What is Capital Allocation?
Capital Allocation is a series of rules and guidelines to manage the financial resources of an organization. A disciplined capital allocation system optimizes a company’s financial resources, including cash, debt and taxes, to maximize shareholders’ value over the long term.
Because shareholders’ value is the ultimate goal of strategy, good capital allocation is critical for the success of any organization and must be a central part of any business strategy.
Multi-year research led by Harvard Business School professor William Thorndike found that the common trait that separates the best performing CEOs from their peers is that they were all great capital allocators.
These CEOs were all masters in the art of managing their company’s financial resources to maximize value for shareholders, and outperformed their industries and peers between five to ten times.
|CEO||Company||Period as CEO||Stock’s Compound Annual Growth Rate (CAGR)||Factor by which the stock outperformed the S&P 500|
|Jack Welch||GE||1981-2001||20.9%||3.3 Times|
|Tom Murphy||Capital Cities||1966-1996||19.9%||16.7 Times|
|Henry Singleton||Teledyne||1960-1989||20.4%||12 Times|
|Bill Anders||General Dynamics||1991-1993||23.3%||6.7 Times|
|John Malone||TCI||1973-1998||30.3%||40 Times|
|Katharine Graham||The Washington Post||1971-1993||22.3%||18 Times|
|William Stiritz||Ralston Purina||1981-2001||24%||4 Times|
|Dick Smith||General Cinema||1962-2005||16.1%||16 Times|
|Warren Buffet||Berkshire Hathaway||Since 1965||20.7%||Over 100 Times|
In general, among the common practices that professor Thorndike found in these CEOs conclude the following:
- They religiously devoted an important amount of their time to make capital allocation decisions.
- Their favorite metric for growth was long-term value per-share, rather than sales growth or market share.
- They rarely paid dividends, considering them tax inefficient, and instead compensated shareholders through large stock buybacks.
- Their management focus was not sales or operating margins but cash.
- They seldom relied on the advice of external consultants, and instead based capital allocation decisions, including acquisitions, on their own analysis and the work of their in-house teams
They seldom relied on the advice of external consultants, and instead based capital allocation decisions, including acquisitions, on their own analysis and the work of their in-house teams
In this article we will explain the existing connections between capital allocation decisions and business strategy, walking you through the practices of the most successful CEOs. The following is an outline of what we will cover:
- The truth about profits and cash
- The capital allocator toolkit
- The trick behind capital allocation
- Centralized capital allocation
- Evaluating investment opportunities
- The best business strategy books
The content of this article is based on our best-selling book Strategy for Executives which you can now download for free here.
If you feel that you need a quick refresher on Financial Statements and important financial metrics, check out our crash review of those subjects.
Now let’s dive in.
The truth (and lies) about profits and cash
Most strategy frameworks have been developed around the idea of maximizing profits, and even we talk in our framework about profits and profitability as the main goal of a business strategy.
However, although profits are a direct measure of the financial gain a company obtains from running a business, the truth is that you can’t pay your bills or buy raw materials with profits; for that you will need cash.
There is a big different between the profits and the cash that a business produces, and it is important that we understand this difference in order to plan and execute a strategy properly.
Let’s quickly review three of the most important misconceptions about profits and cash:
1. Sales are just an estimate: Under the Generally Accepted Accounting Principles (GAAP) sales, or revenues, have nothing to do with cash coming through the door.
Accountants are required to record a sale when it has been earned, but it is up to them to decide the moment when a sale is considered to be a sale.
Accountants could say, for example, that a sale happens when a contract is signed, when the product is delivered, or when a service is completed, even if the buyer hasn’t paid yet.
In most cases what is recorded as revenue in an Income Statement does not match the period when the cash is actually received.
With the exception of cash businesses, revenues are the accountants’ best guess of when sales were earned, even if no money changed hands.
2. Costs are an estimate: For the same reasons, costs are also an estimate. When preparing a company’s income statement, accountants stick to what they call the “matching” principle, which says that costs and expenses are those the business incurred in generating the sales recorded during the reporting period.
That means that a company that buys a truck for $100,000 and plans to use it for 10 years will only record $10,000 every year in its income statement as the cost of the truck, even if it was paid in full upfront.
In another classic example, a company that makes $10 million in sales in a given year and that pays out 10% in bonuses to its salesforce has to record the $100,000 bonus as a cost during the year the sales were made, even if those bonuses are paid out the following year.
Accountants also get to decide whether a piece of equipment will last 10 years or only 5 for financial purposes, which also has an important impact on the business’s reported profitability during that period.
In short, GAAP rules give accountants a lot of discretion in preparing a company’s financial statements, making sales and costs just a good guess.
3. Cash is still king: If 1 and 2 are true then profits (i.e. the difference between revenues and costs) are as a result an estimate as well, so they are not a measure of the business’s bank account as many people believe.
In fact, you may find a number of companies that show great numbers in their income statement (meaning that they are profitable) but that don’t have enough cash to survive another quarter.
