The most important duty of company management is the allocation of capital. It is most important to shareholders because, over time, allocation of capital determines shareholder value.

Management has a choice to invest capital in ways that will achieve an acceptable return on investment, or invest it in other ways. Management has the duty to either reinvest earnings into expanding the business, reducing debt, or return that money straight to shareholders in the form of dividends or a share buyback. Deciding a game plan to deal with capital is to Buffett an exercise in logic and rationality.

All companies go through a number of stages in their life cycle. Sometimes they will reinvent themselves and jump back a step in the cycle, or sometimes they will make a serious blunder and get booted out of it entirely, but typically there are four stages in the life of a company. They are defined as development, rapid growth, maturity and decline, moving onto the next stage brings enormous changes in earnings, growth rates, sales and cash flows.

In the development stage, a company loses money as it tests and develops products and establishes markets.

A company reaches the rapid growth stage when it finally gets the formula right and sales take off. In this stage the company has extensive capital needs and may need to take on substantial debts in order to finance their activities as well as retail all of their earnings.

A mature company's growth rate slows, it begins to generate more cash than it needs for development and operating costs. It holds a secure place in its industry and would be regarded as a blue chip company.

A declining company may still generate excess cash, however their heyday is past but they still continue as a major name in their industry.

If cash reinvested in the business can produce an above average return on equity, a return higher than the cost of capital, then the only rational choice would be to retain all earnings and pay no dividends at all. If a company is at a stage when future expansion is unlikely and reinvestment in the business does not produce high returns, the only sensible thing to do is hand it back to the owners of the company - the shareholders.

Retaining earnings to reinvest in the company to produce returns lower than the cost of capital makes no sense at all, yet this irrationality is common among company managers.

A company producing excess cash but able to produce only average or below average returns has three choices.

It can buy growth.

It can return the money to shareholders.

Or it can go on and ignore the problem, reinvesting money in the company anyway and systematically destroy shareholder value.

This is a time that Buffett considers crucial and watches management very closely. Will the company directors act rationally or irrationally?

Managers who continue to invest in the company despite poor returns do so out of a conviction that their difficulties are only temporary. They are convinced that through their cunning and wits they will be able to steer the company back toward growth and profitability and give shareholders optimistic forecasts to dream about. If the management is not so adroit, they will fail, and cash will become increasingly indolent. A company with poor returns, lots of cash and a low stock price will attract the attention of corporate predators, ending the tenure of the current management. To avoid this happening many managers instead try to buy growth by purchasing another company.

Buffett doesn't believe in the option of purchasing growth, while it excites shareholders and dissuades corporate raiders, it often comes at an inflated price and opens up a can of worms when the company tries to integrate its new business, leaving shareholders exposed to management blunders.

The only option left then is to hand the spare cash back to shareholders. This can happen in two ways, to increase the dividend of buy back shares.

Shareholders will have the opportunity to take their dividend cheques and reinvest elsewhere at potentially a higher return, this all seems pretty good but Buffett feels this only makes sense if the investors could get more for their money than the company could if it reinvested in the business.

For superior companies able to reinvest at a high rate, Buffett feels that dividends make no sense. As Berkshire Hathaway's own return on equity has been so high it is only natural that Buffett has a policy not to pay dividends at all, but to keep every dollar within the business to finance new high performance investments.

When management chooses instead of paying a dividend to repurchase stock to increase earnings per share, the reward is twofold. If the stock is selling below its intrinsic value then the company is creating new value with every share it buys. Remember that the principle behind value investing is to buy $2 worth of assets for $1, so for every dollar it spends it gets back two. Transactions like this can be very profitable for the remaining shareholders. Naturally when a company is trading at above its intrinsic value then every stock it buys back will destroy shareholder value, a process all too common in times when stock buybacks are fashionable.

When directors buy the company's stock back in the market, they demonstrate a concern for shareholders rather than an egotistic need to expand their empire. This attitude sends a very positive signal to the market and attracts new investors. Existing shareholders benefit double from this boost in interest, first of all when the company's orders hit the market, and then when the market takes notice and forms new opinions on the value of the stock.