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The Importance of Capital Allocation

Analysis

File picture shows Warren Buffet testifying before a House finance subcommittee in Washington, D.C.

Photo by mark reinstein / Shutterstock.com.

In his experience, Les Nemethy says most owners, CEO’s and boards of companies are highly concerned with improving operations but do not devote sufficient time to capital allocation or deal with capital allocation issues on a very ad hoc basis.

Decisions taken with respect to capital allocation have the potential to affect the share price or valuation of a company at least as much as operational decisions.

There are five ways in which the capital of a company may deployed: 

a) investing in existing operations (e.g., organic growth);

b) paying down debt;

c) acquiring other businesses;

d) buying back shares; or

e) issuing dividends.

There are three primary ways of acquiring capital: 

a) internal cash flow;

b) raising equity; or

c) issuing debt. I would consider joint ventures or franchising as variations of the above.

The above sources and uses of capital might be considered the capital allocation toolkit available to companies. 

As Warren Buffett wrote in Berkshire Hathaway’s 2007 Annual Report, “The worst sort of business is one that grows rapidly, requires significant capital to engender the growth, and then earns little or no money.” 

Capital light business models offer more opportunities for optionality, the flexibility to move in different strategic directions.

Be the Investor

There is no “one size fits all” capital allocation formula. A CEO or board of directors should constantly review the toolkit, take on the perspective of an investor, and decide where to allocate cash within a company or group of companies.

The toolkit should be used to optimize long-term shareholder returns and a company’s capital structure. A few examples:

• The debt mix should be reviewed in light of changes in the company’s operational risk or changes in actual or forecast interest rates.

• A start-up that is bleeding cash will have difficulty raising debt financing from banks; pure equity financing makes much more sense given the risk profile of such a company.

• A mature, capital-intensive utility with low, regulated returns and a very stable cash flow might take on substantial debt levels to improve shareholder returns.

• Many years ago, I advised a mature traditional copper wire telephone company, where the writing was on the wall that the days of fixed wire telephones were numbered, to acquire a data transmission company, which was the future. Shareholders would, over time, have lost all their money had they remained with the traditional copper wire business.

• Warren Buffet’s company, Berkshire Hathaway, repurchased enormous quantities of its own shares over the past decade, believing that there are very few investments out there that are better than their shares (and because the tax treatment of share repurchases is more favorable than dividends).

• For those businesses whose operations are capital intensive, it may be worth setting criteria for capital allocation. For example, I was once CEO of a telecom operator where any investment in new infrastructure with a return on investment below a certain threshold (x%) was automatically rejected by the board. Any investment with an ROI above y% was automatically approved. Any investment with an ROI between x% and y% was subject to review by the board and usually required a non-monetary or potential future benefit to justify the investment (e.g., creating the potential for more business in the future).

• If a public company trades at 15x earnings, and there are plenty of private companies of similar quality and risk profile trading at 5-10x earnings, the public company can potentially create massive wealth by adopting a “roll-up” strategy consolidating the sector through acquisitions.

Capital allocation decisions are often based on intuition; they should be based on extensive and quantifiable analysis. The decisions are immensely complex, requiring the processing of a vast amount of information. Just the due diligence on one acquisition target or getting a definitive quote on interest rates from banks can take many person-months of staff time. Decisions are enhanced by extensive financial modeling, which allows sensitivity analysis (e.g., analyzing “what if” type situations), as well as extensive knowledge of tax regimes, as it is the after-tax returns that count for shareholders.  

It is no wonder that very few companies are indeed masters of capital allocation, especially among smaller businesses that have fewer resources.

I conclude with another excerpt by Warren Buffett from that 2007 Berkshire Hathaway Annual Report:

“Long-term competitive advantage in a stable industry is what we seek in a business. If that comes with rapid organic growth, great. But even without organic growth, such a business is rewarding. We will simply take the lush earnings of the business and use them to buy similar businesses elsewhere. There’s no rule that you have to invest money where you’ve earned it. Indeed, it’s often a mistake to do so.”

Les Nemethy is CEO of Euro-Phoenix Financial Advisers Ltd. (www.europhoenix.com), a Central European corporate finance firm. He is a former World Banker, author of Business Exit Planning (www.businessexitplanningbook.com), and a previous president of the American Chamber of Commerce in Hungary.

This article was first published in the Budapest Business Journal print issue of January 14, 2022.

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