Capital Allocation
Have you ever wondered where all those earnings go…?
An introduction to Capital Allocation:
Quite simply capital allocation is the way in which a company decides to distribute its financial resources. Capital allocation is extremely important in the success of a company; Warren Buffett says that capital allocation is now his primary job at Berkshire!
The broad goals of capital allocation are quite simple: to ensure the ongoing health and operation of the business, and to optimize the long term intrinsic value of the company. Really, it is the ways in which managers reinvest money to try and create the best results for investors. This is an incredibly complicated concept, and it is why the CEOs are paid the big bucks. At the end of the day, where the money the company has is invested is crucial in both its short term and long term performance. Moreover, when prudently allocating capital, it is vital to consider the opportunity cost of every choice; that means that CEOs must consider all the alternative options and ensure that the reward of their choice is greater than what they’re giving up by taking an alternative.
Specific Attributes of Capital Allocation
Maintenance Expenses:
This is the first area where capital will be allocated. First off, this means ensuring that all machinery, buildings and workplaces are up to code and are not in dire need of repair. These expenses are obviously urgent, and cannot be delayed — they may be the easiest part of capital allocation because they are so essential. Second, it is important to return the balance sheet to a ‘safe state’. This means that the company can overcome temporary adversity like economic downturns or internal delays/unforeseen issues. This could include paying down unsustainable debt to ensure there is some room to borrow in the future (more on reducing debt in a moment). Finally, under this category, a business may make small upgrades to ensure the business remains competitive. Overall, maintenance expenses are at the top of the list when it comes to capital expenses because they are crucial in sustaining production.
Reducing Debt
After paying down maintenance expenses, an executive may decide to pay down more of the companies debt. This decision is more complicated for executives because they need to consider whether or not they can yield a greater rate of return from other investments compared with the interest accrued on their loans. On the one hand, the company is one hundred percent guaranteed to save the interest they would’ve paid on the loan, which means if there is no other attractive option to allocate capital, this is an extremely safe choice.
Internal Growth Projects
Another way to reinvest the companies money is in internal growth projects and research and development. Most of the free cash flow in a younger company will likely be reinvested to grow the company: since it is young, there is likely considerable market left to penetrate. This is one of the reasons why P/E and ROE are Older companies that have already grown into their market might consider investing to enter into a new market.
Stock Buybacks/Dividends
Towards the end of a companies lifecycle (which is misleading because this doesn’t mean the company is about to die), the company will very likely pay out dividends or buy back shares. Companies do this when they feel like they have no other effective/efficient use of all their cash flow. After a consistent period of extra cash on hand, the company will likely redistribute the money directly to shareholders. It is important to understand that dividends and stock buybacks both distribute the earnings of the company to investors, they just do it in different ways. By buying back stock, the company is increasing the ownership share of each individual investor, making the shares more valuable, whereas, with dividends, the company is taking some of its value and giving it directly to its owners (decreasing the value of the company).
The rationale behind paying back investors differ greatly by industry. Well developed industries that operate with very high fixed costs might be more apt to offer a dividend/buyback because investing in a new project would take a lot of upfront investment, and the company has likely already saturated the market. On the other hand, a well-developed company in an industry like technology is likely to be constantly redistributing money to R&D to remain competitive. An example is Apple. They offer a dividend yield of 1.09%, despite the fact that they are a well established, very profitable company. This is because, in order for Apple to remain competitive, a lot of their money has to go to develop new products (Apple is also an interesting case because they have a lot of idle money).
Acquisitions
This is another way a company could choose to expend a vast amount of free capital. Acquisitions can be riskier then internal investments, and most businesses will only acquire other companies that fit into what the company is already doing. Berkshire Hathaway’s capital allocation strategy, for instance, is largely built on making acquisitions and has a vast portfolio of subsidiaries.
Other companies typically choose to make either horizontal or vertical acquisitions. A horizontal acquisition is where the target company also produces the same product or service, allowing for a larger market footprint. A vertical acquisition where the target company is in the same industry, but at a different level of production. An example would be if a clothing retailer were to acquire their main manufacturing supplier.
Why is capital allocation important?
Where companies decide to employ their capital makes a huge difference in the returns they will get, ultimately for investors. Although these topics will be covered in greater depth in a future article, we’ll now briefly look at what ROE and ROA are.
Return on Equity and Return on Assets
ROE looks at the growth of the company compared to shareholder dollars. Remember, the entirety of shareholder’s equity is equal to the company’s net assets (subtracting total assets and total liabilities). Thus the ROE is the ratio net income to stockholder’s equity. ROA is the return on a company’s assets. In other words, it is the ratio of net income to assets.
What can ROE and ROA tell us?
The ROE and ROA can indicate whether or not management is making full use of the funds it has available. It is important to understand why some industries will be lower growth than others before looking at these ratios. In older, more capital intensive industries, it will take considerably more assets and investment to earn money than in a younger growing firm. Industry-wise, compare a telephone company to a growing fast-food chain… if you were to compare the amount of assets needed to set of telephone lines along with the cost of the location and equipment of a fast-food chain, the former is much costlier than the latter. Although the telephone sector makes money, the ratio of their net income to their assets/shareholder’s equity will, as an industry, be lower. Secondly, the age of businesses also plays a major role. Young growing businesses add assets that rapidly increase net income, bolstering ROA/ROE, whereas older businesses that are fully developed are unable to get high returns on their assets as they are already being used productively, and thus provide direct returns to investors through dividends and share buybacks.
The point of the above paragraph is to show that when looking at ROA or ROE, it is very important to compare apples to apples. A ROA/ROE that is above industry average looking at comparable companies is often a sign of a well-run company that is maximizing the potential of its resources.
Citations:
Hopefully, this article helped you learn more about what capital allocation is and why it is important. If so, be sure to look over some key takeaways and at some next steps you can take to support us and further your learning!
Key Takeaways
- Capital allocation is the way(s) in which a company decides to allocate its financial resources. The main objectives are to ensure the ongoing operation of the company and to maximize shareholder value in the long run.
- Maintenance expenses are the first priority for firms' resources. After maintenance expenses, CEOs will try and maximize shareholder value by paying down debt, funding internal growth projects, or making acquisitions or by providing direct returns to investors through dividends or stock buybacks.
- Capital allocation is important to long term shareholder value, and looking at ROA and ROE can give investors an idea of how well a company is using its assets.
- When comparing companies ROEs/ROAs, it is very important that they are similar in industry and age (among other things)
Next Steps
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