Capital Allocation

How Does Capital Allocation Work?

Capital allocation is a critical piece of long-term value creation and the formation of a sustainable economic moat.

Capital allocation is the distribution of resources to maximize profitability and increase the market value of a company (and stock price) over the long run.

The priority for capital allocation decisions is to select profitable investments with a long-term objective of positive value creation.

The long-term viability of a company’s business model and the establishment of a sustainable economic moat is determined by the management team’s ability to allocate capital efficiently.

Therefore, capital allocation is the process by which corporations select the most efficient investment strategy to create the most economic value and ultimately maximize shareholder value.

The efficient allocation of capital is necessary for companies, especially for those operating in competitive markets.

Furthermore, the projects and growth strategies undertaken by the company must exceed its opportunity cost of capital, i.e. the minimum rate of return.

If the company’s capital investments generate returns less than the cost of capital, the erosion in value will inevitably impede the company from reaching the next stage of growth and profitability.

One method to analyze the economic feasibility of a company’s current initiatives is to compare its return on invested capital (ROIC) to its cost of capital (WACC).

• Cost of Capital → The cost of capital, or “WACC,” is the minimum rate of return that a company must exceed (i.e. the “hurdle rate”).
• Return on Invested Capital (ROIC) → The ROIC measures the efficiency by which a company spends the capital contributions of equity shareholders and lenders to generate returns.

General Rules of Thumb

• ROIC > Cost of Capital → Value Creation
• ROIC < Cost of Capital → Value Destruction

The initial groundwork to facilitate informed decision-making is clear strategic priorities. From there, consistent growth production requires the right strategic planning and execution of the plan.

The greater the spread between ROIC and WACC, the more value is created, and vice versa.

Growth is a critical factor that enables management to reinvest profits into operations, which leads to more value creation.

External capital is obtained from equity issuances and debt issuances, while internal capital is derived from the cash generated by the operations of the business (and asset sales).

Sources and Uses of Financial Capital

^{Capital Allocation (Source: CounterPoint Global)}

What are the 5 Capital Allocation Methods?

1. Organic Growth Strategies

Companies exhibiting positive organic growth are expanding to new markets, enhancing their sales and marketing strategies (S&M), improving their product-service mix, or introducing new products/services.

The priority is to continuously implement operating improvements and produce more revenue, which can be achieved by setting prices more appropriately after researching the target customers and end markets.

For instance, organic growth arises from a company optimizing its internal operations and streamlining its recurring business activities.

Organic growth stems from the optimization of a business model from the internal efforts of management and their team of employees.

The strategies to facilitate organic growth include the optimization of internal processes, reallocation of resources, and introducing new product offerings.

The most common internal growth strategies to achieve organic growth are as follows.

• Expansion into New Industries (and End Markets)
• Operational Improvements to Improve Cost Efficiency
• Improve Mixture of Existing Products and Services Offerings
• Development of New Products to Sell to Customers (R&D)
• Developing New Business Model (Method of Distribution)
• Optimized Sales and Marketing Strategies (S&M)
• Upselling and Cross-Selling Tactics
• Bundling Complementary Offerings

2. Mergers and Acquisitions (M&A)

Corporations often opt to engage in mergers and acquisitions (M&A) as a method to achieve inorganic growth, rather than using capital to improve internal operations.

Once the opportunities for organic growth are limited, a corporation often turns to inorganic growth strategies, i.e. growth driven by M&A.

The company can benefit from synergies post-M&A, such as having a new end market to sell products/services to, bundling complementary products, and increased diversification in revenue streams.

M&A can often yield a favorable outcome by enhancing capabilities post-integration, creating new revenue streams, and expanding market reach, which collectively improve profitability.

Of course, M&A is not a foolproof plan, with the most common pitfalls including overpaying, inadequate due diligence, and overestimated projections for potential revenue and cost synergies.

The return on investment (ROI) for reinvesting into operations to drive organic growth will inevitably reach a point where the number of profitable opportunities to allocate capital diminishes.

Nevertheless, M&A is still an inherently risky strategy, but presents growth opportunities that were otherwise improbable to attain.

• Revenue and Cost Synergies
• Economies of Scale
• Economies of Scope
• Access to New Technologies (IP, Patents, Proprietary Technology)
• Revenue Diversification
• Talent Acquisitions
• Expansion in Geographic Reach and into New End Markets
• Increased Number of Channels to Sell Products/Services
• Supply Chain Efficiencies

3. Debt Repayment (Pay-Off)

For corporations with excess cash sitting on their balance sheet, the decision to settle debts early could be reasonable, especially for borrowers with high credit risk.

