Capital Allocation and Value Creation: A Market-Based Framework for Executives

✍ Scribed by Torbjörn Arenbo

• Publisher: Palgrave Macmillan
• Year: 2023
• Tongue: English
• Leaves: 239
• Category: Library

✦ Synopsis

By adopting a practical, market-oriented approach to capital allocation, this book sheds light on the complex issue of cash flow deployment and the creation of shareholder value. In order to run a company efficiently, it is not sufficient to simply be a competent businessperson. One must also possess the skills of a knowledgeable investor. The management must determine where to invest capital given the diverse range of investment options available, such as mergers and acquisitions (M&A), dividends, share repurchase programs, and organic growth opportunities.

This book provides a useful analytical framework for corporate executives to consider when allocating capital, along with empirical findings from peer group studies and company case studies.

The book helps answer the following questions:

· What are the primary factors that drive your company's shareholder value? Are they aligned with the strategy the company is pursuing?

· What are the key dynamics and trade-offs between return on investments (ROIC), growth, and earnings quality?

· What are the current market expectations embedded in the stock price?

· Given the capital allocation priorities, what does an “optimal” capital structure look like?

· How do you set, and in turn communicate, the capital allocation and funding priorities?

Written by an expert with more than 25 years of experience, this book helps business executives improve their skills as capital allocators by better understanding the financial markets.

