Capital Allocation

Firms should invest in innovation while cutting losses when a strategy is unlikely to pay off. This is an explicit recognition of the value of quitting

The research shows that companies that are more proactive in their internal resource allocation generate a higher ROA than those that are more conservative.

There is also evidence that companies that are good at internal capital allocation are also effective at external allocation

Capital allocation is ultimately about assessing opportunities and executing on the ones that are attractive. As such, it requires a willingness to be a buyer or a seller given the circumstances. 

“What is the right amount of capital (and the right number of people) to have in this business in order to support the strategy that will create the most wealth?”182 The answer is based on the future and does not rule out reducing net investment when appropriate.

Great capital allocators always have a sense of the difference between price and value in all of their businesses. And, as important, they are willing to act to build value when those gaps become large enough to overcome frictions such as taxes and fees.

A more suitable mindset is that capital is accessible but comes at a cost...

many executives act as if the cash that the business generates is essentially free. The right mindset is that all capital, whether from an internal or external source, has an opportunity cost. 

Cash deals do better, on average, than deals funded with equity or a combination of cash and equity.36 The basic idea is that management of the buyer will finance a deal with cash if it thinks the stock of its company is undervalued and will use stock if it thinks it is overvalued. Cash deals also provide a higher payoff for the shareholders of the

Capital allocation should support a company’s strategic goals. Capital allocation should start with an assessment and approval of strategies and then determine which projects support the strategies.

M&A is by far the largest source of redistribution of corporate resources among the capital allocation alternatives. M&A deals in 2021 totaled nearly $2.6 trillion, or 13.5 percent of sales. The chart shows that M&A tends to be cyclical. Early movers tend to do better than companies that buy later in the cycle.