Editor's note: By now, you know who Whitney Tilson is...

As one of the most famous hedge-fund managers on Wall Street, he made several major market calls, including the dot-com crash in 2000... the housing crisis... and the bottom of the market in December 2008.

And as regular Digest readers know, Whitney recently partnered with Stansberry Research to launch his own financial-advisory business called Empire Financial Research. Through this new venture, he aims to help everyday folks like yourself become better investors.

This weekend, Whitney has graciously agreed to share some of his valuable analysis in the Masters Series. In this two-part essay, you'll learn all about the seven ways companies can choose to spend their excess cash...

What to Do With All That Cash... The Dilemma Profitable Companies Face

By Whitney Tilson, founder, Empire Financial Research

When analyzing a company and estimating its intrinsic value to determine whether its stock is undervalued, most investors focus on the free cash flows it will generate in the future. This is indeed critical information to determining what it's worth.

But often overlooked is the other half of this equation: What a company does with its cash flows – in other words, capital allocation. It turns out that this can create (or destroy) as much value as how much cash it generates.

How many times, for example, have you seen a company run into trouble by taking on too much debt or buying back its shares when they're richly valued?

The first step to evaluating capital-allocation decisions is to understand what the possibilities are...

(All of them presume that a company is free cash flow positive. For companies losing money, the analysis – focused on how to fund losses – is different.)

1. Do nothing at all.

A company's default option is to do nothing at all, in which case cash will simply build up. That's true not only of companies, but also of individuals.

If you earn more money than you spend each year, you're going to have more money in your checking account at the end of the year than you had at the beginning.

Many companies have taken this approach and are currently drowning in ever-growing piles of cash – like tech giants Alphabet (GOOGL) and Facebook (FB).

2. Squander it by allowing expenses to get out of control.

Sadly, many companies that are consistently highly profitable get fat and lazy and let expenses get out of control. They squander marketing dollars on vanity projects like putting the company name on a sports stadium, buying private jets and country-club memberships, letting layers of management build up, and of course, giving every vice president an administrative assistant or two.

You won't see these costs on the cash flow statement, but they're there...

3. Pay down debt.

A company with debt generally has the option to pay it off (although sometimes there's a prepayment penalty). Whether it makes sense for a company to do so with its excess cash depends on many factors, such as the interest rate on the debt and other uses for the cash.

Similarly, you might choose to pay off your high-cost credit-card debt while not doing so for tax-advantaged, fixed-rate, long-term mortgage debt.

4. Invest that money back into the business.

There are two general types of reinvestment that companies can make: The first is maintenance capital expenditures ("capex"), which is required to replace worn out computers, trucks, etc. And the second is growth capex, which is optional, to open new stores, build new factories, etc.

5. Pay a dividend.

The next two options involve returning capital to shareholders...

A company can pay out a dividend, which is generally taxed as income. Most big companies pay a regular quarterly dividend. In fact, some take pride that they have paid a dividend for decades. An elite group known as the "Dividend Aristocrats" – which includes household names like PepsiCo (PEP), Coca-Cola (KO), Johnson & Johnson (JNJ), Procter & Gamble (PG), and dozens more – has not only paid a dividend but grown it every year for the past 25-plus years.

Dividends are an important part of the return that investors earn from owning stocks over time.

If you buy a stock at $100 at the beginning of the year and it's trading at $110 at the end of the year, you've made 10%. But if the company paid a 2% dividend along the way, you're actually up 12%. So it's important when calculating your returns (and comparing your performance with, say, the S&P 500) to include dividends.

Some companies also pay out "special dividends." One company that comes to mind is membership club Costco Wholesale (COST). It's a fabulous business that generates more than $5 billion of annual operating cash flow. Even after it reinvests in maintenance and growth capex of approximately $3 billion, there's more than $2 billion left. It pays out $1 billion of that in regularly quarterly dividends (equal to a small 1% yield at today's share price) and another $500 million in share repurchases.

This means that Costco's cash balance is growing by roughly $500 million to $1 billion annually, which it sends back to shareholders in the form of special one-time dividends every couple of years. In 2017, it paid out $804 million in regular dividends and an additional $3.1 billion in the form of a special, one-time dividend. It did the same thing two years earlier in 2015 – paying out $664 million in regular quarterly dividends and $2.2 billion in special dividends.

6. Repurchase shares.

The other way companies can return cash to shareholders is by repurchasing their own shares. This is one of the most powerful things companies can do with their cash... Yet it's also the most controversial because companies often do it all wrong.

The key is for a company to only buy back shares when they're trading at a meaningful discount to intrinsic value. Buying dollar bills for 80 cents (or less) creates value.

A business that regularly repurchases its shares over time and grows its intrinsic value meaningfully over time is likely buying back its stock at a discount. The key is that the company needs a good grasp of both its current intrinsic value and its future growth prospects.

Repurchases can be really powerful... If a company buys 2.8% of its outstanding shares every year, it can reduce its share count by a quarter over a 10-year period. At 6.7% annually, the share count will drop by half in a decade. In this case, even if earnings are flat, earnings per share will double!

The most remarkable example I've ever seen is auto parts retailer AutoZone (AZO). In the two decades since hedge-fund manager Eddie Lampert invested in the company in 1999 and pushed for big share repurchases, it's been buying back an average of 8.5% of its shares every year. This has caused the share count to decline by a stunning 83%. Thus, in a period when earnings rose a healthy six times, earnings per share skyrocketed 34 times – and, not surprisingly, so did the stock...

Sadly, however, AutoZone is the exception, not the rule. Most companies destroy value by buying back shares aggressively when they're overvalued and not at all when they're cheap. When times are good, in order to "show confidence in the stock" or juice earnings, they take $1 of their cash and buy shares that are worth less than $1, which of course destroys value. Then, during turbulent times when the stock has fallen, they get conservative and stop repurchases.

If a company's stock is fully valued (or overvalued), then shareholders would be better off receiving excess cash via a dividend. At least then they're getting a dollar of value for each dollar of cash.

Investing legend Warren Buffett has written about this topic extensively in his annual letters to Berkshire Hathaway shareholders. The company is drowning in excess cash, which continues to grow every year. This presents Buffett with a high-class problem: what to do with it? Even he – the greatest capital allocator in the world – isn't able to put all of it to work, especially 10 years into a bull market with valuations as rich as they are today.

With the cash piling up, Buffett is starting to get more aggressive. He's buying back Berkshire shares... But he has clearly communicated to shareholders that he'll only do so when he feels the stock is trading at a meaningful discount to intrinsic value, which is the only correct answer.

In tomorrow's essay, I'll share a common mistake many companies make... and share a real-life case study in capital allocation...

Regards,

Whitney Tilson

Editor's note: Whitney's approach led him to buy Apple back when it traded for $1.50... Amazon at $56... Netflix at $7.78... and McDonald's at $13. Now, he's using that exact same strategy to help his Empire Investment Report readers find similar opportunities in the market. In fact, the stock he recommended last month is already up around 15%. Learn more about his investment approach – and how to claim four months of his service, essentially for free – right here.