Capital allocation is a critical task for CEOs and CFOs, yet there is a lack of literature on how to effectively navigate this process. In my conversations with CFOs, treasurers, and controllers, I have gathered insights that I plan to share in the coming weeks. However, for now, I want to propose some basic guidelines for CFOs and boards when it comes to allocating free cash flows (FCF), which is calculated as operating cash flows minus capital expenditure.
When deciding how to use FCF, there are several options available to CFOs: paying dividends, investing in capex, buying back shares, or making acquisitions. But how does one determine the appropriate allocation? Let's explore a few factors to consider:
1. Maintenance Capex: It is crucial to assess whether the deduction for capex in calculating FCF is sufficient to maintain the business's market share. Consistently under-investing in capex can lead to long-term failure. Additionally, CFOs should also prioritize spending on maintenance intangibles like research and development and human capital.
2. Dividends: Set dividend payments at a sustainable level to avoid disappointing dividend-dependent shareholders. Consider the trade-off between paying dividends and reinvesting that capital in the company. If profitable opportunities for reinvestment are limited, distributing dividends may be a prudent choice. Moreover, consider how shareholders might use the dividend payment and evaluate alternatives such as the FCF yield of the S&P 500 or Total Stock Market Index compared to your own FCF yield.
3. Token Dividends: Even if the FCF yield on the broader market is lower, paying a token dividend can be advantageous. It ensures eligibility for inclusion in ETFs requiring non-zero dividend payments and reassures investors that management is focused on prudent capital allocation.
4. Special Dividends: A special dividend may be appropriate if the company has excess capital beyond its targeted debt level. However, firms with fluctuating cash flows or an inability to sustain regular dividends should exercise caution when considering special dividends.
5. Acquisitions: The expected return on invested capital (ROIC) of an acquisition over the next five years is crucial in evaluating its economic viability. Avoid being swayed by buzzwords and focus on understanding the post-acquisition integration challenges. The projected ROIC should exceed the returns provided by stock buybacks or dividend payments.
6. Capex: Apply the same decision rule used for acquisitions to assess the expected ROIC of capex investments over the next five years.
7. Buybacks: Stock buybacks are warranted when the intrinsic value of the stock exceeds its market price. Consider the FCF yield, in comparison to the cost of capital or other alternatives, to validate the economic sense of buybacks. Bear in mind that large companies in the S&P 500 often appear overpriced.
In conclusion, capital allocation is a complex endeavor with no one-size-fits-all approach. Every CFO and company may have their unique heuristics. The guidelines presented here offer important considerations for CFOs and boards to make informed decisions about allocating their FCF. If your company follows a different approach, I’d love to hear about it. Stay tuned for more insights on this topic in the coming weeks.
