1. Focus on the metrics that matter to shareholders

Using the right core measures and targets lays the foundation for effective capital allocation. Investors use them to judge short- and long-term performance:

• Net present value (NPV), calculated via DCF analysis, continues to be the best metric for evaluating new capital investments, and for determining the value of assets in place.
• ROIC works well for assessing the performance of existing assets, such as business units, products, and brands. Activist shareholders strongly favor ROIC in evaluating a company’s capital efficiency.
• Total shareholder return provides an outside-in look at overall company performance. TSR factors into a growing number of executive compensation plans.

Guided by these three critical financial metrics, you can establish processes and select tools for informed decision making around capital deployment.

Note that we do not include two of the most talked-about performance measures, revenue growth and EPS. Both are easy to observe and explain, but they are only indirectly and imperfectly related to value creation. Pursuing growth for its own sake often destroys value, as when companies overpay for acquisitions. Using roll-up strategies to consolidate fragmented industries can create value, as first movers are initially able to acquire businesses at attractive prices relative to the value that can be extracted. But as time progresses, competition for the most desirable targets shifts more and more of that value to sellers through the purchase price. Doing more acquisitions at uneconomic prices (NPV less than zero) definitely grows revenue and can increase EPS, but actually destroys shareholder value.

Repurchasing shares also raises EPS but does not create value by itself. By virtue of basic arithmetic, buying back shares of stock raises EPS for the remaining shareholders, but their aggregate value stays the same—when the shares are fairly valued.

2. Employ consistent evaluation criteria and objective processes for all investment decisions

As a general rule, you should fund all investment opportunities with a positive NPV. So if an incremental dollar is then invested anywhere across the enterprise, it will yield a return equal to the project’s cost of capital. If it doesn’t, that could be a symptom of deeper problems. CEOs and CFOs deviate from this rule for a few legitimate reasons:

• Resource constraints. Consider a technology firm with a finite number of software engineers to staff its investment projects. The company needs to allocate capital to those projects that will generate the greatest NPV for the talent available. Managers should calculate a “profitability index” by dividing each project’s NPV by the number of engineers required, and then fund projects from highest to lowest until the engineer pool is exhausted.²
• Difficulty estimating cash flows. When managers lack confidence in their ability to forecast results, they could decline projects with an ostensibly positive NPV. The nature of the uncertainty may call for an alternative to DCF such as real options valuation.

These deviations from the rule to fund all positive-NPV projects can have far-reaching negative consequences on value:

• Rationing capital with self-imposed constraints. When senior management assumes business leaders who make capital requests are gaming the process by inflating cash flow forecasts, CFOs typically respond by setting hurdle rates substantially higher than the project’s cost of capital. This sets in motion a vicious circle: managers inflate their forecasts even more and their leaders trust them even less. Discount rates that are unnecessarily high also destroy value by encouraging managers to seek out overly risky projects in order to clear the excessively high hurdle rates.
• Applying a single, company-wide hurdle rate. If you set a single discount rate for all investment opportunities, your firm will underfund projects with a lower required cost of capital, and overinvest in those with a higher capital cost. Similarly, you may misprice or fail to pursue acquisitions and reject fair offers for businesses that should be divested, as shown in Figure 3.1. We see this behavior when political wrangling over different assigned discount rates overwhelms the CFO, who publishes a single rate, then hopes to subjectively adjust for project- specific risks.
• Emphasizing metrics such as EPS or revenue growth instead of NPV. Some large biopharmaceutical companies that describe themselves as “cash rich and EPS poor” underinvest in value- creating projects in order to achieve earnings targets.
• Allowing multiple, inconsistent approaches across the company. Large, multibusiness firms often use different models, metrics, and processes across R&D, corporate development, and manufacturing. Unless all investments compete for funding on a level playing field, how can you expect to optimally allocate capital? Or, at the beginning of a planning cycle, firms allocate a pool of capital to each business unit and then end up over- and underinvesting in opportunities across the company.
• Succumbing to politics, influence, and CEO hubris. Despite widely reported failures of ego-driven acquisitions, too few companies have sufficient checks and balances in place to ensure a thorough vetting of investment projects. Company leadership needs to encourage challenges from all levels so that the loudest or most powerful voices don’t automatically drive capital allocation. Open debate on capital requests that includes multiple perspectives helps test underlying assumptions and drive a merit-based evaluation process.

3. Establish a “cash culture” that prizes cash flow and does not tolerate unnecessarily tying up capital

William Thorndike’s study of outperforming CEOs, The Outsiders, has become a kind of manifesto for activist shareholders. Thorndike, cofounder of Housatonic Partners, identified the outsider CEO’s “genius for simplicity, for cutting through the clutter … to focus on cash flow and to forgo the blind pursuit of the Wall Street holy grail of reported earnings.”³ Optimizing free cash flow rather than EPS was the key to a strong long-term valuation. “[T]his emphasis on cash informed all aspects of how [successful outsider CEOs] ran their companies–from the way they paid for acquisitions and managed their balance sheets, to their accounting policies and compensation systems.”

