David Giroux writes in “Capital Allocation: Principles, Strategies, and Processes for Creating Long-Term Shareholder Value”:
Capital allocation is defined as the process by which management teams and boards deploy their firm’s financial resources both internally and externally. Examples of capital allocation include:
- Building a new plant
- Expanding into a new market or geographic region
- Increasing or decreasing the R&D budget
- Making an acquisition
- Paying a dividend
- Repurchasing shares
- Buying new enterprise software
All of these capital allocation examples involve an outlay of cash or shares (i.e., the investment) and should be expected to generate an attractive return for shareholders on the investment over a reasonable time.
… The compounding power of generating strong returns on excess capital and a strong FCF (free cash flow) conversion rate (FCF divided by net income) cannot be overstated. A company that grows its profits at 4% organically but is able to earn 10% returns on excess capital deployment by year five and convert 100% of its net income into high-quality FCF can grow EPS at an impressive 11.2% per year. Another company with a similar organic growth profile that is only able to generate 6% returns on excess capital deployment and converts its net income into FCF at a 60% conversion rate will only grow at 6.5% per year.
The book offers a suggestion to how to differentiate between businesses in a firm:
For a company with some businesses that have secular challenges and others that don’t, one of the best ways to maximize shareholder wealth is to create two publicly traded companies.
GrowthCo would hold the assets without secular risk. This company can support a higher level of debt and will likely focus its capital allocation on acquisitions, share repurchase, and moderate dividends.
ValueCo will hold the businesses undergoing secular challenges. Its focus should be on maximizing cash returns to shareholders through dividends and regular special dividends while continuing to invest in innovative products and services. ValueCo can also be used as a consolidation vehicle for similarly challenged businesses.
The book has a checklist of strategic actions:
- Compare Returns of All Alternatives Before Deploying Capital
- Focus on Return on Invested Capital (ROIC) Instead of Discounted Cash Flow (DCF) or Internal Rate of Return (IRR)
- Monitor the Returns from Capital Deployment
- Identify a List of Potential Acquisitions
- Create Appropriate Incentives for Management
- Develop a Long-Term Strategic Plan to Make Each Business Better
- Conduct an Annual Review of Strategic Alternatives
- Engage with Shareholders
It also has a list of “Critically Important Mindsets” for boards:
- Challenge Assumptions
- Be Willing to Say No
- Take Everything Investment Bankers Say with a Grain of Salt
- Practice Patience
- Make Capital Deployment Independent of What Is Happening in the Core Business
- Prioritize Shareholders over Executives