock price is high when management and the board feel optimistic about business prospects. Then, 6 to 12 months later, when the stock dives because of a missed quarter or a recession and is available at a large discount to previous purchase prices, guess what happens to the amount of capital devoted to share buybacks? It decreases drastically. You might guess that perhaps this is because the company’s cash flow is greatly reduced and it can no longer afford to spend as much or more on buying back stock. Nope. The reduction in buybacks after the stock price declines greatly exceeds the average reduction in cash flow. So what is happening? It’s a pure behavioral bias issue. The management team usually lacks a robust process for buying back shares, and freezes up when the near-term prospects seem more uncertain. They hide behind a belief/excuse that they are being prudent in taking a wait-and-see attitude. They are not – they are just being conventional, which is not the same thing as conservative. Wait and see they do, until they are again more optimistic about the business outlook. Except there is one problem. By that time so is everyone one else, and the stock price is much higher. And so the cycle of buying high and not buying low continues, to the detriment of shareholders. As a CEO, don’t be like that average manager. Here is a basic framework that you should follow: Estimate a reasonable range for the company’s intrinsic value (if you can’t do this as the CEO and CFO, who can?)

Establish a clear threshold below which you will act relative to that range. It should result in an attractive IRR relative to your cost of capital for the base case value of the business, conservatively estimated.

Communicate clearly with the shareholders about how they should expect you to act with respect to share buybacks. Make sure that they know in advance that you as the management team believe the shares to be undervalued and are planning to buy them back. The last thing you want to do is to take advantage of your own shareholders due to them not having sufficient information to make a decision as to whether or not they want to sell their shares.

Follow through, no matter how scary it feels, assuming there are no better uses of capital at that time. If you can’t or won’t do the above, at the very least follow a consistent buyback rule without regard to current business conditions or stock price as long as the balance sheet allows it and there are no better calls on the company’s capital. That is sub-optimal, but at least it will help you avoid the trap that the typical CEO falls into of buying fairly or over-valued shares and not buying much stock when the price is actually well below a reasonable estimate of intrinsic value.

Dividends. Dividends are a way to return unused capital to shareholders. It’s less tax efficient than share buybacks, since using the same amount of capital to buy back fairly valued shares allows the remaining shareholders to benefit from deferring taxes. Returning capital in this way is worse than a well-executed share buyback program, but it is probably a better use of capital than what many CEOs actually do – buy back expensive shares, don’t buy back undervalued shares, and pursue grandiose, “strategic,” acquisitions that frequently destroy shareholder value. I have no problem with a CEO who, managing a mature company that can’t make many profitable investments, decides to establish a large and growing dividend. Perhaps they are unable to pursue a value-based share buyback approach because their board won’t allow it or they do not trust themselves to pull the trigger at a stressful point in time for the company. It is good to be self-aware and choose an option, which while not the best, is still a good one and likely to keep you from making bigger mistakes. The capital markets over-value predictability of dividends and react very poorly to any reduction. So a good way to figure out a level of dividends is to do the same stress-test you would perform when figuring out your company’s maximum level of debt and using a trough free cash flow from that scenario as the maximum amount of recurring dividend. Just remember – the dividend is not the goal, it is the residual of your company’s conservatively estimated cash flow minus better uses of capital that can create value for shareholders. Too many companies focus on optics surrounding the dividend, whether their goal is to keep it high or low, and allow the tail to wag the dog.