Success in capital allocation is critical to the long-term success of companies. The term “capital allocation” may sound fancy, but in practice it is about controlling cash flows generated by the business. In principle, we face the same decision on every payday: how much of the income remaining after compulsory expenses (“operating expenses”) is to be attributed to, e.g., mortgage repayments, a vacation trip, hobbies, new rims for the car or equity investments. It is desirable that these decisions are based on planning. For companies, “the plan” is the long-term strategy which successful capital allocation promotes.
Successful choices enhance the financial situation of both companies and individuals, which continues to generate more capital for allocation and enables a positive spiral and long-term success. Therefore, the success of company management in capital allocation is critical for the company's future.
Positive operating cash flow as the starting point
Capital allocation can be considered at different levels, but in this article the starting point is operating cash flow. Simply put, this means the actual cash generated by the company's business. In the cash flow statement, this is followed by cash flow from financing and cash flow from investments, which from the management's viewpoint are also possible allocation targets. Investors can also use free cash flow as a starting point, and, on the other hand, smaller decisions are constantly made within the business. In this article, we begin by examining the operating cash flow.
It is difficult to allocate capital if it does not exist. If a company's operating cash flow is negative, the company has to use resources to acquire financing. This is a normal situation for companies with strong growth that deliberately invest in growth, assuming that profits will follow in the future.
In companies with negative cash flow, capital allocation is not free in the strict sense of the word, but all capital must be invested in order to generate positive operating cash flow in the future. Naturally, these investments should be made as smartly and timely as possible. In this article, however, we assume that operating cash flow enables capital allocation.
Where can capital be allocated?
There are in principle unlimited potential allocation targets from lottery tickets to pulp mills, but the company's business, strategy and financial targets usually offer a reasonable framework for the allocation of a listed company's capital. We discuss the conventional capital allocation items listed below in the next three paragraphs.
Investments in business and M&A transactions
Maintenance investments are in practice mandatory to ensure the continuity of current business. This can mean, for example, Fortum's investments in the operations of the Loviisa nuclear power plants or paper manufacturers’ investments in machine maintenance. If the current business is profitable and has a good outlook, maintenance investments are the first clear capital allocation target. It is very rare that keeping current business competitive is not at the core of the company's strategy. The better the current business, the more sense maintenance investments make.
However, investments in bad business destroy shareholder value if the return on capital is below the cost of capital. For example, Warren Buffet said it was not worth investing in Berkshire Hathaway's textile business, and therefore allocated the operating cash flow to other investment targets. However, it is much more common that even weak business is kept on life support with unproductive investments while destroying shareholder value.
Growth investments are investments in the organic growth of existing business. While maintenance investments help the company keep the current production capacity of its factories in order, the company uses growth investments to build a new production line to increase its capacity or a new factory alongside the old one. The line between maintenance and growth investment is sometimes difficult, as often, e.g., dismantling of a production line bottleneck both improves the efficiency of the old and creates some new capacity – or when the investment improves the cost-efficiency of production or builds additional capacity to produce products with a better margin structure.
Growth investments are a logical capital allocation target for all companies seeking growth that most listed companies are aiming for in their business. However, growth investments usually require better justification and profit calculations than maintenance investments. The scale of calculations and need to plan investments naturally depend entirely on the scale of the investment. Implementation of an efficiency and quality investment with a short repayment period may be a fairly straightforward and quick, whereas, e.g., a strategic airline fleet update may require years of preparatory work and extensive risk/return analyzes. Typically, small investments offer a more attractive risk/return profile from the company's perspective, but one should not forget strategic major investments to defend long-term growth and competitiveness either.
Similar investment principles are now also applicable to sectors of intangible assets (e.g. software companies or platform services) whose role in the economy are increasing, although investment-like actions in these industries are also recognized as expenses under certain constraints. Thus, investments in intangible development are not necessarily shown in the balance sheet in the same way as tangible investments but may directly reduce the operating cash flow available for allocation.
M&A transactions, usually acquisitions, are an alternative way to seek growth. Again, the line between growth investment is partly artificial, because instead of building a new factory, the company can decide to buy a competitor that is in trouble.
The risk profile of acquisitions is very different: The risk profile of KONE acquiring small maintenance companies to strengthen its own maintenance portfolio is comparable to a small growth investment. In contrast, large acquisitions considering the company’s size class, possibly in new areas either geographically or commercially, involve a huge risk, like strategically large factory investments or other large-scale investments. The riskiest capital allocation is entirely new business, although under certain circumstances this may be fully justified.
Divestments, or selling non-strategic or exceptionally highly valued businesses, can also be part of capital allocation. In principle, this could be a textbook example of reallocating capital: freeing up capital from business with low expected returns and transferring it either to better business or owners. This is, however, significantly less common in listed companies, as most companies support growth with small acquisitions. In general, M&A transactions are an excellent way of creating value, but they can also significantly destroy it. The company's M&A strategy and historical successes must be closely monitored.
Profit distribution, using own shares and optimizing the capital structure
The discussion about capital allocation among investors often revolves around profit distribution. If the company has accumulated surplus capital that it does not need to run its business or for foreseeable investments, it is natural to return capital to the owners. Then the owners can reallocate the capital as they wish.
In a perfect world, the company would not have any reason to maintain significant buffers in its balance sheet, as it could seek more capital in an “efficient market” if necessary. In reality, however, the pricing of shares and the availability of capital vary widely, as previous years have proven, in addition to which operations on the capital market may be far from cost-effective. This makes the situation significantly more challenging for management, but also opens significant opportunities to create shareholder value for those who are able to do so.
