The Capital Allocation Guide for CEOs
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Too many CEOs don't understand capital allocation. They rose up through the sales or operations ranks, and now that they are at the top they have to wing it with respect to one of the most important aspects of running the business. Don’t get me wrong – there are some amazing capital allocators among CEOs. However, in my two decades of investing experience I have come to believe that they are a small minority. The rest have never learned capital allocation from first principles, and instead rely on a combination of conventional “wisdom” and advisors with questionable motivations. The purpose of this guide is to try to change this to help improve capital allocation across the corporate world.
The Purpose of Capital Allocation
The two goals of capital allocation are:
To provide for the safe ongoing operation of the business
To optimize the long-term intrinsic value per share of the company’s stock in a legal and ethical way
If you disagree that these are the two goals, think about what stock ownership is. It is a way to spread ownership of large businesses across a large number of smaller investors. Businesses get access to capital they wouldn’t otherwise have. Investors get access to investment opportunities they wouldn’t otherwise have. However, don’t forget that it is still ownership.
And it is the manager’s job to act in the long-term best interest of the owners.
Imagine you own a small business and you decide that rather than running it yourself you want to hire a CEO to do it for you. You still own the business. The CEO is getting paid by you to make sure that your business is worth as much as possible, as long as that is accomplished in a legal and ethical way.
Incidentally, a lot of things that people who have a problem with this view point out as problems, really aren’t. For example, it is usually in the best interest of the business owner to treat her employees well and to pay them more than the bare minimum. It’s a concept that is called efficiency wage – it increases employee productivity and reduces the company’s costs of looking for new employees. Dumping toxic waste that poisons people into a river would not be ethical, even if it were for some reason legal.
So we don’t need to deviate from the above definition and start taking strides in the direction of socialism in order to solve for most issues that people find problematic with the free market. It’s a false dichotomy to frame the choice as one between a brutal “Gordon Gecko”-style capitalism and a touchy-feely, politically correct “stakeholder capitalism.” Properly defined and understood, capitalism will do just fine under most circumstances.
Back to our hypothetical scenario. Imagine that your CEO comes to you, as the business owner of a private company, and starts telling you some story about how he purposefully lowered the value of your investment because he read some article about stakeholder capitalism and decided to get very generous with your money. Many of you would fire them on the spot, and you would be right. There is plenty of room for generosity and giving in life, and these are values that I hold to be very important. However, it should be done with your own money, not someone else’s.
Let’s return to publicly traded companies with many minority shareholders and a hired CEO. In theory there should be no difference between the above theory and practice, but unfortunately in practice there is. In many cases Western corporate governance fails to prevent the CEO from encroaching on the rights of the owner. Since this isn’t going to change any time soon, my hope is that what follows will help the majority among the CEOs who are trying their best to do the right thing, but in some cases lack all the tools to know what that right thing is.
The General Theory of Capital Allocation
Capital allocation decisions should aim to maximize the company’s intrinsic value per share as long as this is done in a legal and ethical way.
Capital allocation decisions should be made using the idea of opportunity cost. All possible uses of capital should serve as opportunity cost for every other use, necessitating a comparison among all options in order to pick the optimal course.
Capital allocations decisions are part art and part science. The future is always uncertain, and every effort should be made to recognize the various behavioral biases that might impact your decisions. Having strong voices constructively challenge your views before decisions are made is likely to improve the quality of your decisions.
In deciding in which direction it is preferable to err if a mistake were to be made, it is always better to guard against a large permanent capital loss of shareholders’ capital, even if such a posture occasionally results in mistakes of omission.
The Zeroth Law of Capital Allocation
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:
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.
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.
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.
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.
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.
The Five Tools of Capital Allocation (and When to Use Them)
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.
The 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.
Acquisitions. The best acquisitions are the small, tuck-in, ones that readily fit into the company’s existing business. The reason to do them is that sometimes the build vs. buy analysis suggests it is cheaper to buy an existing capability – geographical presence, complementary product/service or access to a new customer segment that it would take too much time or capital to build.
The worst acquisitions are the big, “strategic,” ones which involve a lot of integration. Studies have shown that the acquirer’s shareholders rarely do well in such deals. The cost savings expected by management usually come through. What happens is that revenue melts more than expected. Key people leave. Your existing organization and/or the target’s is paralyzed while they are playing politics to figure out who will get which job (and who will become a “synergy”). The beneficiaries are usually the target’s shareholders who get a nice premium and competitors who pick up easy market share gains while your company is sorting out its internal organization.
If you, as the CEO, ever find yourself using big buzzword-bingo words such as “strategic,” “transformational,” “big synergies,” and other lingo lifted from an investment banker’s pitch book, just stop. Nobody ever puts out a press release announcing that they are doing a tactical deal that will reduce the efficiency and effectiveness of their organization. Nobody is impressed with fancy language – what would be impressive is a good chance of generating returns on capital well in excess of your cost of capital given the high degree of risk inherent in such a deal. Unfortunately, that is something that the acquirer’s shareholders rarely get in these transactions.
