In this post, we explore one of the most important aspects of evaluating a business that can make or break the compounding journey of the business.
One of the most important requisites for long-term compounding in businesses is 'Capital allocation'. Effective allocation of resources is the most crucial aspect of the management's job. The reason is simple. Opportunity Cost! Needless to mention that nothing erodes the intrinsic value of the business in the long term faster than sub-optimal capital allocation.
However, what does capital allocation mean exactly? Let's dive in!
Thinking from the first principles, there are two ways a business can deal with capital. Either invest in the business or repay it to the owners. But there are further ways to invest/reinvest in the business or repay the capital to the owners or investors.
We generally think of Capex (Capital expenditure) when we hear organic investment. This is so because companies usually incurCapex to build or maintain income-producing assets for the long term. These assets may include new factory or office buildings, plant & machinery, warehouses, etc. that expand the current capacity of a business to produce goods or services.
However, from a broader capital allocation point of view, there are other ways of deploying the capital organically. These include investment in research & development, advertisement & marketing, employee training, etc. Though these expenses are routed through P&L, intangible benefits derived from them ultimately enhance the income generation capacity of the business.
Time and again, companies prefer inorganic ways of capital deployment to accelerate growth prospects. Instead of investing and building the assets which take longer, companies pay upfront for acquiring the income-producing assets. Acquisitions, amalgamations, mergers, restructuring, etc. are inorganic ways to deploy capital.
Whilst developing capabilities through organic means takes longer, doing so through inorganic means albeit with shorter timelines is not easy either. It's perhaps the trickiest way of capital deployment as companies end up paying higher for the acquisitions. Furthermore, the effects of such decisions are only visible in the long run and the ramifications of wrong judgments are often huge.
Paying dividends is a simpler way of redistributing the accumulated earnings to the shareholders. Just as lenders are paid interest on the borrowed capital, owners of the business are rewarded with dividends on permanent capital. However, there is a difference. Whist interest has to be paid on the borrowed capital, paying dividends is optional. Companies need to evaluate profitability, liquidity, and alternate investment opportunities before distributing profits as dividends. Nonetheless, it's the most common way of periodically rewarding the owners of the business.
Finally, when companies have large accumulated profit reserves represented by cash and cash equivalents, they buy back their shares from existing shareholders. Share-repurchases are usually done when the companies don't have an investment opportunity to effectively deploy capital and market value is lower than the perceived intrinsic value of the business. Essentially, share repurchases shrink the pool of owners, and hence shareholders who do not participate in the buybacks benefit more from the cash flows generated by the business in the future.
When companies are generating large amounts of cash, they often deploy it towards repayment of existing debt. If the business has an external debt in the form of bonds, debentures, and term loans on the balance sheet, 'de-leveraging' takes precedence over share repurchases. Thus debt repayment is also an important capital-allocation decision.
Why capital allocation is a tough job?
Good capital allocation increases the efficiencies of the capital employed and expands the earnings capacity of the business. These earnings/cash flows need to be effectively deployed again. Thus the allocation of capital is a constant process. Unlike operating management decisions, capital allocation decisions are often decentralized and taken at a lesser frequency. However, the magnitude of the impact is much larger if something goes wrong.
Timing is extremely crucial while making capital allocation decisions. Undertaking acquisitions in a period of high valuations, leveraging the balance sheet in an uncertain interest environment, and repurchasing shares when the stock is trading well above intrinsic value can have devastating impacts on the intrinsic value of the business in the long term. Just like a good capital allocation decision compounds over time, a bad one too compounds in a negative way.
Capital allocation decisions are often driven by wrong incentives. In absence of organic growth plans, top management employs consultants and external advisors, particularly for acquisitions, mergers, restructuring, etc. Incentives of the management and external advisors are not aligned with the long-term value creation and hence inorganic expansions are sometimes undertaken just to demonstrate activity. It's not a good idea to outsource capital allocation decisions.
In academic finance, capital allocation decisions are often highly optimized. Capex projects are undertaken when IRR exceeds the cost of equity. Acquisitions are undertaken when EPS is accretive in the short term. Assumptions in these calculations are over-optimized and leave little room for error. Furthermore, qualitative aspects are often ignored in these decisions. Hence, short-term targets are achieved albeit at a cost of long-term value creation.
Can't avoid including the below quote from Warren Buffet to underscore the complexity of the capital allocation decisions.
The first law of capital allocation—whether the money is slated for acquisitions or share repurchases—is that what is smart at one price is dumb at another. - WB