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The Equitymaster Research Digest

Fire-Ready-Aim CEOs
Nov 2, 2016

  • Why most CEOs don't care about capital allocation
  • Never buy PSU stocks?
  • Dividends are a sign of capital allocation

The Harvard Business Review did an interesting study in 2014. It picked the best-performing CEOs ever and then checked how many of them mentioned the words 'return on capital' in their official biographies. Turns out less than 5% did.

In his 1987 letter to shareholders, Buffet tried to explain why...

  • The heads of many companies are not skilled in capital allocation, and ... it is not surprising because most bosses rise to the top because they have excelled in an area such as marketing, production, engineering, administration, or sometimes, institutional politics.

Return on capital isn't a metric CEOs use to evaluate themselves. During their tenure, many of them are what we can call Fire Ready Aim CEOs. They decide to allocate funds based on growth ambitions rather than careful analysis. The financial implications are evaluated much later.

Nobel laureates Franco Modigliani and Merton Miller identified return on capital (RoIC) as a major component of value creation. And value destruction. RoIC is, in fact, the salt in the value recipe. Unless return on capital exceeds cost of capital, no amount of revenue growth can create value.

Many CEOs, however, are content with return on capital being roughly equal to cost of capital. They don't realise that a gap between the two can result in impressive value creation.

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