Capital allocation: The driving force behind business growth
The difference between value-creating and value-destorying
Capital allocation is the process of deploying a company's financial resources in the most effective way possible to achieve its goals and objectives. There are several ways in which companies can allocate their capital. This article will discuss the five most common ways to allocate capital: internal investments, paying off debt, acquisitions, share buybacks, and dividends.
But first, we need to talk about the basics of capital allocation. The foundation of a sound capital allocation decision is to generate a higher return on the investment than the cost of capital.
If a company has a cost of capital (discount rate or WACC) of 15% and they are presented with the decision options below, they need to choose the investments that generate 15% and above; otherwise, the investment will deteriorate the value of the company.
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Let’s go through the options a company has when it comes to allocating capital.
Internal investments are the activities a company allocates towards its operations, which may involve financing research and development, creating new products or services, or broadening its business activities. Such investments are commonly employed by companies focused on growth, seeking to extend their market dominance or generate novel sources of income. However, internal investments necessitate substantial resources and involve potential risks, such as the possibility of suboptimal returns or project failure.
Paying off debt
Paying off debt can increase the value of a company in several ways:
Reduced Interest Expense: When a company pays off its debt, it eliminates the need to pay interest on that debt, reducing its interest expense. This, in turn, increases the company's net income, which can lead to an increase in its valuation.
Improved Credit Rating: Paying off debt can also improve a company's credit rating. A higher credit rating makes it easier and cheaper for a company to borrow money in the future. This improved creditworthiness can increase investor confidence and a higher stock price, increasing the company's overall value.
Increased Cash Flow: When a company has less debt to service, it can use the cash that would have gone towards debt payments for other purposes, such as investing in new projects, paying dividends to shareholders, or buying back shares. These actions can improve investor sentiment and lead to an increase in the company's valuation.
Reduced Risk: By paying off debt, a company reduces its financial risk, as it is less vulnerable to changes in interest rates or its ability to make debt payments. A lower level of financial risk can make a company more attractive to investors, leading to a higher valuation.
Paying off debt can improve a company's financial health and increase investor confidence, which can increase its overall value.
Acquisitions can help companies diversify their revenue streams, expand their market share, and gain access to new technologies or products. However, acquisitions are often expensive and can carry significant risks, including overpaying for assets or failing to integrate them successfully into the business.
This reduces the number of outstanding shares, which increases earnings per share and can boost the company's stock price. Share buybacks are often used by companies with excess cash and looking to return value to shareholders. Buybacks can also prevent dilution of ownership when employees exercise stock options. Share buybacks are problematic because of the timing issue of the valuation of the share. Iltimed share buybacks can be value-destroying for a company if carried out on a high valuation.
Dividends are typically paid out in cash or stock, and the company's board of directors determines the dividend amount. Mature companies with limited growth prospects often use rewards to transfer excess capital to shareholders. They should be carried out when the above options provide lower returns than the company's cost of capital. Dividends keep the company lean and the return on invested capital high.
Effective Capital Allocation
Effective capital allocation requires companies to make informed decisions based on carefully analyzing available options. By allocating capital wisely, companies can maximize their return on investment and create value for their shareholders.
There are several fundamental principles that businesses should consider when allocating capital:
Assessing risk and return
Before making any investments, businesses must evaluate each opportunity's potential risks and returns. Riskier investments may offer higher returns, but they also pose a greater threat to the company's financial stability. It's important to strike a balance between risk and return to ensure that investments align with the company's goals and objectives.
Not all investments are created equal, and businesses must prioritize their investments accordingly. Investments that align with the company's strategic priorities and have a higher potential return on investment should be given priority over other options.
Evaluating alternative investments
Often multiple investment options are available to businesses, and it's essential to evaluate each thoroughly. This includes assessing the potential risks and rewards and considering the opportunity cost of passing up other investment opportunities.
Monitoring and adjusting investments
Capital allocation is an ongoing process, and businesses must continuously monitor their investments and adjust their strategies as necessary. This includes regularly reviewing financial performance and assessing whether investments meet their expected returns.
Communicating with stakeholders
Effective communication is critical when it comes to capital allocation. Businesses must be transparent about their investment decisions and regularly update shareholders and other stakeholders.
The world is full of companies with lousy capital allocation. Due to it being a decision by the management and board of directors, the decision-making can be clouded by several biases. Biases and reasons why management fails to make sound capital allocation decisions.
Little Ceasars - Empire builders
The goal of the management/board of directors is not to deliver value, or they perceive it as providing value when the company becomes larger.
Keep a trend and history
Many companies strive to increase their dividends each year once they start paying them and may be reluctant to cancel them, even when it's the prudent decision due to changes in the company's financial situation. There has even been a trend in Sweden to carry out a new issuing of shares to have the necessary funds to pay dividends.
No skin in the game
Without influential owners or a presence of ownership within the board of directors and management, the company may not prioritize delivering maximum value to shareholders, as their interests may not align. Furthermore, if the board's primary concern is preserving their salaries, they may hesitate to take risks that could lead to the best outcomes for the company.
Dividends and share buybacks demand no creativity.
Dividends and share buybacks are simple ways to transfer value to shareholders. The simplicity of it has pros and cons. It can be the easy route when evaluating the options available, and it can also be reluctance against it because it feels lazy and counterproductive.
During a bull market, acquisitions are joint, but some of the worst ones occur when companies diversify their revenue streams. Although a new business can offer stability and reduce earnings volatility, an acquisition without any connection, synergy or overlapping interests between the two businesses is never a wise decision. The buyer may lack the necessary knowledge to manage the new business, leading to neglect and, ultimately, a loss of shareholder value.
ROIC is not a concept in the management discussion
Return on invested capital is not a widely discussed concept in management and is typically only addressed in finance studies. Consequently, the board of directors and management rarely consider it. This is evident from the low number of companies that include a return on capital in their financial objectives, whether it be invested, employed, equity, or assets. The notion that returns must exceed the cost of capital is even rarer in discussions among the board of directors and management. Furthermore, it's uncommon for a company to set a high-water mark for return on investments to maintain a certain level of return for shareholders.
In summary, capital allocation is vital for companies to manage their financial resources effectively. The five primary methods for allocating capital are internal investments, debt repayment, acquisitions, share buybacks, and dividends. Each method carries unique advantages and risks, requiring careful evaluation by investors to determine the best approach for a given company. Ultimately, a company's success or failure can depend on its ability to allocate capital wisely, making it crucial for investors to assess the skills of a company's management team when making investment decisions.
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