Best Capital Allocation Practices for CFOs

As a CFO, your mind is constantly on finances: Where’s the money coming from? How’s cash flowing through the business? And, of course, what are the best ways to allocate your company’s capital?

If that’s where your head is at, it’s in the right place.  As CFA Ryan Barnes puts it, “Capital allocation decisions are vital in determining the future of the company and, as such, are some of the most important responsibilities of company management.”

The pandemic has escalated the importance of capital allocation even further.  A recent EY survey revealed that 56% of CFOs believe “their capital allocation strategy needs to be completely rethought,” and 80% reported that, at the very least, “their capital allocation process needs to be improved.”

In this article, we dive into four areas of capital allocation, exploring why crises like the COVID-19 pandemic are the perfect time to take on certain types of risks (like investing in growth areas and pursuing M&A) and to limit or eliminate shareholder payouts (like dividends and buybacks).

Organic Growth: Reallocate Capital, Especially to Growth Areas

The impulse during a crisis like the COVID-19 pandemic might be to eliminate spending wherever possible. But, as the Boston Consulting Group notes: “[T]he growth areas after a shock are likely to be different than those that existed before it. Crises often cause a shift in customer preferences, as people are forced to unlearn old habits and adopt new ones.” By extension, crises open unforeseen or previously non-existent investment opportunities.

Instead of hoarding cash when uncertainty strikes, savvy CFOs should have their eyes out for areas of potential growth where they can reallocate capital. But how can CFOs accurately identify areas of potential growth?

Harvard Business Review outlines a simple, two-step process for conducting such evaluations, specifically during the pandemic. First, CFOs should “start by drilling down from a big behavioral shift to identify specific products or business opportunities that are likely to grow or contract as a result of the pandemic.”

As an example, the pandemic has meant that many people are spending more time working at home. On one hand, this might signal a decrease in spending on traditional office workspaces, but on the other hand, an increase in spending on home office supplies. When one door closes, another opens.

After identifying areas of potential growth or decrease, the second step is to “categorize behavioral shifts according to whether they are likely to be short- or long-term and whether they existed before the pandemic or are new since it began.” Breaking things up in this way will further help uncover which trends are likely to last just through the crisis and which are actually here to stay.

Which products and business units you, as a CFO, decide to reallocate capital towards will depend on the specifics of your market and industry. But as a general rule of thumb, the best investment bets will be those trends that are poised to stick around long after COVID-19 is out of the picture.

Inorganic Growth: Keep Going with Mergers & Acquisitions

In the best of times, M&A is a risky part of a capital allocation plan. It’s no surprise, then, that M&A tends to be one of the first things that gets  shut down during periods of decreased performance or economic uncertainty. A 2019 report from the International Corporate Governance Network states, “While M&A deals offer a great potential for significant value enhancement, much academic research suggests that M&A activity destroys value.”

Counterintuitively, companies that engage in M&A during crises like the pandemic tend to do better than those that don’t.

Ernst & Young partner Evan Sussholz and senior manager Ben Hoban write, “EY research shows that companies that made acquisitions or divested businesses during the last global financial crisis saw significantly higher total shareholder returns (approximately 60% vs. 40%) in the years following the crisis.”

The message is clear: if your capital allocation strategy already includes M&A for 2021, keep going. If you’ve been avoiding M&A, the pandemic might be a good time to consider taking on the sort of high-risk, high-reward activity that M&A represents.

Due diligence still matters, and you should treat any prospective M&A deals with the same care you would if there wasn’t a pandemic happening. As Intuit CFO Neil Williams points out, that means doing build-or-buy analyses and understanding whether new products, features, and capabilities are faster to purchase externally or create in-house: “We’ll put the dollars toward M&A when it makes more sense to acquire the technology in order to get to market faster and more efficiently,” says Williams. Otherwise, better to just build internally.

Dividends: Maintain Them if Possible, Slash Them as Necessary

During a crisis, companies should keep cash on hand to support organic and inorganic growth initiatives. That means reducing shareholder payouts like dividends and stock buybacks (more on this in the next section), at least until the pandemic ends.

If your company had a pre-pandemic practice of issuing dividends, you have a few options. First, investors will likely be understanding and flexible regarding changes in dividend payouts given the circumstances of the pandemic, as ICGN has written. That means you can expect at least some leeway around the size of the dividends you issue and the frequency with which you pay them.

ICGN also points out that “dividends themselves are in many ways a social good insofar as they support the livelihoods of ordinary pensioners and long-term savers—including many retail investors.” If your company is able to reasonably maintain dividends without destabilizing the financial future of your operations, it’s a good idea to keep it up.

The pandemic (or any other crisis) will typically not be an ideal time to launch a program of rhythmically doling out dividends. So, if dividends aren’t already part of your company’s capital allocation policy, 2021 is not the year to start.

Stock Buybacks: Just Say “No”

As mentioned above, crises like the pandemic are times when companies should be prudent with their cash, reserving it for maintenance and growth rather than returns for shareholders. With the pandemic’s ongoing uncertainty likely to last through 2021, it’s best to keep stock buybacks out of your capital allocation plans and instead to invest that money back in the business or keep it around to help weather future instability.

This advice about avoiding stock buybacks might be usefully applied even when there’s no crisis to worry about. In a recent opinion piece,  MarketWatch writer Philip van Doorn describes how in the decade leading up to the pandemic, six major airlines (Southwest, Alaska, Delta, United, American, and JetBlue) spent 96% of their capital on stock buybacks. When the pandemic hit in late 2019 and early 2020, these airlines didn’t have any cash on hand to keep themselves afloat and were forced to seek bailouts from the government.

Whether or not your company has engaged in stock buybacks in the past or wishes to engage with them in the future, the bottom line is that until the pandemic is over, the best practice is to keep cash in the business and spend it in ways that will foster long-term company health and stability.

Evaluate Your Capital Allocation Strategy Continuously

As you shift and update your capital allocation plan to incorporate these best practices for 2021, keep in mind that nothing should be set in stone. Markets change rapidly, and a brilliant move today could prove disastrous tomorrow. That’s why it’s best to revisit and revise your strategy continuously. As  McKinsey research has observed, companies that regularly evaluate their businesses and adjust their capital allocation plans accordingly tend to be worth, on average, 40% more after 15 years than companies that do not.
In your journey of constantly evaluating and updating your capital allocation strategy,  Planful is here to help you and your FP&A team. Offering a single source of truth for all of your financial data, our platform gives you the agility you need to navigate and respond in real-time to today’s dynamic financial business challenges.

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