Making the right capital allocation decisions is essential if technology companies are going to grow over the long-term and maximize shareholder returns. Capital allocation decisions are even more important now because interest rates are rising, as is geopolitical uncertainty. As many tech companies begin to unwind their debt positions and are less inclined to borrow, they are relying more on deploying excess cash to fund long-term initiatives. At EY, we believe they need to take a more balanced approach and make the critical decisions necessary to effectively allocate capital.
Responding to a recent EY survey, 50% of technology CFOs say that return of capital to shareholders (i.e., dividends and share repurchases) is a main focus area of their companies’ capital allocation strategy. We see this trend in the public markets as several technology companies, including mega caps, turn to share repurchases and dividends to deliver returns to shareholders while still maintaining a cash stockpile. In their most recent public filings, the top 10 public technology companies showed more than $520 billion of cash and short-term investments.
The survey also revealed the primary reason CFOs turn to share repurchases: 41% cite increased earnings per share (EPS) growth, while 30% say they do so to fulfill shareholder and analyst expectations. While a lack of share repurchases and/or dividends can make companies targets of activist investors, are companies too focused on share repurchases and dividends as part of their capital allocation strategy?
Rather than view share repurchases as a lever to appease investors, they should only be considered when the share price is well below intrinsic value or when cash exceeds operational and liquidity needs. However, only 10% of CFOs say their primary motivation for share repurchases was in response to a belief that their business was undervalued in the market.
Tech companies should take a more balanced approach to capital allocation, as overly focusing on share repurchases in a rising interest rate environment may yield less ROI over the long-term, compared with a more diversified capital allocation approach. They should consider an approach that includes cash dividends, M&A, strategic divestitures and R&D.
Ultimately, a company’s capital allocation strategy needs to support the organization’s long-term strategic plan and be agile enough to pivot as necessary. Financial and operational data is essential to making capital allocation decisions, but 49% of the CFOs in the EY survey cite insufficient data as a top barrier to optimally allocating capital. If data does not exist internally, third-party data can and should be leveraged to help executives make more informed decisions.
The report findings also show that companies often have the data available but lack the tools needed to properly process and analyze it. Companies should consider using data visualization software to understand where capital investment may be needed. They should also carefully assess data to the extent that it does exist. For example, legacy allocation methodologies may result in misguided conclusions as to the profitability of a business segment or product and, in turn, result in the wrong capital allocation decision.
Companies should also confirm that management incentives and long-term strategy are aligned. The survey found that 31% of technology CFOs believe their long-term strategy is not consistent with employee incentives. Tying compensation solely to EPS or quarterly accounting metrics does not foster forward thinking and often promotes a capital allocation strategy centered on share repurchases. Rather, executive incentives should be tied to longer-term growth in market capitalization and enterprise value, which ultimately promote a balanced and long-term capital allocation strategy.
Keys to a successful capital allocation strategy
1. Diversify your business’ capital allocation strategy beyond share repurchases and dividends.
2. Employ consistent evaluation criteria and use both internal and external data to drive more informed decision-making.
3. Incentives matter. Confirm that capital allocation, incentives and strategy are aligned.
Ken Welter leads EY Global and EY Americas Transactions Technology services, focusing on strategic decisions relating to improving, preserving, allocating and managing capital. Max Cohen, Ernst & Young LLP (US) also contributed to this article.
The views reflected in this article are the views of the authors and don’t necessarily reflect the views of the global EY organization or its member firms.