Therefore, success in managing a company’s finances is due in part to your ability to convert profits from the Income Statement into cash in the Balance Sheet (see our financial refresher if you need a quick review of financial statements).
For that reason, as a business executive you must pay close attention to cash and understand well how it is created and used.
You should also learn to use cash-based performance metrics which provide a more realistic view of the true financial performance of your organization.
Accounting rules make every profit metric no more than a good guess, except cash. Cash is cash, and money in the bank is really hard to fake.
To see our full list of selected financial misconceptions download our book Strategy for Executives here, now free for all our readers.
The capital allocator toolkit
In trying to optimize a company’s financial resources there aren’t many things that a CEO can really do.
To raise capital, for example, CEOs only have five options: they can use the company’s cash flow, raise new debt, issue new shares, sell the company’s assets, or tap into any kind of cash reserve accounts the company has such as pension funds.
Similarly, there are only five things they can do with that money: they can reinvest it in the business, pay down debt, buy other companies, repurchase stock or pay dividends.
But the long-term value that a company creates for its shareholders is greatly influenced by how its CEO manages these ten levers.
The challenge for the CEO then is how to use this 10-lever toolkit to maximize shareholder value over the long run.
The trick behind capital allocation
In practical terms, the true magic of capital allocation is in creating positive tradeoffs, that is, using money for business activities that yield a higher return than what that money costs.
The CEO’s Capital Allocation Toolkit. The long-term value that a company creates for shareholders depends a lot on how its CEO manages these ten levers
That may sound like a way too basic rationale, but it is what capital allocation is all about: taking low cost money and re-investing it in areas of higher return. That’s the only way to create wealth, and the capital allocation of a company is no different.
If a company raises debt at a 4% interest rate and invests that money in a business unit that produces a 13% return on that investment, it will be creating shareholder value.
A good example of this mentality is how Warren Buffett has famously used insurance floats (the money that insurance companies collect from customers, which usually sits in the insurers’ bank accounts waiting to be paid in claims), to invest in other companies.
He takes very cheap money and uses it to pursue investments that yield high returns.
That opportunistic thinking is a key component of every good capital allocation decision.
If you have reasons to believe that your stock is undervalued, go ahead and buy it aggressively using the cheapest money you can find.
If instead your stock is trading above its true value, then issue new shares to finance strategic acquisitions, then buy those shares back when they hit a low point again.
Good capital allocators are always on the lookout for opportunistic tradeoffs to make, and when they find them they move fast.
And sometimes you may just realize that your best investment opportunities are inside your company, not outside.
In fact, one of the most impactful moves that good capital allocators can make is to re-allocate resources from poor-performing areas onto high growth businesses.
When you simultaneously cut costs and resources in low growing areas inside your company and direct those resources to the units that are growing the fastest, the effect on your bottom line is multiplied.
Take a look at the following statement issued by Amazon with regards to a massive layoff in early 2018: “As part of our annual planning process, we are making headcount adjustments across the company, small reductions in a couple of places and aggressive hiring in many others. For affected employees, we work to find roles in the areas where we are hiring.“
That’s resource re-allocation at its best. A continual adjustment of the company’s value chain to double down on the things that create the most value and eliminate poor performing activities.
This has a multiplying effect on profitability, because at the same time that your business is divesting from low-performing areas, which alone should increase profitability, it is also re-investing those same resources in activities with higher return within the same balance sheet.
I hope you can see the hidden opportunity here, to 1) go out and find areas of high growth and 2) reallocate underperforming resources to go bullish on them.
Centralized capital allocation
If you run a company with multiple business units, product divisions or maybe a few international operations, you necessarily have to give each of those the freedom to make strategic decisions.
At the end of the day, a business strategy is no more than the answer to the threats it faces, and each market will need a different game plan to win.
For that reason, you must give the executives in those units the leeway they need to do their jobs. But there’s one exception to that rule: capital allocation decisions must be centralized.
While those units may operate as standalone businesses with their own full-time personnel and balance sheet, the decisions about how the money they make is spent must be done at a higher level, usually at the corporation’s headquarters.
We found that most companies with a serious approach to capital allocation enforce a centralized management of the cash produced by each individual unit, even if those operate as individual businesses.
In plain English, the cash those businesses produce must be sent to the headquarters where it will be reallocated in the way that executives at that level understand creates the most value for their shareholders.
You can envision this approach to capital allocation as a “cash factory”, where the company’s individual divisions are seen purely as cash machines whose only job is to produce cash and send it over to the headquarters, and the corporation at the top level decides how that money is distributed across all operations or invested towards new areas.
Part of your success as CEO is in understanding the timing of your businesses.
By sitting at the center of the cash factory, you can make decisions to properly balance resource allocation across business units in the way that creates the most value for shareholders.
You may move the money produced by steady businesses into growing ones, or to finance longer-term plays.
Amazon, for example, subsidizes its aggressive retail division which arguably loses money in heart-stopping proportions with money from successful cash-making businesses like Amazon Web Services (AWS) and Prime.
Having a centralized cash management practice in place helps top executives make those decisions and ensures the most growth for shareholders in a more disciplined, fact based-fashion.
