In-depth understanding of capital allocation

Market-leading companies succeed not only through their business results, but also through the appropriate allocation of capital in the most beneficial way for shareholders.

Capital allocation decisions are often overlooked as a central theme. They are critical to determining the company’s future and are therefore some of the most important responsibilities of the company’s management. This article will study some indicators that will help us assess the management’s ability to effectively allocate capital under any market conditions. Read on to learn how to use these indicators to facilitate stock research and find companies that are ready for long-term success.

Capital allocation decision

Should the company pay or increase dividends? Should it build a new factory or hire more workers? These are the dilemmas faced by managers of listed companies today.

Every company follows a life cycle; in the early stages of life, capital allocation decisions are very simple-most of the cash flow will be reinvested into the growing business, and there may not be much money left. After years of strong and stable revenue growth, the company found that the market space was limited. In other words, adding the next product to the shelf, or adding the next shelf for this purpose, the profit per unit is only half of the first batch of products placed on the shelf many years ago. Eventually, the company will reach a point where cash flow is strong, and there will be additional cash “idle.” Then you can start the first discussion about:

  • Entering new lines of business-This requires higher initial cash outlays, but may be the most profitable process in the long run.
  • Improve the ability of your core business-this can be done with confidence before the growth rate starts to decline.
  • Paying out or increasing dividends-the correct and tried-and-tested method.
  • Repay debt-this will improve financial efficiency, because equity financing is almost always cheaper.
  • Investment or acquisition of other companies or enterprises-this should always be done cautiously and adhere to core competitiveness.
  • Buy back company stock.
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Management makes such decisions by using the same indicators that are available to investors.

Return on equity

The return on equity (ROE) of a stock shows the company’s growth rate in “shareholder dollars”.

When looking at a company’s ROE, some factors need to be considered, such as the age of the company and the type of business it operates. Younger companies tend to have higher ROE because cash deployment decisions are easy to make. Older companies and those engaged in capital-intensive businesses (such as telecommunications or integrated petroleum) will have a lower ROE because the upfront cost of generating the first revenue is higher.

ROE is very specific to the industry in which the company operates, because each industry has unique capital requirements; therefore, when reviewing this valuable indicator, it should only be compared with similar companies. ROE higher than the industry average is a good sign, indicating that management is squeezing as much profit as possible from every dollar invested.

Return on Assets

Return on assets (ROA) is similar to ROE in theory, but the denominator of the equation has changed from shareholder equity to total assets. The ROA number tells us what kind of return management is dealing with the assets it is disposing of. Like ROE, ROA data will vary greatly in different industries, and this should be taken into consideration.

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In the long run, ROA performance will provide a clearer picture of profitability than ROE. why? Because in ROE calculations, current net income and last year’s net income are the main variables; they also happen to be more volatile than long-term growth rates. When calculating ROA, most of the denominator is composed of long-term assets and capital, which can eliminate some short-term noise that ROE may generate. Essentially, the ROE of a company varies greatly from year to year, and ROA data takes longer to change significantly.

Capital requirements and cash management

Suppose Company X has an average ROE of 18% in the first 10 years of its establishment. This represents a strong growth record, but it was achieved during a period when a large number of new markets entered.

With its leading market share, Company X has seen that it cannot maintain this growth rate and must start to find other ways to increase shareholder value. The capital requirements to maintain the business are known and put on hold, and the remaining free cash flow can be assessed for its durability and consistency.

Once this is verified, management can sit down and decide the best use of funds. One or more of the options mentioned above can be used. Once the process begins, investors can really begin to evaluate the effectiveness of the company, rather than simply operating the core business.

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Stocks that pay dividends are attractive to many investors. Dividends are an effective way to return free cash flow to shareholders and encourage long-term investment in the company. By looking at the payout ratio of stock dividends, investors can easily determine what percentage of net income is used to pay dividends. The smaller the payment ratio, the more room managers will need to increase this amount in the future.

The most mature dividend-paying companies pay 80% or more of all net income to shareholders, which provides considerable income, but leaves little cash to generate future income growth. These stocks ultimately resemble real estate investment trusts (a security that must distribute at least 90% of net income to shareholders each year). Therefore, investments in companies that pay very high dividends will hardly appreciate in value.

Stock buybacks are another common way to allocate excess capital within an organization. When is this in the best interests of shareholders? If the company really feels that its shares are undervalued, repurchasing shares is likely to be the best use of funds. This will increase the percentage of ownership of all other shareholders and is usually seen as a positive sign that management believes in the company’s future.

Bottom line

For individual investors, part of any effective due diligence should include understanding the history and expectations of the company’s capital allocation capabilities. When considered together with valuation and growth, the management’s ability to allocate capital effectively will determine whether it is destined to own preemptive stock or “run too.”

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