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The Capital Allocation Playbook


When you step into our world you will hear the term "capital allocation" a lot. But what does capital allocation mean, exactly?

 

As personal CFO to entrepreneurs, we use the term very broadly to encompass decisions about all kinds of business and personal assets.

 

But the concept is more typically connected to the corporate finance world, so let's start there. Here's the 20 second summary for how a corporation might think about capital allocation:

 

  • Focus on free cash flow (that's operating cash flow less capital expenditures less required debt service) per share

  • Free cash flow is finite - when the business generates free cash flow there are only a few things you can do with it:

    • Reinvest in the business

    • Pay down debt

    • Buy another company or buy other assets

    • Pay a dividend

    • Buy back stock

    • Let cash build in the business

  • Each one of those options contains an economic and strategic reality

  • Management's job is to determine the long-term returns (and risk) for each option and then allocate capital to each option (or not) accordingly

 

Also important - other options for using cash that are not listed above are usually dumb. Of course, nobody comes to the board meeting and announces "I'd like to do something dumb," so part of the responsibility of the management team and board of directors is to always have their "is this a dumb idea?" filter on.

 

To paraphrase the late great Charlie Munger - it's remarkable how successful you can be by just not doing dumb things.

 

Thanks to Cove Street Capital for sharing a longer form summary of capital allocation which comes from a public company earnings call.(1) It's a tidy synopsis.


 

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