Profit distribution should never be an end in itself. If the company has an excellent business to which it can allocate new capital, for example with a 30% expected return, the threshold for profit distribution should be very high. If a company can generate better return on capital than Warren Buffett could, the effect of profit distribution would be negative in terms of shareholder value. However, at some point in the life cycle of the company, when high return investments have been made, the situation has normalized and the company has reached maturity, a high payout ratio is justified. Otherwise, the company would start to accumulate ever more capital for which it would not generate the required return. On the other hand, in a business where the expected return on capital is lower than the cost of capital, it would in principle not make sense to allocate capital as it would be more profitable elsewhere. However, the world is not black and white, and extremes are usually avoided.
In Finland, profit distribution mainly means dividends, after all Finns love dividends. In the US, however, share repurchases are more common, which is usually justified with the tax effect. Taxes are paid immediately on dividends while share repurchases reduce the number of shares and thus support the value of individual shares. Taxes will, however, only be paid if the shares are sold at a profit.
The clear strength of dividends lies in the fact that they offer investors cash flow during the investment period, thus spreading the risk. Even if the value development of ownership is weak, the dividend flow accumulated over the years can elevate the total return to a reasonably good level. There is no similar security mechanism in share repurchases.
Own shares allow for different ways of value creation. In addition to the traditional "buyback programs", share repurchases can be made to create shareholder value when the share is significantly undervalued. The company's own shares can also be sold, i.e. a share issue, when the share is overvalued. This is rare, but e.g., Remedy's directed share issue in February 2021 at a EUR 41.5 share price seems in retrospect to have been a successful decision to create shareholder value. If the investment of the collected good EUR 40 million is successful, the expected return will be very good, considering the relatively moderate dilution (over 8%). At the time of writing, Remedy's share price is around EUR 18, so now you could buy clearly more own shares for the same sum.
Own shares can also be used as currency in company M&A transactions. When a share’s valuation is high it is nice to offer it as part of the consideration. In addition to the high value, its use also partially limits the risks. Similarly, it is not nice to “sell” a very low-valued share and especially a negative valuation difference is normally an obstacle to the acquisition.
Share buyback programs are relatively common, but usually the underlying reason is either 1) acquiring shares to be used in incentive schemes or 2) profit distribution to shareholders (especially international investors). These are part of capital allocation, but they do not in principle create shareholder value. Properly executed share repurchases can create shareholder value by purchasing the share when it is significantly undervalued. In Finland, very few such “opportunistic” share repurchases have been made. This was done successfully by Sampo, who, in the midst of the financial crisis in 2009, bought shares in Icelandic forced sales dirt cheap. However, there are many examples from around the world.
Even though the idea of timely share repurchases is simple, it is difficult to implement them: management must understand the fair value of the company and be able to make share repurchases clearly below this value. Since fair value is principally based on the idea of the company's future development, and forecasting is always difficult, it is an eternal challenge to create shareholder value through timely repurchases. On the other hand, management should have a clear information advantage to the development and outlook of its own business. The information advantage should be considerable when buying your own company compared to, e.g., other acquisitions, which however are often carried out. In principle, share repurchases should always be an alternative cost to acquisitions, but this is seldom how it is viewed when management implements the growth strategy.
In addition, share repurchases for profit distribution also include a classic pitfall: the company has most to distribute when it is doing very well. And when the company is doing very well, the share price is, in principle, high (excluding companies that are recognized as highly cyclical by the market). By contrast, when the company is in difficulty, there is little to distribute and the share price is low. This is probably the main reason why share repurchases have traditionally not been well timed. There are exceptions, but success requires patience and also an understanding of the stock market.
Optimization of the capital structure is also part of capital allocation if we look at it as part of a wider whole. We feel one could argue that good capital allocation also leads to a justified capital structure that can optimize the risk-adjusted return of shareholders.
It is clear that sometimes the best target for capital is repaying loans or, e.g., buying the company’s bond from investors who have a bleak view of the company's solvency. Sometimes there are situations on the market where bond holders are ready to give up their loans at a strong discount relative to the nominal value. In general, optimization of a company's capital structure (e.g. use of debt) is a financial issue and therefore no longer really falls under capital allocation. However, we believe that there is a strong link between funding, capital structure and capital allocation. We will discuss the optimization of capital structure in more detail later in the Analysis school.
Good capital allocation
At the heart of good capital allocation is ultimately successful creation of shareholder value. Simplified, it means that the return on capital exceeds the cost of capital by a margin that provides a good compensation for the risk taken. On the other hand, simply achieving this does not yet indicate actual success, as the aim would naturally be to achieve the best possible return on capital in the long term.
If we would look at capital allocation purely as a mathematical exercise, it would always be easy to criticize managers for non-optimal decisions. However, the company's strategy defines the framework for capital allocation, which significantly limits possibilities. As a result, different companies or managers are dealt different cards and good capital allocation becomes a relative concept. Again, it is important to understand how, e.g., capital allocation and strategy are linked together.
However, it is important to have indicators for measuring the success of capital allocation. Among applicable indicators to identify pure allocation skills return on invested capital is possibly the best, as 1) the premise for sustainable value creation in the long term is that the return generated on cash flows accumulated from underlying business is higher than the cost of capital, and 2) return on invested capital is based purely on operational performance and the quality of made investment decisions, and it does not consider the effects of different capital structures (cf. ROE %). However, if we also consider optimization of the capital structure, the return on equity is a strong contender in the long term.
We could take a very complicated approach to this, but in the long-term success is indicated by earnings growth. Earnings per share will in practice increase if the company can continuously allocate capital with a higher return than the cost of capital. By contrast, earnings will shrink if investments do not produce returns. However, the total return, including dividend income, is key for the shareholder. In the long term, the indicator of success is the share’s total return, although in the short term the share price and its valuation are primarily driven by market forces.