The Capital Allocation Playbook (Part 2)

Capital Allocation

William Thorndike writes in his book, “The Outsiders”:

CEOs need to do two things well to be successful: run their operations efficiently and deploy the cash generated by those operations. Most CEOs (and the management books they write or read) focus on managing operations, which is undeniably important.

Basically, CEOs have five essential choices for deploying capital—investing in existing operations, acquiring other businesses, issuing dividends, paying down debt, or repurchasing stock—and three alternatives for raising it—tapping internal cash flow, issuing debt, or raising equity. Think of these options collectively as a tool kit. Over the long term, returns for shareholders will be determined largely by the decisions a CEO makes in choosing which tools to use (and which to avoid) among these various options. Stated simply, two companies with identical operating results and different approaches to allocating capital will derive two very different long-term outcomes for shareholders.

Essentially, capital allocation is investment, and as a result all CEOs are both capital allocators and investors. In fact, this role just might be the most important responsibility any CEO has, and yet despite its importance, there are no courses on capital allocation at the top business schools.

Investopedia adds: “Greater-than-expected profits and positive cash flows, however desirable, often present a quandary for a CEO, as there may be a great many investment options to weigh. Some options for allocating capital could include returning cash to shareholders via dividends, repurchasing shares of stock, issuing a special dividend, or increasing a research and development (R&D) budget. Alternatively, the company may opt to invest in growth initiatives, which could include acquisitions and organic growth expenditures. In whatever ways a CEO chooses to allocate the capital, the overarching goal is to maximize shareholders’ equity (SE), and the challenge always lies in determining which allocations will yield the most significant benefits.”

This graphic from Strategy for Executives captures the key ideas:

In Netcore, I had not given much thought to capital allocation until recently. Yes, we were profitable and therefore had a lot of cash on our books. What next? Cash sitting in banks and mutual funds earns just a few percent interest each year. It needs to be deployed into opportunities to accelerate business growth. That is where we started the process for looking at acquisitions of reasonable scale – resulting in the Unbxd deal. While that was a one-off, what I realized is that successful companies made capital allocation core to their business. This is what I had to understand. Luckily, there are many teachers for curious students.

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Rajesh Jain

An Entrepreneur based in Mumbai, India.

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