Capital allocation plays a crucial role in determining a business's success.
Marathon Asset Management often references Warren Buffett on this matter, quoting: “After ten years on the job, a CEO whose company annually retains earnings equal to 10 per cent of net worth will have been responsible for the deployment of more than 60 per cent of all the capital at work in the business.”
This statement underscores how critical capital allocation decisions are, primarily when a company is held for the long term.
Understanding capital allocation
Capital allocation might sound complex, but it’s pretty simple to understand. Think of a business as a machine. On one end, it provides customers with products or services; on the other, it generates a cash stream. What you do with this cash is capital allocation.
The way you use this cash will shape the future value of your business. You can invest in ways that boost the company’s value, return it to shareholders, or waste it on unproductive ventures.
Investor Will Thorndike highlights this in his book The Outsiders, which explains that successful CEOs excel in two areas: running operations efficiently and deploying cash wisely.
While most focus on operations, the best CEOs give significant attention to capital allocation. Thorndike emphasizes that capital allocation is like a toolkit, where each decision—whether to reinvest in the business, acquire other companies, pay down debt, issue dividends, or buy back shares—impacts long-term shareholder returns.
The power of capital allocation
Capital allocation decisions wield tremendous power. Buffett suggests a simple test to measure the effectiveness of a CEO’s capital allocation: Has the CEO created at least a dollar of value for every dollar of retained earnings?
The influence of capital allocation extends beyond just financial metrics; it shapes a company's strategic direction. Every decision made in how capital is deployed impacts immediate returns and defines the long-term trajectory of the business. To navigate this effectively, CEOs have a set of core strategies at their disposal, each with its own implications for the company's future.
Five key capital allocation strategies
1. Reinvesting Earnings:
Reinvesting earnings in your business is often the default choice, especially for growing companies. However, as a business matures, continued reinvestment might yield diminishing returns. It’s essential to recognize when reinvestment no longer offers the best return on capital.
2. Mergers and Acquisitions:
Acquiring other businesses is another option, but it’s not without risks. The key question is whether the acquisition adds more value to your company than its costs.
CEOs must consider whether the acquisition justifies the expenditure or whether the capital could be better used elsewhere. Synergies often promised in mergers are rarely realized, making acquiring companies with proven track records safer.
3. Paying Down Debt:
Using excess cash to reduce debt is another wise move. Companies with manageable debt levels can seize opportunities when competitors, burdened with debt, cannot.
4. Issuing Dividends:
Returning capital to shareholders through dividends seems straightforward, but it’s often tax-inefficient. Many top capital allocators avoid regular dividends, opting for occasional special dividends when they have no better use for the cash.
5. Share Buybacks:
The best capital allocators often favor share buybacks, especially when the company’s stock is undervalued. This strategy increases the value of remaining shares, benefiting long-term shareholders.
However, buying back shares when the stock is overvalued can destroy shareholder value, like making a bad acquisition or reinvesting in low-return projects.
Capital allocation beyond large companies
Capital allocation isn’t just for large corporations. Every business generates cash that can be reinvested to maximize returns. Buffett, who sees himself as a businessman and an investor, emphasizes that many CEOs lack the skills necessary for effective capital allocation. Most rise through the ranks based on their expertise in marketing or engineering, not capital management.
Understanding and mastering capital allocation isn’t only crucial for large companies but also vital for businesses of all sizes. Regardless of a company’s scale, the principles remain the same: how capital is allocated will ultimately determine its success or failure. It is clear that a strategic, disciplined approach to capital allocation can elevate a company’s performance and secure its future.
Final thoughts
Capital allocation is often straightforward in a company’s early stages, with reinvestment being the best option. However, as a company grows, the decisions become more complex.
According to Thorndike, the best capital allocators prioritize increasing per-share value over overall growth, focus on cash flow rather than reported earnings, and embrace independent thinking. They understand that the best investment opportunity sometimes lies within their own company.
Capital allocation is about making intelligent decisions that benefit shareholders. While shareholder returns aren’t the only measure of success, they are a significant factor for any business owner. As Thorndike observes, successful CEOs think more like investors than managers, blending careful analysis with bold actions when opportunities arise.
This article is inspired by "Building a Valuable Business: It's How You Spend It That Matters" by Cedric Chin.
Comments