Capital Allocation and Value Creation: A Market-Based Framework for Executives

Acknowledgements
Contents
Abbreviations
List of Figures
1 Introduction
	To Master Capital Allocation, You Have to Think Like an Investor
	The Corporate “Eco-System”
	Using the Market for Guidance
	The Structure of the Book
	References
Part I The Value Drivers That Matters
2 Value Creation—The Theoretical Foundation
	The Three Drivers of Value—Profitability, Growth, and Cost of Capital
	Return on Invested Capital
		A Basic Understanding of ROIC
		ROIC and Competitive Advantage
		Differentiation Versus Cost Leadership Strategies
	Growth
		Balancing Profitability and Growth in the Valuation Framework
		Balancing Profitability and Growth in Real Life
	Cost of Capital
		Earnings Quality as a Proxy for the Cost of Capital
		CFOs Prefer Using the Capital Asset Pricing Model (CAPM)
		Why Using CAPM and WACC Could Lead You “Precisely Wrong” Rather Than “Roughly Right”
		The Market-Implied Cost of Capital
		Asking the Market Participants
		The Cost of Capital for Your Company
		Cost of Capital Over Time and Across Sectors
	How to Use and Interpret Valuation Multiples
		Which Valuation Multiple Should You Consider?
			Price to Earnings (P/E)
			Enterprise Value to EBITDA (EV/EBITDA)
			Enterprise Value to Operating Earnings (EV/EBIT or EV/EBITA)
		Benefits of Understanding Valuation Multiples
		Limitations and Common Pitfalls Using Valuation Multiples
	Conclusions
	References
3 Market-Based Insights to Capital Allocation
	A Description of the Total Shareholder Return Framework
	Peer-Group TSR Study
		General Findings—A Brief Summary
		ROIC—Where It All Starts
		Growth—A Double-Edged Sword
		Margin Stability and the Cost of Capital
		Valuation Multiples per Quartiles
		Top and Bottom Performers—A Head-to-Head Comparison
			Top Performers
			Bottom Performers
		Is There a Destiny with Belonging to a Sector?
	Case Study: Royal Unibrew vs Carlsberg
		The Pre-crisis Period (2006–2009)—Focus on Growth
		The Post-crisis Period (2009–2012)
		From 2013 Onwards
		Case Study Summary
	Case Study: Elisa vs Telia
		The Local Challenger Versus an Expanding Market Leader
		The First Period (2006–2013)—The Devil Is in the Details
		The Second Period (2014–2020)—Time to Harvest the Investments
		The Evidence
		Case Study Summary
	Conclusions
	Reference
4 Earnings quality
	What is Earnings Quality?
	Quantifying Earnings Quality
	Margin Volatility and Valuation
	Business Strategy
	Methods for Achieving the Strategy Change
	Case Study: Nolato
	Earnings Quality and Shareholder Value Creation
	Conclusions
	Reference
Part II Cash Flow Deployment Alternatives
5 The Art of Deal-Making
	What the Empirical Evidence Tells us About M&A and Value Creation
		A Meta-Study Review
		Public versus Private Deals
			Price for Private Targets is Lower Due To Size And Liquidity Discount
			Preferred Buyer
			Public Deals Are More Risky
		Probability of M&A Success Based on Deal Type
	Reviewing our Nordic Peer Group from an M&A Perspective
		Size Seems to Matter a Great Deal
		The Nordic Sample According to the Clark and Mills Categorisation
	Synergies—The Key to Unlock Value
	How to Pay for an Acquisition
	Conclusions
	References
6 Portfolio Optimisation and Why Less So Often Is More
	The Investor’s Take On What to Keep and What to Divest
	Not Always a Conglomerate Discount
	Multiple Drivers Behind Divestiture’s Operational Success and Failures
	Different Ways to Divest a Business Unit
	Study Review—Nordic Spin-Offs
		Strong Performance on Average But with a Wide Dispersion
		TSR Drivers for the Various Groups
	Case Study: Novo Nordisk and Novozymes
	Conclusions
	References
7 Shareholder Remunerations—Time to Give Back?
	Why Dividend Policy Matters for Value Creation
	The Power of Compounded Dividends
	Ways to Distribute Excess Cash
	Ordinary Dividends
	Share Buybacks (SBB)
		SBB—What to Consider?
