Capital allocation of companies: Sources & Uses

Capital allocation of companies: Sources & Uses

Author: Joris Kersten, MSc

Kersten CF: M&A advisory and Valuations @ The Netherlands. www.kerstencf.nl

Training: Business Valuation & Deal Structuring, 5 days @ Amsterdam. 4th – 8th November 2024, registration & manual @ www.joriskersten.nl . 130 recommendations @ https://www.joriskersten.nl/nl/reviews

Source used: Morgan Stanley Investment Management, Counterpoint Global Insights. Capital allocation: Results, analysis and assessment. 2022. Michael J. Mauboussin & Dan Callahan.

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Introduction

The source of capital for companies can be external or internal.

In order to assess whether a company will require external capital, you need to look at NOPAT and ROIC.

NOPAT is net operating profit after taxes, and ROIC is return on invested capital.

In order to check whether a company needs external capital, the growth rate in NOPAT needs to be compared with the ROIC return.

Companies, whether they are young or old, that grow faster (in NOPAT) than their ROIC return, need external capital !

This is fine, and OK, but ONLY when the ROIC of the company is above the cost of capital (WACC).

Because only then the company is creating value ! (ROIC > WACC)

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Internal capital

Internal capital comes from the cash a company generates.

This includes cash flow from operations and asset sales.

In cases where the NOPAT growth is below the ROIC the company will have funds available to return to the shareholders, or to put on the balance sheet.

For companies in the US since 1980, internal financing has been the primary source of capital.

These companies have also added new debt steadily, apart from some years when the economy was in a recession.

And these companies have also retired equity on average.

And “net equity issuance” is even negative for the Russell 3000 after taking stock based compensation into account.

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Capital structure

The debt to total capital ratio is a measure of “capital structure”.

So it says something on how companies finance their operations.

We can look at this ratio for companies in the Russell 3000 from 1985 – 2021 (see source used for this blog). Companies in the financial and real estate sector are excluded.

Debt to total capital ratio is defined as:

Book value of debt / ( book value of debt + market value of equity )

That ratio was for 2021 on average 16%.

This versus the long term average of about 31%.

In spite of a general decline in interest rates during 1985 – 2021, capital structures have become more conservative.

This even with for example “10 year US treasury note yields” of 10.6% in 1985 and 1.5% in 2021.

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Uses of capital

Companies can use capital to either invest in the business, or to return it to the claimholders.

Internal investments are for example:

·???????? CAPEX = capital expenditures;

·???????? Working capital;

·???????? Investment in R&D;

·???????? Investment in SG&A (excluding R&D) = investments in “intangible assets”.

But firms can also make external investments like:

·???????? Mergers & Acquisitions (M&A).

When we look at how companies spend their money in the US since 1985, we get to the picture as shown below.

Mergers & Acquisitions (M&A)

M&A consistently is the largest share of capital companies allocate !

But these M&As are very cyclical and it matches the ups and downs of the economy and the capital markets.

For example, M&A was about 22% of sales in 1998 during the “dot com boom”.

But M&A was as low as 3% of sales during 1991 when the US economy was in recession.

The average was about 9% of sales yearly.

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Investment SG&A (excluding R&D)

This basically is internal spending that creates intangible assets.

You see a steady increases here, so we get more and more intangible assets.

This item grew from 5.8% of sales in 1985 to 7.1% in 2021.

And when we add investment R&D expenses, total spending on intangible assets went from 7.1% in 1985 to 9.4% in 2021.

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CAPEX (capital expenditures)

CAPEX as a percentage of sales declined from 1985 to 2021.

But this is in line with the shift from “tangible assets” to “intangible assets”.

CAPEX were 9.7% of sales in 1985 and went down to 5.7% of sales in 2021.

This reduction also reflects a shift in “sector composition” for public companies in the US.

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Share buybacks

Share buybacks went from 1.5% of sales in 1985 to 5.4% of sales in 2021.

This shows a change on how companies return money to shareholders.

From 1985 to 2021 buybacks went from 0.6 times dividends to 1.6 times dividends.

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When we look at the “sector composition” of companies in the S&P 500, we find answers on why companies allocate their capital differently today compared to a few decades ago.

“Information technology” and “healthcare” companies went from 20% of the market in 1985 to more than 40% in 2021.

And during 1985 to 2021 energy companies, materials companies and industrials went from 34% to 13% of the market.

So the capital allocation mix, and changes from tangible to intangible assets, fit the evolution of the sector division from 1985 to 2021.

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Back to ROIC and growth in Invested Capital (IC)

Capital allocation is very important because:

Aggregate ROIC > the aggregate growth rate of NOPAT.

Basically this means:

Companies are generating excess cash !!

The average ROIC was 9.1% from 1990 to 2021 (companies for the Russell 3000).

Here the NOPATs and balance sheets were cleaned for internally generated intangible assets.

And the average growth in NOPAT was 8.5%. So this is lower than ROIC !

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Excess cash

The average growth in invested capital (adjusted for inflation) was about 4%, on average, during 1990 – 2021 (see source used for this blog).

Here the definition of invested capital (IC) is WITHOUT excess cash.

The combination of excess cash generation, and the change in sector composition, has led to higher balances of cash and short term investments.

The average of excess cash + short term investments as a percentage of assets, was for the Russell 3000 estimated at 5.4% on average (during 1985 to 2021).

And this was estimated at about 2% in 1985 and at about 10% in 2021, so it grows !

Reason = Aggregate ROIC > Aggregate NOPAT growth.

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Capital allocation

Companies need to be careful on how to deploy these "excess funds", because they will not make the “opportunity cost of capital” as a return.

But of course they can function as a buffer.

In the upcoming weeks I will discuss the alternatives, next to excess cash/ short term investments, for capital allocation.

I will discuss the following capital allocations in depth:

1.????? M&A;

2.????? Investment SG&A (excl. R&D) = intangibles;

3.????? CAPEX;

4.????? R&D;

5.????? Net working capital;

6.????? Divestitures;

7.????? Dividends;

8.????? Share buybacks.

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So see you next week again with a new blog !

Thanks for reading, best regards, Joris????

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Source used: Morgan Stanley Investment Management, Counterpoint Global Insights. Capital allocation: Results, analysis and assessment. 2022. Michael J. Mauboussin & Dan Callahan.