Capital Allocation: A Framework to Prioritize Investments
One of the most important financial decisions that corporate executives must make is how to formulate their capital allocation framework. Unfortunately, the capital allocation process at many companies leaves much to be desired. As a result, opportunities for generating shareholder value are often missed — or worse, shareholder value is destroyed, and strategic goals aren’t met due to misallocated capital.
To allocate capital effectively, you must prioritize your investments appropriately while having a clear focus on where your organization can compete the best. In addition, you need to move beyond a business unit or “silo” definition of teams to a more consolidated approach. This will help link your capital flow to your strategic initiatives, thus aligning all your departments with the same overall goals.
The Dangers of “Silo Thinking”
An effective capital allocation framework will prioritize long-term, risk-adjusted performance while helping ensure the sustainability of excess returns and maximizing synergies within your portfolio. It will also make sure that the best investment options receive funding before other, less-attractive options. This is jeopardized when “silo thinking” takes over and business units start looking out more for their own interests than the interests of the company.
The challenge is to devise a capital allocation process that generates shareholder value and aligns the entire organization with successful long-term, risk-adjusted financial performance. Such a process will incorporate Residual Capital Earnings (RCE) to show whether you’re generating enough earnings to cover the risk-adjusted cost of capital invested, as well as an RCE Profitability Index (RPI) that can help you rank competing investment possibilities.
Your company could experience negative impacts by failing to devise such a process, including the following:
- Poorly prioritized and missed investments opportunities.
- Arbitrary funding decisions.
- Missed earnings goals.
- Misalignment of strategy.
- A lack of focus in terms of where to compete.
Creating a New Structure
To avoid these negative impacts, you should apply a new capital allocation structure based on the following areas outlined in a J.P. Morgan report1:
Financial performance of the investment
Will the profit earned on the invested capital exceed the project’s risk-adjusted cost of capital?
Length of competitive advantage period
Will the excess return generated by the invested capital be sustainable?
Fit within your overall portfolio
Are there synergies between the investment and other businesses in your portfolio, and does it extend their competitive advantage period?
Risk profile of the investment
How much risk is associated with the investment, and does it make other businesses more or less risky?
Political and regulatory environments
Is the investment sensitive to changes in these environments, and might it affect the marketplace perception of your business?
How much absolute shareholder value will the investment create, and how does this compare to other opportunities in your portfolio?
Your company could realize positive outcomes by creating and implementing an effective capital allocation framework. For example, you will:
- Have evidence of whether the company is covering all its operating costs and cost of capital.
- Maximize corporate and shareholder value.
- Bring strategic goals into alignment with high-performance results.
The capital allocation process at many companies leaves much to be desired, which can result in missing opportunities for generating shareholder value. An effective capital allocation structure will prioritize long-term, risk-adjusted performance while helping ensure the sustainability of excess returns and making sure that the best investment options receive funding before other, less-attractive options. An on-demand CFO partner from an outsourced CFO services firm can help you create an effective capital allocation framework.
1 Creating Value Through Best-In-Class Capital Allocation; Marc Zenner, Tomer Berkovitz & John HS Clark; J.P. Morgan
John W. Braine, Partner, CFO Edge, LLC