Creating Value Through Best‐In‐Class Capital Allocation1

With the economy showing signs of recovery, companies are shifting their focus from liquidity and balance sheet concerns back towards capital allocation and value creation. This article provides a comprehensive framework to examine shareholder value creation through capital allocation, and discusses important capital allocation lessons that have re‐emerged over the last few years. Notable among the key lessons are the following: • Growth alone does not guarantee value creation, which suggests that companies should allocate capital based on the economic value of each investment opportunity. • The limits of diversification in a financial crisis should be considered when allocating capital and managing liquidity. • Companies should be conservative with base‐case cash flow projections and incorporate the possibility of downside scenarios into their projections. • It is important to incorporate all forms of capital when managing liquidity. • Whether using a long‐term or current‐market approach, companies should be consistent throughout the cycle in their cost of capital methodology. • Companies should continually rethink investments and allocate capital in an attempt to maintain a competitive advantage. • Evaluate returns relative to risk and cost of capital, and not against the company's average ROIC. • Comparing the IRR of share repurchases to new investments is not an apples‐to‐apples comparison. Finally, companies should concentrate on the strategic uses and value of particular assets and not allow their decisions to be driven by the value they might receive relative to their initial cost.