Key CFO Decision Rules for Capital Allocation

Capital allocation is a critical task for CFOs, yet there is limited literature on how to do it effectively. To shed light on this topic, I’ve gathered insights from CFOs, treasurers, and controllers. While I plan to delve deeper into this in the future, I want to propose some decision rules for allocating free cash flows (FCF), defined as operating cash flows minus capital expenditure. CFOs have several options for FCF use: dividends, capex, share buybacks, or acquisitions. Here are some guidelines to consider:

Maintenance Capex : It’s crucial to ensure that capital expenditures are sufficient to maintain market share. Businesses that consistently under-invest relative to their market needs are likely to fail in the long run. It’s also important to consider the role of maintenance intangible spending, such as research and development (R&D) and human capital investment, which may not always receive adequate attention.

Dividends : When setting dividends, aim for a sustainable level that can be maintained over the long term. Shareholders who rely on dividends are often wary of dividend cuts. Additionally, consider the trade-off between paying dividends and reinvesting capital in the firm. If profitable reinvestment opportunities are limited, it may make sense to distribute dividends to shareholders.

Token Dividends : Paying a token dividend, even when the FCF yield on the stock is higher than the market, can be beneficial. It can help the stock remain eligible for inclusion in certain exchange-traded funds (ETFs) that require a non-zero level of dividend payments.

Special Dividends : Special dividends should be considered when the firm has excess capital beyond its target debt levels. However, firms with volatile cash flows or those unable to maintain a regular dividend should be cautious about paying special dividends.

Acquisitions : When evaluating acquisitions, focus on the expected return on invested capital (ROIC) over the next five years. Avoid getting swayed by buzzwords like long-term synergy or transformative effects, and instead, look for clear cash-on-cash returns.

Capex : Apply the same principle of evaluating expected ROIC over five years to capital expenditure decisions. Ensure that the expected returns justify the investment.

Buybacks : Buy back stock when the intrinsic value exceeds the market price. Consider the FCF yield compared to the cost of capital or other investment opportunities. Be cautious of overpaying for shares, especially when FCF yields on stocks are poor.

Case Study: IBM : Evaluate acquisitions like IBM’s purchase of RedHat using the five-year ROIC filter. Ensure that the projected returns justify the investment and that the acquisition aligns with the company’s long-term strategy.

Case Study: Home Depot : Assess buybacks against alternative investments. Consider factors like technology investments and surplus cash. Evaluate whether the investment opportunities within the company justify buying back stock.

In conclusion, capital allocation is a complex and nuanced process that requires careful consideration of various factors. Understanding these principles can help CFOs make informed decisions about how to allocate their company’s free cash flows effectively.