Is your capital allocation strategy driving or diminishing shareholder returns?

Authors

Evan Sussholz

EY Americas Corporate Finance Leader

Global client services partner and experienced transaction advisor who helps clients enhance shareholder value by making better decisions around capital strategy. Dedicated husband and father.

Andre Toh

EY ASEAN Valuation, Modelling & Economics Leader

Seasoned transaction advisor and valuation professional.

Jeffrey Greene

Leader, EY Corporate Development Leadership Network

Counsels senior executives on the corporate finance implications of strategic and operating decisions. Thought leader on life sciences and the capital agenda — M&A, portfolio management and valuation.

Contributors

Mike Lawley

6 minute read 3 Dec 2018

The capital allocation process must change. Without a systematic approach, companies will fail to benefit from long-term value creation.

Companies across sectors face disruptive factors such as industry convergence, geopolitical uncertainty and technology are fuelling fundamental changes to customer behaviors, which are forcing businesses to evolve rapidly. However, in our experience, a business that embraces a formal, systematic approach to capital allocation will be better positioned to reap value from this disruption and have the flexibility to quickly assess new investment opportunities that emerge. 

Without a systematic approach to capital allocation, poor investment decisions can result in low shareholder returns, financial underperformance and increased pressure from investors. Yet, in the most recent EY survey of more than 500 global CFOs, 72% admit that their capital allocation process should be improved.

Room for improvement

72%

of CFOs admit their capital allocation process should be improved.

Some noteworthy survey findings identify key areas where you can adapt your capital allocation strategy to a rapidly evolving economy and deliver value creation in a rapidly evolving economy.

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1

Chapter 1

Creating flexible decision-making

A lack of agility undermines effective capital allocation and growth opportunities.

To drive maximum value in this ongoing era of uncertainty and disruption, effective capital allocation should support business strategy and maintain enough flexibility to adjust when the need arises. However, only 40% of CFOs say that they can change their capital allocation approach quickly enough to consider new opportunities and modify pre-planned investments. 

Seizing opportunities

40%

of CFOs can be flexible with their capital.

Data isn’t the end of the story 

Despite technological advances, 41% of CFOs say that insufficient data is a primary barrier to the optimal allocation of capital. Given the speed at which business is evolving, companies must seek new ways to understand what drives profitable growth – and then find ways to acquire data to measure these drivers.

And acquiring this data isn’t the end of the story. If an organization cannot use it effectively, it must rethink the tools it is using to analyze that data and unlock the insights it contains. Data visualization tools can not only help identify trends and value key drivers, but also greatly increase stakeholder engagement.

A refined analytical process for decision making is an essential pillar of a successful capital agenda.
Andre Toh
EY ASEAN Valuation, Modelling & Economics Leader

Freeing up cash

In addition to robust data analytics, the ability to reallocate capital is essential to enable flexible decision-making.

Some organizations have strong cash cultures, where they value cash flow and do not tie up capital in unproductive areas like underperforming or noncore business units, or in certain jurisdictions where moving or repatriating capital is structurally difficult. These organizations have the advantage of using their cash opportunistically, and in a time of uncertainty and rapid change, this ability to move fast will be vital for resilience.

Managing risk

Agility enables a company to quickly react to new opportunities or threats and may entail taking on higher-risk/higher-return investments that can help companies become disruptors, rather than being disrupted. 

We believe that holding high-risk, high-reward investments – either at a corporate level or in an internal venture capital arm – can safeguard against concerns about short-term losses for business unit leaders whose financial incentives may be affected. Of those surveyed, 41% said that such investments are owned at the corporate level, while 23% said they are proposed and owned by the company’s venture capital fund. Nevertheless, one-third state that all approved projects, regardless of risk, are owned by the business unit that requested them. 

A company that prizes a cash flow culture is empowered to move quickly toward new opportunities.
Mike Lawley
EY Americas Valuation, Modeling and Economics

Disney’s approach to maintaining flexibility while taking on risk has helped it adapt to convergence and disruption in the media and entertainment industry. Its mixture of investments from its lower risk acquisition of Lucasfilm and Marvel film studios to its higher risk, but potentially higher return partial ownership of Hulu demonstrates that it is possible to maintain a flexible approach to capital allocation while maintaining a strong balance sheet. Over the past five years, Disney’s annual total shareholder return of 13% was approximately 300 basis points higher than the average of its peer group and the S&P 500.

Building trust in capital allocation
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Chapter 2

Building trust in capital allocation

Transparency in capital allocation greatly improves trust between companies and investors.

