[Why should value determine whether a management team is living up to its responsibility? There are two
reasons. The first is that companies must compete. A company that is allocating its resources wisely will
ultimately prevail over a competitor that is allocating its resources foolishly. The second is that inputs have an
opportunity cost, or the value of the next best alternative. Unless an input is going to its best and highest use,
it is underperforming relative to its opportunity cost.
Capital allocation is a dynamic process, so the correct answer to most questions is, “It depends.” Sometimes
acquiring makes sense and other times divesting is the better alternative. There are times to issue equity and
times to retire it. Because the components that determine price and value are changing constantly, so too
must the assessments that a CEO makes. As Buffett says, “The first law of capital allocation—whether the
money is slated for acquisitions or share repurchases—is that what is smart at one price is dumb at another.”3
The message here should be clear. A decision isn’t good just because someone in the organization can justify
it or because some other company is doing it. Proper capital allocation requires a sharp analytical framework
and independence of mind.
Internal financing represents a larger percentage of the total source of capital for companies in the U.S. than
for companies in other developed countries. For example, internal financing has been about 70 percent of the
total source for the United Kingdom, 66 percent for Germany, 55 percent for France, and 50 percent for
Japan.9 The ratio of internal financing to the total source of capital tends to correlate with the underlying return
on invested capital for the country. A country with a high ROIC can fund a higher percentage of its
investments with internally-generated cash than a country with a low ROIC.
The academic research supports the notion that capital allocation is challenging and that growth is not
inherently good. But we must keep in mind that context is very important. Recall that the correct answer to
almost every capital allocation question is, “It depends.”
How should companies assess the merit of an M&A deal? Mark Sirower, a consultant at Deloitte, suggests
that acquirers use the following formula:
Net present value of the deal = present value of the synergies – premium
Cost synergies are much more reliable than revenue synergies. About one-third of the executives surveyed
said that their company achieved all or more of the anticipated cost synergy, while one-quarter of the
companies overestimated their cost synergy by 25 percent or more. But roughly 70 percent of mergers fail to
deliver the anticipated revenue synergy. The most common challenges companies cite for synergy realization
include delays in implementing planned actions, underestimation of costs and complexities, and flat-out
overestimation of synergies]
via: CS
