Capital Allocation: Evidence, Analytical Methods, and Assessment Guidance

A Guide for How to Think About Capital Allocation

Capital Allocation: Evidence, Analytical Methods, and Assessment Guidance is another great paper written by Michael J. Mauboussin and Dan Callahan, both currently at Credit Suisse.

CA1

  • Capital allocation is a senior management team’s most fundamental responsibility. The problem is that many CEOs don’t know how to allocate capital effectively. The objective of capital allocation is to build long-term value per share.
  • Capital allocation is always important but is especially pertinent today because return on invested capital is high, growth is modest, and corporate balance sheets in the U.S. have substantial cash.
  • Internal financing represented almost 90 percent of the source of total capital for U.S. companies from 1980-2013.
  • M&A, capital expenditures, and R&D are the largest uses of capital for operations, and companies now spend more on buybacks than dividends.
  • This report discusses each use of capital, shows how to analyze that use, reviews the academic findings, and offers a near-term outlook.
  • We provide a framework for assessing a company’s capital allocation skills, which includes examining past behaviors, understanding incentives, and considering the five principles of capital allocation.

Executive Summary

  • Capital allocation is the most fundamental responsibility of a senior management team of a public corporation. The problem is that many CEOs, while almost universally well intentioned, don’t know how to allocate capital effectively. The proper goal of capital allocation is to build long-term value per share. The emphasis is on building value and letting the stock market reflect that value. Companies that dwell on boosting their short-term stock price frequently make decisions that are at odds with building value.
  • Capital allocation is always important but is especially pertinent in the United States today given the high return on invested capital, modest growth, and substantial cash on corporate balance sheets. Companies that deploy capital judiciously have a significant opportunity to build value.
  • Internal financing represented almost 90 percent of the source of total capital for U.S. companies from 1980-2013. This is a higher percentage than that of other developed countries including the United Kingdom, Germany, France, and Japan.
  • Mergers and acquisitions (M&A), capital expenditures, and research and development (R&D) are the largest uses of capital for operations. In the past 30 years, capital expenditures are down, and R&D is up, as a percentage of sales. This reflects a shift in the underlying economy. M&A is the largest use of capital
    but follows the stock market closely. More deals happen when the stock market is up.
  • The amount companies have spent on buybacks has exceeded dividends for the past decade, except for 2009. Buybacks did not become relevant in the U.S. until 1982, so you should treat comparisons of yields before and after 1982 with caution. Research shows that the overall proclivity to return cash has not
    changed much over the decades, but the means by which the payout occurs has shifted.
  • Academic research shows that rapid asset growth is associated with poor total shareholder returns. Further, companies that contract their assets often create substantial value per share. Ultimately, the answer to all capital allocation questions is, “It depends.” Most actions are either foolish or smart based on
    the price and value.
  • Divestitures are substantial and generally create value. If the buyers tend to lose value, it stands to reason that the sellers gain value. Selling or spinning off poor performing businesses can lead to addition by subtraction.
  • Past spending patterns are often a good starting point for assessing future spending plans. Once you know how a company spends money, you can dig deeper into management’s decision-making process. Further, it is useful to calculate return on invested capital and return on incremental invested capital. These metrics can provide a sense of the absolute and relative effectiveness of management’s spending.
  • Understanding incentives for management is crucial. Assess the degree to which management is focused on building value and addressing agency costs.
  • The five principles of value creation include: zero-based capital allocation; fund strategies, not projects; no capital rationing; zero tolerance for bad growth; and know the value of assets and be prepared to take action.

Some Great Data

Below are some of the great exhibits that’s in the paper.

CA2 CA3 CA4 CA5 CA6 CA7 CA8 CA9 CA10 CA11 CA12  CA14 CA13CA15

 

 

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