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Companies Spending Cash: Capital Allocation Explained

By Motley Fool Staff - Apr 30, 2016 at 7:00AM

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How companies spend their money, and why they choose the strategies they do.

Capital allocation, simply put, is the way companies spend their financial resources to maximize shareholder value.

In this segment from the Industry Focus: Tech podcast, Sean O'Reilly and Dylan Lewis explain the primary methods companies use to allocate their funds, why they do it, and why different types of companies prefer different strategies.

A full transcript follows the video.

This podcast was recorded on April 15, 2016. 

Sean O'Reilly: So, Dylan, for those who may not know, what is capital allocation?

Dylan Lewis: Capital allocation is basically how a company decides to divvy up their financial resources, the goal, of course, being to maximize value for shareholders. So it might be unfamiliar as an umbrella term for some people. Investors will generally recognize the different actions businesses can take, though. So think about things like share repurchases, initiating a dividend, or growing that dividend, plowing money into research and development, purchasing new property and equipment, making an acquisition, something like that -- these are all the types of things that play into the idea of how a company allocates its capital.

O'Reilly: And obviously, it requires making a judgment as to future returns to any of those initiatives. There needs to be a hurdle, and all that stuff needs to be done. How would you say, for the layman, a business should make those decisions, given where they are in their business cycle, or anything like that?

Lewis: The things that are most predictable, and I think probably the things you hear about most as an investor, are repurchase programs and dividend payments. It's really hard to anticipate something like an acquisition. Research and development is obviously this ongoing thing behind the scenes, and you don't get a ton of insight into it. So those are the two that really stand out. And for those two, I think it really depends on the business profile. So you have your high-growth company, they're in a phase where they're plowing money into R&D, they're trying to build out sales force to better sell their products, grow the top line, they're going to be looking to hold on to their capital, push it into different types of innovation.

O'Reilly: Because, theoretically, the money that could be made with their fast-growing operations and forming out a niche market is better than paying out a dividend to shareholders.

Lewis: Exactly. If you're growing your top line at 30% or something like that, you shouldn't be passing along a 3% dividend yield to investors. The money is much better spent investing it internally and just growing that engine. And typically, these will be your mid- and small-cap companies. They also tend to have less stable cash flows. 

O'Reilly: Or lack thereof.

Lewis: [laughs] Yes. You don't want to be committing to a dividend program in particular, because once you initiate something like that, game on, people are expecting it all the time. Or even just announcing share repurchases, if you don't have the money set aside to continue to grow your business and also handle those other operations.

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