Capital allocation is the process of deciding how to spend financial resources.  You might think of it as a corporate budgeting process where companies decide how to invest their resources.  The goal of capital allocation is to invest the company’s financial resources in the areas with the highest returns.

Knowing how companies operate and make business decisions, such as capital allocation, is an important part of investing.  It enables us as investors to assess our investment options like stocks with more context. Capital allocation specifically is very important because investors need to understand how companies are spending the financial resources and if they are in the best interests of the shareholders.

The primary responsibility of company management is to invest financial, physical, or human resources in the manner which generates the highest rate of return.  All investment must be greater than the company’s cost of capital (essentially the cost to raise or borrow money).

Companies have four primary options for capital allocation:

  • Capital expenditures – investments in assets, equipment, and technology
  • Mergers & acquisitions (M&A) – acquire other companies
  • Dividends – return capital to shareholders directly by giving shareholders dividends
  • Buybacks – return capital to shareholders indirectly by buying back the company’s own shares on the stock market

Capital expenditures

Capital expenditures (also called CapEx) are financial resources used to acquire or improve physical assets such as property, plants, equipment, and technology.  Companies frequently evaluate many different potential projects for investment. These projects can be focused on growing sales or increasing profit margins on existing business.

Mergers & acquisitions

Companies can also use capital to acquire other companies.  These acquisitions are thoroughly evaluated with periods of screening and due diligence.  All different aspects of the company being acquired are evaluated, but some of the most important factors are the company’s sales, EBIT, growth potential, and the purchase price.

Companies may also factor cost or growth synergies into their business case.  For example, if the merger of two companies will open up new sales opportunities then the business case for the acquisition may include more sales than the target company currently has based on the assumption of new sales opportunities.

The purchase price is very important because it will determine the potential rate of return on the investment.  The price of the company is negotiable with the company’s owners or shareholders.

Dividends

Companies can return funds directly to shareholders by paying dividends to shareholders.  Companies do this by paying each investor a certain amount per share of stock owned. In the U.S. dividends can be quarterly, semi-annually, or annually.  Occasionally companies also offer special dividends.

Buybacks

Companies can also return funds to their shareholders indirectly by buying back their own stock on the market.  Shares that the company buys are retired from trading, reducing the total number of outstanding shares. By doing this, each existing shareholder owns a larger portion of the company because there are fewer shares outstanding.  This increases the value of each existing share.

Summary

Projects are usually evaluated with a business case that includes measures such as IRR (internal rate of return) and NPV (net present value).  Among other strategic considerations (such as feasibility, risk, etc.), projects with the highest rate of return are selected for implementation.

Generally all companies spend some funds on CapEx, but growth companies generally spend most or all of their funds on CapEx and internal projects as they focus on growth.  As companies’ growth slows and they mature, they are usually more likely to allocate funds to other areas such as M&A to supplement growth inorganically. If CapEx and M&A do not provide sufficient returns, companies can return funds to their investors through dividends and M&A.

Capital allocation basics: How companies decide to spend capital on dividends, buybacks, and investments
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