Occasionally a large deal does make sense. The above is meant to raise the bar very high and to make you skeptical, given that the base-rate probability of success is against you. What’s worse, nobody is going to stop you from a bad deal. The bankers are eager for a fee. The board will usually rubber-stamp it if you push hard. Your CFO isn’t going to put her job on the line if she knows you really want to do it. So it is really up to you to guard yourself against the many biases that are likely to push you towards doing big, expensive deals that will come at your shareholders’ expense.
Cost of Capital
Academic textbooks are full of formulas involving terms like Beta and invoking the sophisticating-sounding Capital Asset Pricing Model (CAPM). The very name is meant to make it sound precise and authoritative. Ignore it and keep it simple. It doesn’t really work all that well in practice.
So what should your cost of capital be based on? Most companies finance themselves with some combination of debt and equity. Occasionally hybrid securities come into play, such as convertible bonds, which combine aspects of both equity and debt. What follows is meant to favor the approximately right approach, even if it lacks precision to the second decimal point. Keep this in mind: if it’s close, pass. You are likely to be over-optimistic in your assumptions to begin with (even if you are aware of that bias), so you should err on rounding up as far as cost of capital is concerned.
Debt. The cost of debt is usually explicit, since you will know exactly the interest rate that you are paying at any given time. However, be careful of very long-term investments financed in part or in whole with shorter-term debt. For example, if you are making an acquisition of a company you plan to own forever, and your average debt maturity is less than 5 years, then unless you are planning on paying down that debt you are taking on refinancing risk. This is particularly an issue in the current, circa 2019, environment when interest rates are very low by historical standards. If you calculate your cost of capital by assuming that the current 2 to 7 year rates are going to remain this low forever, you are risking low-balling your estimate. One option is to term out your debt fairly far, as in 10 to 30 years. Alternatively be conservative by assuming that if you are using short/intermediate term debt in your financing plan that rates will go up substantially over time. They might not, but doing it this way gives you an appropriate margin of safety. Skip any deal that only works based on the current, historically low, interest rates.
Equity. The cost of equity is impossible to know with certainty. The best way to think about it from your shareholders’ perspective is using the idea of opportunity cost. The owners of the company that you manage could take their equity capital and invest in other companies of similar risk. Your job is to exceed their opportunity cost without taking on undue risk of permanent capital loss. That opportunity cost is both uncertain and changes over time. Historically, U.S. stocks have produced returns of 6% to 7% in excess of inflation. From the 2019 starting point the forward long-term rate of return is likely to be materially lower. Nonetheless, you would do well to not lower your required equity rate of return below 9%-10%. If the worst that happens using this approach is that you miss out on some marginal project or deal, that’s OK. Others will come along. If you use too low a rate and turn out to be wrong, you will have permanently destroyed a portion of your owners’ capital – a big no-no.
So where does this leave us in practice? Let’s say you are planning on having 1/3rd debt and 2/3rds equity as your capital structure. A conservative cost of debt might be 6% pre-tax for a U.S. company. A conservative cost of equity might be 9%. So your cost of capital might look something like this:
Cost of Capital = (1/3) x 6% * (1 – 25%) + (2/3) x 9% = approximately 8%
Yes, you can poke holes in the above, but the whole idea is that good capital allocators only make compelling investments. So the above estimate, which is approximately right while erring on the side of conservatism is likely to keep you out of trouble. The worst that will happen is that you will miss out on a marginally profitable investment. By definition, that’s not a big deal.
Capital Allocation Stories from the Field
Spreadsheets Are Not the Truth. I was at a group meeting with the CEO and the newly appointed head of R&D of a very large pharmaceutical company. The management team was proposing to slash the R&D budget by ~ 25%, or ~ $2B. Their rationale was that these were projects that did not clear their cost of capital.
I asked the management team how this could be, given that that surely the prior head of R&D had presented compelling arguments, backed by spreadsheets and PowerPoint slides to get these projects approved. Presumably they were deemed to have cleared the financial threshold back then.
The answer was that when the new head of R&D did his assessment, the assumptions changed and so did the conclusions.
It’s hard to know who was right. The point is don’t confuse some Excel calculation rationalizing a capital allocation decision with the truth. It is just an estimate, and like all estimates it can be wrong.
“We are going to consistently buy back shares to offset dilution from stock options.” This is a terrible approach to capital allocation and makes no logical sense. Yes, stock options are a cost of attracting/retaining/motivating employees. When they are issued, the company gets the benefit of the employees’ work and the negative of having to slice the pie into more pieces. The number of shares issued in such a way should in no way determine the amount or timing of share repurchases. Buying back overvalued shares is only going to exacerbate the cost of stock options, not offset it.