✦ Table of Contents

Acknowledgements
Contents
Abbreviations
List of Figures
1 Introduction
To Master Capital Allocation, You Have to Think Like an Investor
The Corporate “Eco-System”
Using the Market for Guidance
The Structure of the Book
References
Part I The Value Drivers That Matters
2 Value Creation—The Theoretical Foundation
The Three Drivers of Value—Profitability, Growth, and Cost of Capital
Return on Invested Capital
A Basic Understanding of ROIC
ROIC and Competitive Advantage
Differentiation Versus Cost Leadership Strategies
Growth
Balancing Profitability and Growth in the Valuation Framework
Balancing Profitability and Growth in Real Life
Cost of Capital
Earnings Quality as a Proxy for the Cost of Capital
CFOs Prefer Using the Capital Asset Pricing Model (CAPM)
Why Using CAPM and WACC Could Lead You “Precisely Wrong” Rather Than “Roughly Right”
The Market-Implied Cost of Capital
Asking the Market Participants
The Cost of Capital for Your Company
Cost of Capital Over Time and Across Sectors
How to Use and Interpret Valuation Multiples
Which Valuation Multiple Should You Consider?
Price to Earnings (P/E)
Enterprise Value to EBITDA (EV/EBITDA)
Enterprise Value to Operating Earnings (EV/EBIT or EV/EBITA)
Benefits of Understanding Valuation Multiples
Limitations and Common Pitfalls Using Valuation Multiples
Conclusions
References
3 Market-Based Insights to Capital Allocation
A Description of the Total Shareholder Return Framework
Peer-Group TSR Study
General Findings—A Brief Summary
ROIC—Where It All Starts
Growth—A Double-Edged Sword
Margin Stability and the Cost of Capital
Valuation Multiples per Quartiles
Top and Bottom Performers—A Head-to-Head Comparison
Top Performers
Bottom Performers
Is There a Destiny with Belonging to a Sector?
Case Study: Royal Unibrew vs Carlsberg
The Pre-crisis Period (2006–2009)—Focus on Growth
The Post-crisis Period (2009–2012)
From 2013 Onwards
Case Study Summary
Case Study: Elisa vs Telia
The Local Challenger Versus an Expanding Market Leader
The First Period (2006–2013)—The Devil Is in the Details
The Second Period (2014–2020)—Time to Harvest the Investments
The Evidence
Case Study Summary
Conclusions
Reference
4 Earnings quality
What is Earnings Quality?
Quantifying Earnings Quality
Margin Volatility and Valuation
Business Strategy
Methods for Achieving the Strategy Change
Case Study: Nolato
Earnings Quality and Shareholder Value Creation
Conclusions
Reference
Part II Cash Flow Deployment Alternatives
5 The Art of Deal-Making
What the Empirical Evidence Tells us About M&A and Value Creation
A Meta-Study Review
Public versus Private Deals
Price for Private Targets is Lower Due To Size And Liquidity Discount
Preferred Buyer
Public Deals Are More Risky
Probability of M&A Success Based on Deal Type
Reviewing our Nordic Peer Group from an M&A Perspective
Size Seems to Matter a Great Deal
The Nordic Sample According to the Clark and Mills Categorisation
Synergies—The Key to Unlock Value
How to Pay for an Acquisition
Conclusions
References
6 Portfolio Optimisation and Why Less So Often Is More
The Investor’s Take On What to Keep and What to Divest
Not Always a Conglomerate Discount
Multiple Drivers Behind Divestiture’s Operational Success and Failures
Different Ways to Divest a Business Unit
Study Review—Nordic Spin-Offs
Strong Performance on Average But with a Wide Dispersion
TSR Drivers for the Various Groups
Case Study: Novo Nordisk and Novozymes
Conclusions
References
7 Shareholder Remunerations—Time to Give Back?
Why Dividend Policy Matters for Value Creation
The Power of Compounded Dividends
Ways to Distribute Excess Cash
Ordinary Dividends
Share Buybacks (SBB)
SBB—What to Consider?
Conclusions
Reference
8 The Balancing Act of Finding the “Optimal” Capital Structure
Capital Structure from the Academic Perspective
Minimizing the Cost of Capital
The Pecking Order and the Signalling Theory
Debt as a Corporate Governance Tool
Capital Structure from a Practical Perspective
The Cost of Financial Distress
Valuation Risks
Losing Business
Ownership Dilution
Forced Divestments
Underinvestment
Option Value of Financial Flexibility
Strategic Capex
Acquisitions
Dividends Through the Cycle
Working Capital and Customer Finance
How to Measure Leverage
Rating Agencies and Capital Structure
Conclusion
References
9 Winning Financial Strategies—Funding and Risk Considerations
Liquidity Back-up
Access to Capital
Credit Rating
Maturity Profile
Hybrid Bonds
Key Credit Ratios and FX Risks
Conclusions—Putting the Pieces Together
Part III Reading the Market and Thinking Like an Investor
10 Financial and Macro-economic Backdrop
Pre-COVID-19—Great Moderation and Secular Stagnation
The New Game Has Come—And We Are Still Making Up the Rules
Post-COVID-19—Are We Heading for a New “Financial Regime”?
Financial Regimes and Valuation
Conclusions
References
11 Adopting an Investor Mind-Set
Disciplined Rule-Based Investing
Develop a Risk vs. Reward Mind-Set
Risk Tolerance
Distribution and Probabilities
Expected Value
Thinking in Scenarios
Benefits of Stress Tests
Capital Budgeting and Scenario Thinking
How to Think When Setting Up Scenarios
Shareholder Activism
Conclusions
References
12 Downturns Rearrange the Board
Sharp Divergence in Performance During the Downturn
Recession Winners Pulled Ahead and Excelled Also in the Post-recession Period
Growth Was the Largest TSR Driver for Recession Winners
Necessary to Move Past Survival Mode
During a Downturn, the Best Defence Can Be a Good Offensive
A Solid Financial Footing
Case Study: Lindab
Equity Story and Business Case Leading Up to the Financial Crisis
Highest Leverage in the Sector
Growth Took a Beating After the Recession
Could a Stronger Balance Sheet Have Opened Up for a More Offensive Post-recession Strategy?
Conclusions
References
Part IV Put It All Together
13 Financial Targets and Policies—Capital Allocation Priorities in Essence
Starting with Shareholder Feedback
Financial Targets Should Express the Company’s Ambition to Create Value
Case Study: A Telecom Company
Case Study: Church & Dwight
Capital Allocation Priorities
The “Self-Sustaining” Model
Pros and Cons with Different Targets
Earnings Quality—The Missing Piece of the Target Puzzle
Difficulties with Earnings Quality Targets
Risk with Unbalanced Targets
Earnings Quality in a KPI and Incentives Setting
TSR Rooted Targets That Changed Over Time—Coloplast Case Study
Stage 1-Growth at Any Price
Stage 2-Balanced Profitable Growth Strategy
Stage 3-Back to a More Rigid Growth Target
Business Strategy and Financial Targets—Atlas Copco Case Study
Business Strategy
Financial Targets
Mapping the TSR to the Group-Wide Components of the Business Strategy
Case Study Summary
Conclusions
References
14 An Investor-Based Evaluation Process
What are the Main Drivers of Total Shareholder Return?
What do the Capital Allocation Priorities and Historical Cash Flow Deployment Look Like?
Financial targets
Cash Flow Deployment
Peer Comparison
What are the Current Market Expectations Embedded in the Valuation Multiple?
What Does an “Optimal” Capital Structure Look Like Given the Capital Allocation Priorities?
How Can the Capital Allocation and Financial Targets Be Communicated to the Market?
Are the Communicated Targets in Line with the Market’s Views of Value Creation?
Are the Targets Consistent with Each Other?
Priority of Targets
15 A Three-Step Capital Allocation Framework
Step 1—Determine the Relative Importance of the Three Value Drivers
Emphasis on the ROIC and the Durability of Excess Returns
Earnings Quality and Cost of Capital
Growth—A Double-Edged Sword
Step 2—Evaluating Cash Flow Deployment Options With a “Risk-Reward” Mind-Set
Maintenance and Strategic Investments
Acquired Growth—Comes With a Higher Risk to TSR
Why Less So Often Is More
Returning Excess Cash
Capital Structure
Step 3—A Practical Guide to Capital Allocation Priorities
Financial Target Priorities Aligned With Long-Term Value Creation
Reference
Correction to: Capital Allocation and Value Creation
Correction to: Chapters 3 and 10 in: T. Arenbo, Capital Allocation and Value Creation, https://doi.org/10.1007/978-3-031-47048-6_3 https://doi.org/10.1007/978-3-031-47048-6_10
Appendix 1: Evaluating Management’s Capital Allocation Skills
Appendix 2: A Business Strategy Summary
Appendix 3: ROIC Calculation Extended
How to Think About Intangible Assets and the Use of ROIC
References
Index