In my experience, 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 affect share price or valuation of a company at least as much as operational decisions.

There are five ways in which 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 major ways of acquiring capital: (i) internal cash flow; (ii) raising equity, or (iii) issuing debt. I would consider joint ventures or franchising as variations on 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.

There is no “one size fits all” capital allocation formula. A CEO or Board of Directors should constantly be reviewing the toolkit, taking on the perspective of an investor, deciding where to allocate cash within a company or group of companies.

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

• The debt mix should be reviewed in light of changes in operational risk of the company, or changes in actual or forecast interest rates.
• A start-up that is bleeding cash not only 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 levels of debt, 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 are 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 their own shares over the past decade, believing that there are very few investments out there that are better than their own shares (and because 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 a return on investment above y% was automatically approved. Any investment with a return on investment 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, etc.)
• 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 earning, the public company has the potential to create huge 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 allow 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 truly masters of capital allocation, especially among smaller companies that have fewer resources.

I conclude with another excerpt by Warren Buffett from the 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.”