While the corporation might have a surplus of cash now, an unexpected downturn in the economy or underperformance can quickly deplete those cash reserves, placing the borrower at risk of default.

Conducting credit ratio analysis is necessary from a risk management standpoint to ensure the company is not in a position where the margin for error presents a material risk to the borrower, where even a minor reduction in performance could cause financial distress.

In particular, borrowers with low credit ratings should strive to improve their credit profile with a strong balance sheet to reduce their cost of debt.

If interest rates are low, corporations are better off refinancing the debt and securing cheap rates for a longer borrowing term.

Given the “cheap” financing readily available, the company could perhaps even issue more debt to have more capital to invest.

However, if the current market interest rates are high, there is a significant incentive to pay off the debt before reaching maturity.

Therefore, the decision ultimately comes down to the current interest rate environment.

• Low Interest Rates → Refinance the Debt Obligation
• High Interest Rates → Pay Off the Debt Obligation Before Maturity

4. Shareholder Dividend Issuances

Corporations can opt to issue shareholder dividends from holding excess cash with limited opportunities for reinvestment into operations.

The objective of corporations is to maximize shareholder value. Therefore, management can decide that returning funds directly to stockholders is the best course of action, which the board of directors must approve and then set the relevant terms.

If a corporation with an optimal capital structure has excess cash remaining after exhausting all other profitable investment opportunities (positive NPV), management should consider returning the residual cash to shareholders via dividends, stock buybacks, or a combination.

The issuance of dividends can influence the valuation of a company and stock price, but the direction of the movement depends on the market’s perception of the decision.

Generally, dividends are issued by corporations after the opportunities to reinvest in operations or spend cash (e.g. engage in M&A, capital expenditures, expansion plans) are limited.

Hence, the market often interprets long-term dividend programs as a signal that the company’s growth potential will continue to fall in a downward trajectory.

Corporations that announce long-term dividend programs tend to be financially stable and optimistic in their long-term outlook on producing consistent profits, as dividends are seldom cut once implemented.

5. Stock Buybacks (Share Repurchases)

In a stock buyback, or “share repurchase,” the shares previously issued to the public and traded in the open markets are bought back by the original issuer.

Once the issuer has repurchased a portion of its shares – either in the open markets or in a tender offer – the number of shares outstanding in the market declines.

• Sufficient Liquidity → Stock buybacks demonstrate the issuer has enough cash to repurchase shares.
• Undervalued Stock Price → The repurchase brings attention to the fact that management believes the market is currently mispricing its shares. The decision to perform the buyback could be from management’s belief that its current stock price is undervalued, causing the repurchase to be profitable.
• Optimistic Growth Outlook → The repurchase also signals that management is optimistic about the company’s growth outlook. In effect, the post-buyback impact on share price is usually positive.
• Artificially Inflated EPS → Technically, there is no real value creation, as the fundamentals of the underlying company have not changed. The reduction occurs in the share count, which causes the company’s earnings per share (EPS) to “artificially” rise.

But corporations have increasingly been relying on stock buybacks, rather than dividends, because the net impact on share price is positive, and the return of value to shareholders in a more tax-efficient way.

The decision to purchase its own shares often sends a positive market signal that the corporation views its shares as underpriced.

Since committing to a share buyback is frequently perceived as a positive indicator of a company’s long-term outlook, the company’s stock price tends to increase in value thereafter.

Capital Allocation Calculator

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Capital Allocation ROIC Ratio Analysis Example

Suppose we’re tasked with measuring the capital allocation of a company with the following financials.

By dividing NOPAT by the average invested capital (IC), we can arrive at the ROIC of the company from Year 1 to Year 5.

• ROIC – Year 1 = $6 million ÷ AVG ($60 million, $65 million) = 10.0%
• ROIC – Year 2 = $8 million ÷ AVG ($65 million, $70 million) = 11.6%
• ROIC – Year 3 = $9 million ÷ AVG ($70 million, $75 million) = 13.0%
• ROIC – Year 4 = $11 million ÷ AVG ($75 million, $79 million) = 14.6%

For illustrative purposes, we’ll assume the cost of capital of our hypothetical company is 10.0%.

• Cost of Capital (WACC) = 10.0%.

In conclusion, there was no value creation in Year 1, however, the differential between ROIC and the cost of capital gradually increased to 4.6% by the end of Year 4.

Therefore, the company is profitable by the end of the projection period and has created value (and earned “excess returns” – i.e. the ROIC exceeds the cost of capital).

• Excess Value Creation – Year 1 = 0.0%
• Excess Value Creation – Year 2 = 1.6%
• Excess Value Creation – Year 3 = 3.0%
• Excess Value Creation – Year 4 = 4.6%