In addition to optimizing free cash flow from operations, leading capital allocators are always on the lookout for ways to generate cash from currently invested capital, including:

• Liberating excess working capital. In EY’s regular industry-specific studies of working capital management, we consistently find that most companies have 5–10% of sales tied up in unproductive working capital. (See Chapter 8 for a full discussion.)
• Monetizing unused or underused assets. With greater investor scrutiny of capital allocation, companies have sold more off-strategy brands, excess real estate, and surplus R&D projects; unfortunately, some managers continue to unnecessarily stockpile assets for a rainy day.
• Divesting businesses that could be worth more to others. A rigorous portfolio management process regularly tests whether converting a business or holding on to it contributes more to current enterprise value.

4. Take a zero-based budgeting approach to deploying capital

Active reallocation of resource budgets–management time, talent, capital, and operating expenses–can lead to significantly higher TSR.⁴ We go further and advise CEOs and CFOs to take a zero-based budgeting approach to currently deployed capital. One of our preferred techniques is to perform a “virtual carve-out” of each business unit, regardless of whether management intends to divest it. This involves many of the planning steps for an actual divestment, in particular determining appropriate stand-alone costs in order to value the business properly. With a “what it’s worth to us” valuation in hand, management can weigh the likelihood of netting substantially more in proceeds from a sale against the strategic implications and operational feasibility of divesting. We discuss this in more detail in Chapter 4 on portfolio management.

As an added benefit, by highlighting virtual stranded costs–those expenses that would be left behind–the virtual carve-out exercise stimulates an in-depth examination of corporate cost centers to identify rationalization opportunities. In our experience, cost-reduction potential often represents a significant portion of the business’s EBITDA.

5. Practice continuous improvement by examining each investment and implementing lessons learned

Installing a robust post-investment review (PIR) process has become axiomatic, yet few companies have adopted the practice. Three main barriers hold management back:

1. Human nature keeps people from admitting their own mistakes, and it’s much easier to critique someone else’s work. We find the best time for PIR implementation is after a change in senior management, especially the CEO or CFO.
2. The quality of documentation for the initial decision directly correlates with the ability to assess improvement opportunities. If the board-approved financial model, synergy assumptions, and 100-day plan are all clear, then it’s relatively easy to evaluate the acquisition after the fact.
3. Once identified, lessons learned need to be put into practice, instead of having to learn the same lessons over and over again. For example, companies can use results from their PIRs to regularly refine their acquisition and divestment playbooks.

6. Embed stress testing across capital allocation to build resilience

Just as stressors come in many forms, companies have multiple ways to improve resilience through their approach to allocating capital:

• Mindset. Acknowledge that value creation inherently links to the risks and uncertainties associated with investment evaluation, selection, and structuring. A corporate culture that anticipates and prepares for a wide range of stressors is more likely to thrive.
• Transparency. Articulate actionable capital agenda priorities so investors can monitor interim progress and assess management’s credibility. In 2016, Larry Fink, chairman and CEO of BlackRock, wrote to all S&P 500 CEOs, “We continue to urge companies to adopt balanced capital plans, appropriate for their respective industries, that support strategies for long-term growth. We also believe that companies have an obligation to be open and transparent about their growth plans.”⁵ In his 2018 letter Fink urged CEOs to “publicly articulate your company’s strategic framework for long-term value creation.”

• Credibility. Establish a track record with investors of delivering on your capital plan with strong relative TSR in good times and bad, in order to ward off activist critiques and hostile acquirers. When Bill McNabb was CEO of Vanguard, one of the world’s largest investment managers, he counseled:

  From Vanguard’s point of view, we’re in the relationship to maximize the value of the longest of long terms for our fund investors. We understand that things don’t always go up in a straight line. So if we have a good relationship with a company, they have a great opportunity to tell us their story. If there are performance problems, for example, either own those problems or tell us what you’re doing to fix them.⁶

• Agility. Streamline decision making so you can react quickly to new opportunities and threats as they emerge. Complement this agility by maintaining sufficient financial capacity to seize attractive investment opportunities that arise under high uncertainty. For example, empirical evidence supports the wisdom of buying early within a wave of industry consolidation or restructuring. One study found that early acquirers earned returns seven percentage points higher than those who bought near a wave’s peak.⁷
• Natural hedging. Fund multiple emerging business model experiments to hedge against strategic obsolescence. With the accelerating pace of disruptive forces like digitalization that affect core elements of every value chain, selecting a single strategy that will succeed is not possible.

