Capital allocation

It isn’t a trick question. But it is a question that corporate managers must answer to try to generate the most shareholder value through the deployment of excess capital. Great capital allocators generate excess returns for their investors because they can identify opportunities to deploy cash from their existing businesses into investments and strategies that are ultimately worth more than the cash used. They understand that the market environment demands flexible and opportunistic approaches to investment opportunities. They have the discipline to retain or return excess capital when the market requires prudence, and they avoid expenditures on unproductive or risky projects that may destroy value. In essence, they can evaluate the value of a dollar spent on a variety of capital allocation alternatives.

As Warren Buffett once famously put it, “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.”¹ We must consider constantly fluctuating performance and market variables to try to maximize the value of companies’ scarce capital. In this paper, we seek to arm our clients with insights to help them navigate these capital deployment challenges.

Over time, the ways in which a company deploys capital has an enormous impact on firm value because it is the most difficult aspect of company performance to project.

In practice, company valuation tends to revolve around an assessment of existing earnings and cash flows, how risky they are, and how they are expected to evolve in the short term, because these are the most observable components of most forecasts. But the most observable value drivers are, by their very nature, already baked into market valuations. A simple combination of returns on capital, expected steady state revenue growth, and cost of capital alone can explain current enterprise value / invested capital² ratios with 77% explanatory power across U.S. and European firms³ (Exhibit 1).

In this re-released paper, first published in Q2 2021, we develop a set of distinct frameworks for evaluating the NPV of $1 of capital deployed to the primary capital allocation alternatives.⁴ This paper explores the conceptual value drivers for each option in detail. But we also apply these methodologies to every firm in a broad market sample of about 1,400 public, large cap companies across the U.S. and Europe³. This approach allows us to quantify and compare the values of $1 across the options and validate the intuitive hierarchy for value creation. 

_{1. Buffett, Warren. Berkshire Hathaway Letter to Shareholders, Berkshire Hathaway, 25 Feb. 2012, https://www. berkshirehathaway.com/letters/2011ltr.}

_{2. Enterprise value/invested capital defined as (market value of equity + HOLT debt) / inflation adjusted net assets, including capitalized operating leases and R&D. Return on capital defined as HOLT CFROI. Sales growth defined as sell-side consensus FY3/FY2 revenue growth. Cost of capital defined as HOLT discount rate.}

_{3. S&P 1500 and EuroStoxx 600 (excluding financials, real estate, and utilities) and Proprietary UBS Strategic Insights and Advisory analytics This universe was used throughout the paper.}

_{4. For this paper we standardized everything to USD, however, these insights apply to other currency equivalents.}