In every firm, one of the most important responsibilities of the organization is to properly manage capital allocation. This is how the board and management teams must decide how financial resources will be used. That includes both internal and external use of those resources. Even as critical as it is, many organizations fail to manage the process properly, and that often leaves them with difficulties later.
How Wrong Timing Creates Loss
One example of how firms’ capital allocation may go wrong is when they time the process improperly. For example, S&P 1500 companies made some critical mistakes between 2006 and 2008. During that time, many of these companies spent a lot of capital buying back their stock. The problem was that they pulled back on buying back that stock from 2009 to 2011. Why is this a problem? It is during the later portion of that that companies had valuations and share prices that were much more attractive. This type of timing mistake is costly.
There are other concerns as well. Take, for example, what happens when mergers and acquisitions occur. Capital is deployed in these events, but its timing is often off. For example, many companies aim to buy high and then deploy the wrong amount of M&A capital late into the business cycle. That is generally when valuations and fundamentals are at their highest. In some cases, organizations also increase their capital spending in the middle or even the later parts of other economic expansions. That typically happens right before the demand for their goods has fallen.
Changing the Perspective
It is true that many organizations fall into these types of scenarios, and it is frustrating when they do so. However, just because this happens so common does not mean it has to impact every firm in the same way. “It is possible to beat the odds, so to speak. It is also very important for organizations to make this a priority as it can impact the overall health and wellbeing of the company for decades,” states an executive from Boardsi.
One reason for this is that more structurally slower economic growth is present across most developed countries in the world. That means there is more excess capital that organizations need to be redeployed each year. Key to this is the returns on this excess capital. In recent years, they have become an essential driver of long term returns for shareholders. They are also growing in importance in their ability to provide a competitive and sustainable return for many organizations. Those organizations who deploy capital properly and do so on a consistent basis see a substantial amount of benefit from doing so year after year.
How to Create a Change
Boards need to develop a comprehensive and sustainable process that focuses on capital allocation. The goal of that plan should be to increase long-term shareholder value.
The foundation of this is to ensure that every capital deployment has a full analysis of it, especially the cash-on-cash returns over the intermediate term. That analysis should also provide for a comparison to returns from alternative forms of capital deployment.
The Importance of Monitoring Returns
A key component of the process tends to be holding management accountable. However, it is even more important to monitor returns more thoroughly to look for success and failures that can be learned from later.
Boards need to analyze every situation in their own right. There are several factors to take into consideration. However, at the heart of the process is asking a few key questions.
First, consider prior capital deployments. What characteristics held for these deployments that led to strong returns? What factors contributed to poor returns? What was true of those who landed in the middle?
Look at those capital deployments that generated returns that were beyond the original projections next. Try to determine why this occurred. What specifically set them apart? Do the same thing for those that came in well below projections. Why did it happen?
Using this information, boards can learn to make better decisions going forward. As you look at all of these factors, what can be done to better the outcome later?
Doing this type of work is critical, even though it is sometimes not seen as a priority. With this information, a board will examine past decisions with a critical eye, learning from them so that they can make improved decisions next time.
Avoiding the Weakness Deployment of Capital
A final critical note is that a firm should never alter this capital allocation plan because of a change in the core or underlying business. Do not undertake acquisitions and then repurchase shares as a way to cover up potential earnings-per-share losses. Having a defensive capital allocation strategy is not the goal in any situation. It can harm the long-term shareholders and their goals. It also fails to achieve its objective as well.
Boards with a better view of capital allocation can see a fundamental change in their outcomes when they put a bit more time into analyzing why and when they are investing and ensuring that they are doing so for the best reasons.