Evaluating investment opportunities
In the book, we provide a framework to evaluate new investment opportunities, such as the development of new products, the construction of new facilities, entry into an international market or the acquisition of another company.
When faced with such opportunities, rather than just a dry financial evaluation to measure its returns, what your teams need to produce is a plan to make it feasible, or as we calls it a feasibility strategy: a proactive effort that rather than measuring feasibility, “creates” it.
Our feasibility strategy framework is a combination of seven different tactical plans that you must put in place to optimize the new project from different angles, improving the chances that it will turn into an attractive investment opportunity. These plans are:
This plan also describes in some detail your recommended approach to the market in terms of product, price, sales, distribution and promotion of the final products and services.
2. Technical: This plan provides an optimized arrangement of the project’s value chain to ensure the success of the project, including the selection of optimal technologies, vendors, product architecture, supply chain, configurations, standards, maintenance and all other technical matters that are relevant for the project.
For opportunities that require the construction of new facilities you must also discuss and optimize here the size (capacity) of the installations, locations, machinery type, maintenance, process efficiencies, operations management and how future expansions will be made among other subjects.
3. Organizational: This plan proposes the best organizational structure for the project and defines, at least in general terms, critical job positions that would make the project a winner including support and administrative staff, management and critical skills needed for each job.
4. Legal: This plan proposes the best legal structure for the project entity, and identifies permit requirements, tax treatments and any government incentives that apply to the specific type of project.
When needed, this plan also provides some ideas of potential legal hurdles that the project might have to face.
5. Social and Environmental: This plan is especially important in projects that require the construction of physical infrastructure, as it identifies the communities that would have direct or indirect interaction with the project during construction and operations, pointing at the key stakeholders within each one.
It also provides a measure of job creation and proposed outreach programs budgeting them accordingly. When applicable, this plan must also include mitigation actions in case unexpected situations arise during construction or operations that could put the project in jeopardy.
6. Implementation: Every good strategy always includes a serious discussion of how the team will guarantee its execution.
This part of the plan defines the metrics that will be used to measure progress, including milestones, and a schedule of how it will be developed and implemented.
7. Financial: This section provides the project’s financial projections, which have been optimized to minimize the impact of taxes and other negative effects, optimizing debt service, and taking advantage of any tax incentives and benefits.
The financial plan feeds off the budget and projections of each of the other plans and calculates the financial metrics of the project.
Making these plans may seem like a lot of work, but capital-intensive investments need to be well evaluated before they are put up for approval. The trick here is not doing all the heavy lifting at the beginning, but only as the project progresses through approval stages.
The final project report may include each of these plans as “chapters” of a single document, making it a great support to document any investment approval.
Best business strategy books
The content of this article has been extracted in its entirety from our book Strategy for Executives, a book that provides a fundamental, but practical, framework to understand and create a good strategy from scratch, applicable to the dynamic conditions that modern executives face in pretty much every market today.
There are many great capital allocation books to choose from including Thorndike’s “Outsiders”, but why go through all these different frameworks and ideas, some of them outdated, when you can get a unified map to strategy that incorporates all of them in a single framework?
Strategy for Executives, which is now free to download here, is based on extensive multi-year research, where we broke down the most popular strategy frameworks of the last 40 years, extracted their core ideas, and tied them all together into a single didactical and self-contained body of knowledge.
The research was led by Sun Wu, a seasoned Fortune 500 executive with more than 15 years of real-life experience, complemented by a thorough revision of more than 300 books and research papers, and over 500 hours of videos, interviews and formal training.
The result is a combination of fundamental concepts and a concise map to the strategy choices that modern executives have to make to thrive in today’s highly competitive markets.
Every concept in the book is explained from scratch so that, plain and simple, this is the only strategy book that you and your teams will ever need.
Sun Wu’s Strategy for Executives can now be downloaded for free here.
Thorndike, William N. The Outsiders: Eight Unconventional CEOs and Their Radically Rational Blueprint for Success. Harvard Business Review Press. Kindle Edition.
Berman, Karen; Knight, Joe; Case, John. Financial Intelligence, Revised Edition: A Manager’s Guide to Knowing What the Numbers Really Mean. Harvard Business Review Press. Kindle Edition.
Jay Rosenzweig Interviews William Thorndike, Author of The Outsiders. YouTube video. Watch at: https://youtu.be/3nDz_Q9bafk
Vintage Value Investing (contributor). Here’s how Warren Buffett used insurance to become one of the world’s richest people. Business Insider. April 2017. http://www.businessinsider.com/warren-buffett-insurance-float-2017-4
O’Brien, Sara Ashley. Amazon lays off hundreds of employees. CNN Business. February 2018. URL: http://money.cnn.com/2018/02/12/technology/amazon-layoffs/index.html
TheStreet Contributor. Amazon Is Losing Billions From Its Retail Business and Rivals Should Be Scared. TheStreet.com. April 2018. https://www.thestreet.com/opinion/amazon-is-losing-money-from-retail-operations-14571703