7. Align capital allocation, strategy, and communications

Companies set strategy by deciding in which markets to operate, how to serve customers, and which activities will result in superior shareholder returns. Effective capital allocation translates these choices into economic reality. In the words of Richard Brealey and Stewart Myers, “Strategic planning is a top-down approach to capital budgeting: you choose the businesses you want to be in and make the capital outlays for success.”⁸ Within your organization, executives need a common understanding of how they’ll make capital allocation decisions to implement your strategy. The most important guiding principles are setting investment priorities and defining how they will balance among the following trade-offs (for more information, see ey.com/capitalagenda):

• Organic versus inorganic growth
• Short-term versus long-term results
• Low-risk/low-return versus high-risk/high-return investments
• Reinvestment versus shareholder payouts
• Dividends versus share repurchases

EY recently facilitated a capital allocation workshop for 20 senior executives at a Fortune 50 company. During the debriefing, one of the operations leaders said the session was very valuable “because we learned how the CFO thought about setting investment priorities.” Not surprisingly, much of the self-diagnosis during the workshop centered on the lack of consistency in investment criteria across organizational silos.

CEOs and CFOs must also communicate this shared view of value creation to investors, creditors, and other external stakeholders. Two important success criteria are transparency–“Do they understand it?”–and credibility–“Do they believe in it?” Transparency and credibility are essential not only for resilience but also for converting strategy and operations into value. Doug Giordano, Pfizer senior vice president, worldwide development, explains how investor credibility enables management’s flexibility:

If investors see you as prudent stewards of capital and you’re actually beginning to reap some current benefit from past investments, they will give you more of an opportunity to invest for the long term. If you start to lose that credibility, investors are going to want their money back sooner, in the form of dividends and repurchases.⁹

8. Maintain information systems that generate granular data

Information systems and management accounting policies enable effective capital allocation when they supply data to support decision making around new investments and already deployed capital. With activist shareholders’ focus on capital efficiency, your inability to calculate ROIC for individual businesses, products, geographies, and other assets can be a point of vulnerability. Achieving this level of accuracy depends on economically rational cost allocations that remain consistent over time, as well as establishing reliable balance sheets for each business. Management incentives will align better with desired outcomes when business unit profit-and-loss statements (P&Ls) reflect a charge for their use of capital. For performing a virtual carve-out, critical data include each entity’s tax attributes and its role in the parent’s overall tax strategies (such as transfer pricing).

Research and development

Applying our quantify-debate-judge approach to R&D is particularly challenging for pharmaceutical companies because any positive cash flows from new drugs come years after committing substantial R&D funds; quantitative analyses based on DCF are extremely sensitive to underlying assumptions. Pharmaceutical executives might base R&D funding primarily on the judgment calls of senior scientists because of their own discomfort with relying on a “cloud of numbers.”

Here are a couple of reasons for a more balanced consideration of quantitative analysis:

• Regardless of the uncertainties around future outcomes from such investments as early-stage oncology drug candidates, oil exploration, or geographic expansion into emerging markets, investors will do their own valuations of these assets when gauging the company’s stock price. CEOs and CFOs need to have a well-defined point of view on valuation to guide investor discussions.
• Structuring investments like these–with payoffs far in the future–often requires reaching agreement with multiple third parties over how to share capital contributions, operating expenses, and profits. This can’t be done with a qualitative focus; you need a thorough quantitative understanding of the risks, returns, and valuation implications under various structures.

Share repurchases

We agree with Warren Buffett’s guidance that, under most circumstances, you should repurchase shares only when both of these two situations exist:

1. Share price is well below intrinsic value. The converse, buying back stock when market value is above intrinsic value, transfers value from remaining shareholders to the sellers.
2. Cash held exceeds operational and liquidity needs. Assuming the current capital structure is optimal, repurchasing shares when cash is below these levels makes the firm less resilient. Alternatively, CFOs may want to borrow to fund repurchases if the company is underleveraged.

Senior management and boards frequently justify share repurchases to offset the dilutive effects of stock-based compensation. However, stock-based compensation is a very real expense to shareholders: if companies repurchase at a premium to intrinsic value, they exacerbate the negative effects on shareholder value. Boards need to be on the lookout for executives buying back shares with the primary purpose of raising EPS simply by reducing the number of outstanding shares.

So, under what other circumstances does repurchasing shares actually create value? Because stock prices are based on investor expectations about future management decisions, buybacks can increase value by signaling to investors that they should change their views. If shareholders assign a reasonable probability to management’s overpaying for acquisitions or overinvesting in unprofitable businesses, then they could view management’s diverting more capital to repurchases as value creating. Signaling can work in the other direction, too. If investors infer that management is returning cash because the company lacks worthy investment opportunities, they will likely drive down the share price.

Low interest rates and activist investor pressure have also been major factors in recent repurchases. Empirical data show that companies tend to increase repurchases when their share prices are trading near cyclical highs, when cash tends to be most plentiful. During these times, CFOs have a greater incentive to scrutinize whether repurchasing is a prudent use of capital.