What is Capital Allocation?
Capital allocation refers to the process of a company assigning financial resources to different business functions or departments. The goal is to allocate these resources in a way that generates as much money as possible for shareholders.
Capital allocation is a complicated process involving the evaluation of each potential recipient to determine what effect it will have on the company overall. Capital allocation can have a profound impact on long-term investments, because of how vital it is to the prospects of the company.
Before investing a significant amount of money in a company, you need to have a good understanding of how they spend their extra capital, and whether or not their strategy is a good one. We'll discuss the different methods of capital allocation and whether or not they make a company a secure investment.
How Does Capital Allocation Work?
When a company makes more profits than they expected, management needs to allocate that extra capital in a way that will maximize shareholder’s equity. Determining which allocation strategy will yield the most significant benefits is a challenging process.
Organic reinvestment is the most common strategy for spending extra capital. It essentially means a company takes that extra money and uses it to buy inventory, or marketing materials, or anything else they believe is going to increase their profits.
The company invests in itself, hoping that will bring in even more money the following year. For a young company, organic reinvestment is almost always the best way to allocate capital, so they can continue to grow their business.
At a certain point, allocating all or most of their extra capital to organic reinvestment becomes a lousy strategy for a company. The additional resources need to provide an ROI (return on investment) that justifies the allocation. When that ROI falls below a certain number, shareholders will no longer be happy with organic reinvestment as a strategy.
Reasons why the ROI could drop are varied. They don't necessarily mean the company spent their money unwisely. Companies can't sustain massive growth year after year, so it makes sense to start considering other strategies when further growth becomes too expensive.
There are two main factors a company needs to consider before they choose to reinvest their funds. The first is capacity, or how much money they can reasonably reinvest before the ROI drops. The second is business unit profitability or the amount of return they'll see from their reinvestment.
Mergers and Acquisitions
Mergers and acquisitions are another way to allocate extra capital, though it can be hazardous. The parent company needs to do extensive research on the company they’re investing in, to convince shareholders on both sides that the merger or acquisition will increase the value of their stocks.
A merger is when two companies voluntarily choose to unite into one legal entity. Typically, the two companies are roughly equal in size and scale. There are five main types of mergers.
A conglomerate merger is when two companies that are involved in different types of business choose to merge. The two companies are either in different industries or focus on different activities. One major example of a conglomerate merger is when Disney joined with ABC in 1995.
A congeneric merger, also known as a product extension merger, is when two companies who operate in the same market and have overlapping factors unite to form a new business entity. A product extension merger takes place when a product line from one company is added to an existing product line in the other company, allowing them to gain access to a larger market share.
An example of a congeneric merger is when Citigroup merged with Travelers Insurance. Both were in the financial industry, they just had different products and focused on different areas.
A market extension merger involves two companies that focus on the same products or services, but in entirely different markets. The consolidation gives both of them a broader market and customer base. One example is when RBC Centura merged with Eagle Bancshares Inc.
A horizontal merger is when two companies who operate in the same industry as competitors choose to consolidate. Doing so gives the companies access to a more significant market share. Daimler-Benz and Chrysler took part in a horizontal merger in 1998.
A vertical merger takes place when two companies, operating at different levels in an industry's supply chain, merge. Combining the companies allows them to control a larger piece of the industry's market share and achieve cost reduction and synergies. A very well-known example is when AOL merged with Time Warner.
An acquisition is when one company buys a controlling majority of stocks in another company, thus giving them effective ownership of the second company. The parent company purchases stocks and assets from the second company, so they have greater control over the decision-making process involved in running the company.
When the parent company attempts to acquire a second company without their agreement, that’s considered a takeover.
In the aftermath of an acquisition, the target company’s stock typically goes up, while the parent company’s stock price drops. These are short-term effects and, in a successful acquisition, the parent company’s value will eventually increase.
Repaying debts is another way to allocate capital. It’s a safe option because the return on repaid debt is very predictable. By paying off some of their obligations, a company elevates its asset to debt ratio, improving their overall financial outlook. This, in turn, makes the company a more attractive investment, which increases the value of their stocks.
Debt repayment isn’t always the best option, though. When interest rates are low, it may seem like an attractive choice, but companies are actually better off letting their debts mature.
Dividend payments are a good way to attract new shareholders and increase the value of a company’s stock. Evidence shows that dividend stocks tend to outperform other types of stocks, which makes them an attractive investment.
Not only will dividend payments attract new shareholders, but it's also a way to improve the company's relationship with its current stakeholders.
Capital can also be allocated to the repurchasing of shares in the company’s stock. When a company repurchases its own stock, they reduce the number of shares out on the market, which can improve the per-share price and raise the value of the stock overall.
Usually, a company would invest in share buybacks while its stock valuation is relatively low. Repurchasing dividend stocks is a better investment than repurchasing non-dividend stocks because it will save the company from having to pay those dividends to other shareholders.
How Does Capital Allocation Affect Investors?
Businesses that are capital-intensive—meaning they require a lot of money up-front to produce the service or product they're selling—usually don't make great investments. Since the company needs to reinvest almost all of their capital to keep operating, they often can't use their financial resources to invest in growth projects or diversification.
Eventually, the company will hit a wall, where they are no longer able to increase their market share despite how much capital they're investing in themselves. But because they're so capital-intensive, they have no choice but to continue with this strategy.
Capital-light businesses that don’t need to reinvest all of their capital usually make better investments because they have more options for growing the company and increasing the stock price. They're able to invest their additional money in other growth strategies, such as buybacks, research and development, or acquisitions.
Keep in mind that a business can be a good investment even if they don’t have strong growth prospects. You just need to analyze their strategy for capital allocation to determine if they’re the right choice for you to invest money in.
Public companies are required to release detailed financial information to their shareholders, including their capital allocation strategy. A company that uses multiple methods of capital allocation has a good chance of performing well in the future.
Pay close attention to the company's past methods of capital allocation, as that can be a good indication of how they will choose to allocate funds in the future. Even if their current strategy is healthy, it's important to understand the company's pattern of spending.
If you're committed to optimizing your investment returns, you should check in with these companies at least once a year to see how their capital allocation strategies have changed. A good CEO is continuously searching for new ways to spend the company's money, and will typically release information on how they've allocated capital every financial quarter.