5 Ways of Capital Allocation

Many authors have studied Warren Buffet and other successful American business leaders and one thing they seem to have in common is their emphasis on efficient allocation of capital. They always look out for the best way to allocate their capital to yield maximum value.

There are five options that managers have to choose from each time they make a decision about capital allocation. The five options are as follows:

1. Reinvesting in existing operations
2. Paying down debt
3. Acquiring another business
4. Paying dividends
5. Buying back shares

While these are the five key options, there may be others, though not primary to their business pursuit. One example is social corporate responsibility, which can offer indirect benefits to their business interest.

Good management is expected to make rational choices and constantly assess the opportunity cost between these alternatives to maximize shareholder value.

Now, let’s discuss, in detail, the five main ways of allocating capital.

1. Re-investing in existing operations

The management can choose to reinvest in their core business to increase productivity and drive expansion if they believe they have enough market for that. Managers take this option when there is a huge demand for their products or services or when they want to increase their market share.

Investing in existing operations is the best way to drive organic growth. The business can even expand to other geographical regions to meet the demand there.

Warren Buffet’s Berkshire Hathaway is the perfect example of a company that reinvests in an existing business or even expands its business (see point 3). Berkshire has paid a dividend only once, where Buffett famously says he must have been in the bathroom when that decision was made.

2. Paying down debt

The management can also choose to pay down debt. This is especially important if interest rates are rising, as it would reduce the amount the company spends servicing debts.

However, if interest rates are low and the company has profitable ways to invest the money, they are better off investing than paying off debt. The profits from the investment can service the debt and the excess returns to the company coffers. That way, the company uses the debt to create more value.

3. Acquiring another business

Another way to allocate capital could be to acquire another business. This may be quite risky, especially if the company doesn’t get a good deal. In fact, many financial experts doubt whether acquisitions and mergers create value for shareholders.

However, it depends on how you look at it. Good acquisitions can create shareholder value both in the short term and over the long term. What matters is buying at a discount and having a plan to use the new business to create value.

4. Paying dividends

If a company cannot reinvest free cash flow at an acceptable return, it is better to give the money back to the shareholders in the form of dividends. Dividend income is one of the ways shareholders rip from their investment, and it allows the shareholders to personally choose what they want to do with their returns.

However, it only makes sense to pay a dividend when the management believes their company is overvalued by the market.

If the company is underrated by the market, it makes more sense to buy back shares:

5. Buying back shares

In some cases, instead of paying dividends, management can buy the company’s own shares if the shareholders sanction that. This creates value for investors by reducing the number of outstanding shares. This might be a better option that paying dividends when the stock is “cheap”, and it’s also no taxes on dividends, which it is on dividends.