“Yes, we have plenty of cash, lots of cash flow and no debt. But we have looked at our peers and our balance sheet is consistent with their practices.” This was from a CFO of a sizable company who was fully serious. Really?? Adults aren’t supposed to use the “other kids are doing it too” line, but here we were. If you don’t understand something well enough to explain its logic from first principles, just don’t do it.
“Yes, our stock is undervalued, but we are not going to buy back shares because studies have shown that doing so does not expand valuation multiples.” This was from a treasurer of a major company. Huh? The litmus test should be whether buying back shares a) increases value per share and b) is the best use of capital, not whether or not some stock trader in the short term will give the company’s stock a higher multiple.
“We had been buying stock in the past, and it keeps going down, so clearly that hasn’t worked. Now we are going to stop our buybacks even though our stock is much lower.” Oy. No further comment needed.
“We could easily pay a dividend, but don’t want to do so because we are afraid that would be signaling to the market that we are no longer a growth company.” Don’t worry about what others think. Do your best to do the right thing and over time the market will figure out what your business is worth.
Raising equity to pay a dividend. A well-known energy pipeline company had a practice of paying a very large dividend while needing to raise funds for growth projects via new stock issuance. So essentially, the company was raising money from shareholders via stock offerings, giving a cut to the investment bankers, just to give the money back to its shareholders. The reason? The stock was valued based on its dividend yield by the market at the time, so by having a high and growing dividend the company could sustain a higher valuation. Not completely irrational from the management team’s perspective, but certainly cynical.
Getting lost among acquisition trees and losing sight of the forest. A large wireless telecom company acquired a large competitor. The deal was at a large premium, and the rationale was based on very detailed cost synergies that management expected to generate. What was missing from the spreadsheets was the difference in cultures, the complexity of needing to operate two different wireless networks and the changing competitive landscape that would likely make the target company’s offering less differentiated from competition. Needless to say, shareholders of the acquirer didn’t do very well and not too long after the deal floundered management was replaced.
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Capital Allocation Don’ts
Don’t confuse conventional with conservative. Just because something is a common practice at a point in time doesn’t make it the best decision or a safe one.
Don’t ignore base-rate probabilities. Just because you can torture a spreadsheet to rationalize any decision that you want doesn’t mean you should do so. We all believe we are above-average at some things, but it doesn’t mean we should ignore the history of failure of other people who held similar beliefs in an area and blindly make decisions based on hubris. Be skeptical as you make your decisions.
Don’t assume that because others agree with you that you are right. Many people are not incented to give you honest negative feedback. That certainly includes paid advisers like investment bankers who want to make money off of you. Or your direct reports who might be worried about career risk. Or your typical board member. Of course there are exceptions in each of these categories but my point is that you are unlikely to get honest negative feedback on something that you have already largely decided to do as the CEO from these quarters.
Don’t use buzzwords and fancy lingo in communicating with your shareholders about important capital allocation decisions. Communicate authentically with them. Talk as you would with respected friends with whom you have formed a business partnership. If something makes a lot of sense, you should be able to explain it succinctly in simple terms.
Don’t do things that don’t make sense from first principles, regardless of who else is doing them.
Conclusion
Capital allocation is both difficult and very important to a CEO’s job. Many CEOs were never taught a rational, first-principles approach to capital allocation prior to getting their job. Even founder-CEOs who built the business from scratch usually don’t have a lot of relevant capital allocation experience of managing a large, more mature enterprise.
What’s worse, as the CEO you are supposed to be the leader, and it can be awkward to admit that there is a part of your job that you haven’t mastered. The result is a combination of flawed crutches: relying on advice from biased advisors, deferring to social proof rather than thinking independently, and mistakenly assuming that if nobody in your company has seriously pushed back on what you are doing that it must be OK.
There is a better way. This capital allocation guide is meant to be a good start, not the final answer. If there is something in it which upon reflection you decide, from first principles, that you disagree with – good! The process of thinking independently and having a rigorous framework is the most important takeaway that I hope you get from this guide.
You should also seek out the mentorship of other CEOs who are already proven capital allocators. There aren’t many of those, but their advice can be invaluable as you build your own framework and struggle with specific decisions.
Finally, don’t be afraid to seek the advice of thoughtful long-term investors in your company. Yes, they have never been a CEO of a public company, so perhaps they don’t know exactly what it is like to be in your shoes. However, they likely have seen many CEOs fail at capital allocation and a few succeed, and at the very least their interests are aligned with increasing the long-term intrinsic value per share of your company.
If you are interested in learning more about the investment process at Silver Ring Value Partners, you can request an Owner’s Manual here.
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