	Conclusions
	Reference
8 The Balancing Act of Finding the “Optimal” Capital Structure
	Capital Structure from the Academic Perspective
		Minimizing the Cost of Capital
		The Pecking Order and the Signalling Theory
		Debt as a Corporate Governance Tool
	Capital Structure from a Practical Perspective
		The Cost of Financial Distress
			Valuation Risks
			Losing Business
			Ownership Dilution
			Forced Divestments
			Underinvestment
		Option Value of Financial Flexibility
			Strategic Capex
			Acquisitions
			Dividends Through the Cycle
			Working Capital and Customer Finance
	How to Measure Leverage
	Rating Agencies and Capital Structure
	Conclusion
	References
9 Winning Financial Strategies—Funding and Risk Considerations
	Liquidity Back-up
	Access to Capital
	Credit Rating
	Maturity Profile
	Hybrid Bonds
	Key Credit Ratios and FX Risks
	Conclusions—Putting the Pieces Together
Part III Reading the Market and Thinking Like an Investor
10 Financial and Macro-economic Backdrop
	Pre-COVID-19—Great Moderation and Secular Stagnation
	The New Game Has Come—And We Are Still Making Up the Rules
	Post-COVID-19—Are We Heading for a New “Financial Regime”?
	Financial Regimes and Valuation
	Conclusions
	References
11 Adopting an Investor Mind-Set
	Disciplined Rule-Based Investing
	Develop a Risk vs. Reward Mind-Set
		Risk Tolerance
		Distribution and Probabilities
		Expected Value
	Thinking in Scenarios
		Benefits of Stress Tests
		Capital Budgeting and Scenario Thinking
		How to Think When Setting Up Scenarios
	Shareholder Activism
	Conclusions
	References
12 Downturns Rearrange the Board
	Sharp Divergence in Performance During the Downturn
	Recession Winners Pulled Ahead and Excelled Also in the Post-recession Period
	Growth Was the Largest TSR Driver for Recession Winners
	Necessary to Move Past Survival Mode
	During a Downturn, the Best Defence Can Be a Good Offensive
	A Solid Financial Footing
	Case Study: Lindab
		Equity Story and Business Case Leading Up to the Financial Crisis
		Highest Leverage in the Sector
		Growth Took a Beating After the Recession
		Could a Stronger Balance Sheet Have Opened Up for a More Offensive Post-recession Strategy?
	Conclusions
	References
Part IV Put It All Together
13 Financial Targets and Policies—Capital Allocation Priorities in Essence
	Starting with Shareholder Feedback
	Financial Targets Should Express the Company’s Ambition to Create Value
		Case Study: A Telecom Company
		Case Study: Church & Dwight
	Capital Allocation Priorities
	The “Self-Sustaining” Model
	Pros and Cons with Different Targets
	Earnings Quality—The Missing Piece of the Target Puzzle
		Difficulties with Earnings Quality Targets
	Risk with Unbalanced Targets
	Earnings Quality in a KPI and Incentives Setting
	TSR Rooted Targets That Changed Over Time—Coloplast Case Study
		Stage 1-Growth at Any Price
		Stage 2-Balanced Profitable Growth Strategy
		Stage 3-Back to a More Rigid Growth Target
	Business Strategy and Financial Targets—Atlas Copco Case Study
		Business Strategy
		Financial Targets
		Mapping the TSR to the Group-Wide Components of the Business Strategy
		Case Study Summary
	Conclusions
	References
14 An Investor-Based Evaluation Process
	What are the Main Drivers of Total Shareholder Return?
	What do the Capital Allocation Priorities and Historical Cash Flow Deployment Look Like?
		Financial targets
		Cash Flow Deployment
		Peer Comparison
	What are the Current Market Expectations Embedded in the Valuation Multiple?
	What Does an “Optimal” Capital Structure Look Like Given the Capital Allocation Priorities?
	How Can the Capital Allocation and Financial Targets Be Communicated to the Market?
		Are the Communicated Targets in Line with the Market’s Views of Value Creation?
		Are the Targets Consistent with Each Other?
		Priority of Targets
15 A Three-Step Capital Allocation Framework
	Step 1—Determine the Relative Importance of the Three Value Drivers
		Emphasis on the ROIC and the Durability of Excess Returns
		Earnings Quality and Cost of Capital
		Growth—A Double-Edged Sword
	Step 2—Evaluating Cash Flow Deployment Options With a “Risk-Reward” Mind-Set
		Maintenance and Strategic Investments
		Acquired Growth—Comes With a Higher Risk to TSR
		Why Less So Often Is More
		Returning Excess Cash
		Capital Structure
	Step 3—A Practical Guide to Capital Allocation Priorities
		Financial Target Priorities Aligned With Long-Term Value Creation
	Reference
Correction to: Capital Allocation and Value Creation
	Correction to:  Chapters 3 and 10 in: T. Arenbo, Capital Allocation and Value Creation, https://doi.org/10.1007/978-3-031-47048-6_3 https://doi.org/10.1007/978-3-031-47048-6_10
Appendix 1: Evaluating Management’s Capital Allocation Skills
Appendix 2: A Business Strategy Summary
Appendix 3: ROIC Calculation Extended
How to Think About Intangible Assets and the Use of ROIC
References
Index