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2023 | Book

Capital Allocation and Value Creation

A Market-Based Framework for Executives

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About this book

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

Frontmatter
Chapter 1. Introduction
Abstract
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 programmes, and organic growth opportunities.
Torbjörn Arenbo
16. Correction to: Capital Allocation and Value Creation
Torbjörn Arenbo

The Value Drivers That Matters

Frontmatter
Chapter 2. Value Creation—The Theoretical Foundation
Abstract
Without a sufficient understanding of the theoretical building blocks of value creation, it becomes challenging to make informed decisions regarding capital allocation. Therefore, in this chapter, we start by very briefly describing what roles return on invested capital (ROIC), growth, and cost of capital play in the value creation framework as well as highlight the interaction between them.
Torbjörn Arenbo
Chapter 3. Market-Based Insights to Capital Allocation
Abstract
Our ambition with this chapter is to supplement the analytical framework we just reviewed with empirical findings. We do that by taking a market-based approach in trying to shed some light on the delicate question of capital allocation and shareholder value creation. We use a Total Shareholder Return (TSR) framework to measure and better understand the drivers of a Nordic peer-group’s value creation during a 14-year period ending in 2020.
Torbjörn Arenbo
Chapter 4. Earnings quality
Abstract
We end part one of this book with a chapter where we discuss the, sometimes overlooked, importance of earnings quality as a value driver. In particular, we focus on the way earnings quality and cost of capital can be linked together.
Torbjörn Arenbo

Cash Flow Deployment Alternatives

Frontmatter
Chapter 5. The Art of Deal-Making
Abstract
Mergers and Acquisitions are one of the biggest cash spends for corporates and, as such, have a significant impact on the firm’s operations. Despite its widespread popularity, a substantial amount of literature demonstrates that pursuing an acquisitive strategy comes with a high risk to value creation. The wide range of expected returns suggests that executives at acquiring companies should put in extra effort to master the art of deal-making.
Torbjörn Arenbo
Chapter 6. Portfolio Optimisation and Why Less So Often Is More
Abstract
Not all investments or acquisitions succeed. How should management evaluate investments that do not reach their expected returns? Should the assets be divested or should attempts be made to turn the underperforming entity around? A key factor in a successful long-term capital allocation process is a continuous re-evaluation of the business portfolio to determine which assets to keep and why.
Torbjörn Arenbo
Chapter 7. Shareholder Remunerations—Time to Give Back?
Abstract
Given some of the findings presented so far in this book, it should not come as a surprise that the equity market in many cases has a very strong focus on management returning excessive cash to shareholders. One of the most common capital allocation mistakes is no doubt when corporates with a strong free cash flow, a low debt level, and presence in mature markets try to achieve growth at too high a price.
Torbjörn Arenbo
Chapter 8. The Balancing Act of Finding the “Optimal” Capital Structure
Abstract
Now we turn our attention from the asset side to the liability side of the balance sheet and analyze the role of capital structure in the value creation process. How much leverage can the business model take and how large, if any, are the financial gains from increasing the leverage?
Torbjörn Arenbo
Chapter 9. Winning Financial Strategies—Funding and Risk Considerations
Abstract
Based on the inherent characteristics of the business model, the desired risk level for the capital structure can be set. And based on the combined risk of the two, a funding and hedging policy can be developed. A higher risk level in the two first parts can be mitigated by a more conservative stance towards the latter part. We could call it “financial insurance”. How to play the game depends partly on risk preferences and partly on the potential gains from taking on and paying for “insurance”.
Torbjörn Arenbo

Reading the Market and Thinking Like an Investor

Frontmatter
Chapter 10. Financial and Macro-economic Backdrop
Abstract
This book focuses on making effective capital allocation decisions, with financial market information being a crucial component of the decision-making process. However, the financial market's evaluation of a company's attributes, such as growth potential and margin stability, can vary over time and so can the availability of leverage as a value-generating tool. In this chapter, we take a step back in order to better understand how the investor preferences may change between various macro and financial policy regimes.
Torbjörn Arenbo
Chapter 11. Adopting an Investor Mind-Set
Abstract
Part of the scope of this book is to improve the ability to read the market and make use of the information in the capital allocation process. Additionally, it aims to raise the awareness about the difference between the price and the value of an asset. And understanding financial markets and valuation is crucial for any outperforming investor. However, in this chapter, we will describe three additional investor skills which we believe could be of great benefit to corporate managers in their capital allocation process, namely: Applying a disciplined rule-based framework for investing; Thinking in terms of risk-reward trade-off; Using various techniques for scenario modelling.
Torbjörn Arenbo
Chapter 12. Downturns Rearrange the Board
Abstract
We now turn our attention to a subject closely related to stress scenarios and financial flexibility, namely that of recession management. It is well-known that downturns can represent a big threat to the financial health of a company. However, history has also shown that such periods can open up opportunities to leapfrog the competition. For the companies that manage to excel during a downturn, there is therefore much to win!
Torbjörn Arenbo

Put It All Together

Frontmatter
Chapter 13. Financial Targets and Policies—Capital Allocation Priorities in Essence
Abstract
As the CEO of a company, what message would you like to send to your organization and financial stakeholders, and why? The financial targets should align with the company's mission and strategy. Ideally, when determining the financial goals and their priorities, one should consider the key value drivers of the business.
Torbjörn Arenbo
Chapter 14. An Investor-Based Evaluation Process
Abstract
We began this book by stating that, in order to effectively run a company, being a competent businessperson alone is not enough. It is also necessary to possess the skills of a knowledgeable investor, including the ability to read the market. In this chapter, we apply a practical, market-oriented approach to shed some light on the complex issues of capital deployment and the creation of shareholder value.
Torbjörn Arenbo
Chapter 15. A Three-Step Capital Allocation Framework
Abstract
The CEO’s main objective is to maximize the long-term value per share. This book has demonstrated that total shareholder return does not necessarily correlate with growth, nor does it correlate with any other capital allocation activity on an overall level. Therefore, each CEO must determine the optimal course of action for their company based on its unique circumstances. While there is no one-size-fits-all solution, a thorough understanding of the value creation framework is an essential starting point for developing effective capital allocation strategies.
Torbjörn Arenbo
Backmatter
Metadata
Title
Capital Allocation and Value Creation
Author
Torbjörn Arenbo
Copyright Year
2023
Electronic ISBN
978-3-031-47048-6
Print ISBN
978-3-031-47047-9
DOI
https://doi.org/10.1007/978-3-031-47048-6