How Bad Capital Allocation Plans Can Derail Your Investment

By Markets Fool.com

Having extra money in your pocket is an enviable problem to have, but if you're a company sitting on a pile of cash, figuring out what to do with that extra capital can be tough. Allocate that capital wisely, and investors will rejoice. Spend it foolishly, and shares will take a drubbing.

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Since capital allocation plans can have a big impact on a company's share prices, let's take a minute to review how companies can spend their capital and then consider a couple of metrics that can help gauge whether or not companies are making smart choices.

Choices, choices, choices
Every day, we all make decisions on how we'll spend our money. Should we pay down our debt? Invest a bit more for retirement? Choose the grande or venti latte?

Companies make similar decisions daily -- but on a much larger scale. They can decide to hire more people, build a new plant, open a new store, pay down their debt, or return money to investors through dividends or share buybacks.

How a company decides to allocate its capital will depend on a lot of things, but young companies typically plow money back into their businesses to drive growth by expanding production, entering new markets, or creating new product lines. These companies are less interested in cutting their debt or paying investors than they are in grabbing market share.

Mature companies tend to approach things a bit differently. In many cases, they've already achieved critical mass in their market, and their spending decisions are aimed to maintain steady growth and enhance their profitability.

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The impact on investors
Regardless of where a company is in its life cycle, all capital allocation decisions will result in outcomes that can reward or punish investors.

If a drugmaker invests millions of dollars in a new drug that fails during clinical trials, then its shares will drop because the potential for sales has evaporated. If a manufacturer builds a new plant and demand falls short of forecasts, then profit margins can suffer. If a retailer bets big on a new style that fails to move, then inventory jumps, and deep discounts cut away at earnings.

These are just a few examples of the many choices companies can make and the outcomes that can result, so investors have to rely on management teams to make smart choices and then evaluate those choices by tracking metrics that show whether or not capital allocation plans are paying off.

Rating management
The Holy Grail for any investor is growing sales and earnings. Tracking sales and profit trends allows investors to see quickly whether or not management's decisions are panning out.

But sales and earnings growth aren't the only metrics investors can watch to evaluate management's spending. Investors can also consider return on equity, or ROE, and return on assets, or ROA.

If you're more interested in judging management based on the short term, then the ROE makes sense. ROE measures how much earnings a company generates as a percentage of shareholders equity. In other words, it shows how much profit a company makes on the money its shareholders have invested.

Return on equity = net income/shareholders equity

ROE can provide a helpful snapshot of a company's current performance, but investors interested in a longer-term view can consider the ROA, which divides net income by average total assets over a period of time. What the ROA tells you as an investor is whether or not management does a good job of turning its assets into profit.

In both cases, investors should remember that ROE and ROA differ from industry to industry -- so you shouldn't compare the ROE and ROA of a retailer and an oil driller. Instead, investors should make apples-to-apples comparisons. For example, compare how effectively Rite Aid allocates capital to how well CVS Health deploys capital. Similarly, comparing Appleand Microsoft makes far more sense than comparing Apple and Chipotle.

Tying it together
Companies' capital allocation plans change over time, which sometimes means they become different sorts of investments. If you're a growth investor, you'll be more interested in seeing capital allocated to initiatives that boost sales and grab market share. If you're a dividend investor, then you'll be more interested in companies that don't need to spend as much to maintain their leadership and can therefore return more money to shareholders.

Regardless, knowing how a company allocates its money and comparing the effectiveness of those spending decisions to that of competitors can help you pick winners and avoid losers.

The article How Bad Capital Allocation Plans Can Derail Your Investment originally appeared on Fool.com.

Todd Campbell owns shares of Rite Aid and Apple. Todd owns E.B. Capital Markets, LLC. E.B. Capital's institutional research clients may have positions in the companies mentioned. The Motley Fool recommends Apple and CVS Health. The Motley Fool owns shares of Apple. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.