Trust is earned when companies establish a track record of successful execution and when they are transparent with investors on not only specific capital investment initiatives (such as developing a new product line, making an acquisition, or improving data capabilities), but are transparent with their investment selection process and how they strategically allocate capital. According to Doug Giordano, senior vice president at Pfizer, “if investors see you as prudent stewards of capital…they will give you more of an opportunity to invest for the long term.” 

In October 2017, Honeywell announced two divestments, worth almost US $7.5 billion in revenue. CEO Darius Adamczyk explained that the review process that led to the decision was “objective and fact-based, involving extensive analysis and input from industry experts and participants, as well as from our shareowners.” He added that “the foundation of the announcement was a set of criteria…against which each business was measured”. By strategically optimizing the business with the divestitures, Adamczyk said that he was excited to invest in any of the company’s four remaining platforms.  

The company’s thorough analysis earned broad praise, particularly from a prominent activist investor who was especially pleased with Honeywell’s detailed portfolio review. 

The reaction from the activist investor demonstrates how detailed analysis, combined with effective communication, is fundamental to building trust between a company and its investors.

By adopting a high level of discipline around how capital allocation decisions are made, C-suite, board and investor stress can be significantly reduced, and trust among key stakeholders significantly improved. 

Eight leading practices for allocating capital

The book, The Stress Test Every Business Needs, published by EY, offers guidance on how to create a cohesive approach to capital allocation through eight leading practices.

  1. Focus on a small number of metrics that reflect an outside-in perspective and tie directly to creating shareholder value.
  2. Employ consistent evaluation criteria and objective processes for all investment decisions.
  3. Establish a “cash culture” that prizes cash flow and does not tolerate unnecessarily tying up capital.
  4. Take a zero-based budgeting approach to deploying capital.
  5. Practice continuous improvement by examining each investment and implementing lessons learned.
  6. Embed stress testing across capital allocation to strengthen resilience.
  7. Align capital allocation, strategy, and communications. 
  8. Maintain information systems that generate granular data.
A business that adopts a systematic approach to capital allocation is more likely to constantly outperform its peers.
Jeffrey R. Greene
Leader, EY Corporate Development Leadership Network

The right decisions need a connected strategy

Our research shows that companies that align their management incentives, long-term strategy, and investment evaluation criteria increase in value. But of those CFOs surveyed, 42% say they have no such alignment. 

We believe tying compensation to cash flow and other measures of long-term value creation, rather than solely focusing on earning per share (EPS) or quarterly accounting metrics, can foster long-term thinking throughout the company. These types of incentives, along with embracing a culture of value creation and continuous improvement from the C-suite and throughout the business, are key ingredients in the recipe for sustainable growth and total shareholder return outperformance.

Earn the trust of investors by showing you are an effective steward of capital.
Evan Sussholz
EY Americas Corporate Finance Leader

Overall, the EY CFO survey reveals how getting capital allocation right is essential to driving, rather than derailing sustainable growth. A poor approach to capital allocation can not only result in reduced growth and lower value creation but also makes the company more vulnerable to a hostile acquisition or activist shareholders.

To build confidence in strategic decisions and drive growth and resilience, fostering a strong cash culture, focusing on making unbiased decisions based on rigorous analysis and building investor confidence will help drive a capital allocation strategy that can generate appealing returns for shareholders while maximizing value creation. 

Special thanks to Ben Hoban and Dana Nicholson for their contributions to this article.

Summary

An effective capital allocation strategy consistently creates value and sustainable growth. In today’s transformative age, CFOs need to assess capital allocation decisions faster than ever to effectively drive the shifting business objectives of an uncertain world. But poor data analytics, a culture that does not value cash flow and basic human bias are curbing CFOs’ flexibility, leaving them exposed to hostile investors and takeover bids. Making your capital allocation strategy a fundamental part of your growth strategy can drive, rather than derail growth.

About this article

Authors

Evan Sussholz

EY Americas Corporate Finance Leader

Global client services partner and experienced transaction advisor who helps clients enhance shareholder value by making better decisions around capital strategy. Dedicated husband and father.

Andre Toh

EY ASEAN Valuation, Modelling & Economics Leader

Seasoned transaction advisor and valuation professional.

Jeffrey Greene

Leader, EY Corporate Development Leadership Network

Counsels senior executives on the corporate finance implications of strategic and operating decisions. Thought leader on life sciences and the capital agenda — M&A, portfolio management and valuation.

Contributors

Mike Lawley