What Is Capital Allocation?
Capital allocation is about where and how a corporation's chief executive officer (CEO) decides to spend the money that the company has earned. Capital allocation means distributing and investing a company's financial resources in ways that will increase its efficiency, and maximize its profits.
A firm's management seeks to allocate its capital in ways that will generate as much wealth as possible for its shareholders. Allocating capital is complicated, and a company's success or failure often hinges upon a CEO's capital-allocation decisions. Management must consider the viability of the available investment options; evaluate each one's potential effects on the firm; allocate the additional funds appropriately, and in a manner that will produce the best overall results for the firm.
Capital Allocation: My Favorite Financial Term
Understanding Capital Allocation
Greater-than-expected profits and positive cash flows, however desirable, often present a quandary for a CEO, as there may be a great many investment options to weigh. Some options for allocating capital could include returning cash to shareholders via dividends; repurchasing shares of stock; issuing a special dividend; or increasing a research and development (R&D) budget. Or, the company may opt to invest in growth initiatives, which could include acquisitions and organic growth expenditures.
In whatever ways a CEO chooses to allocate the capital, the overarching goal is to maximize shareholders' equity (SE); and the challenge always lies in determining which allocations will yield the most significant benefits.
Examples of Capital Allocation
Nobel prizewinners Franco Modigliani and Merton Miller identified return on investment (ROI) as a significant contributor to shareholder value. A company may increase ROI by making improvements to profitability and choosing to invest its funds prudently. To measure how well the company turns capital into profit, one would look at the return on invested capital (ROIC).
Newell Brands Inc. (NASDAQ: NWL) held its first-quarter earnings call with investors in April 2016. Two weeks earlier, the company had completed its merger with Jarden in a stock and cash deal valued at more than $15 billion. On the call, Newell's management outlined its capital-allocation priorities, which included continuing to pay dividends, followed by repaying debt. Management's goal was to achieve its targeted leverage ratio within two-to-three years; and once they accomplished this target, then management planned to invest in growth initiatives.
In December 2015, Neil Williams, the chief financial officer (CFO) at Intuit Inc. (NASDAQ: INTU), emphasized the importance of a disciplined capital-allocation approach for the company. This approach included managing internal spending, such as R&D, investing in acquisitions, and returning money to shareholders. Williams also disclosed that Intuit's benchmark return as 15% over a five-year period.