Capital Allocation: When the Right Thing Is Hard to Do.

• Author: Millman, Gregory J.

For many companies, allocating capital can become a choice between short-term share gains and long-term value. Those decisions can be hard, as top financial officers at a number of companies can attest.

Allocating capital to the activities that will build long-term value should not take courage -- but it does. Doing what analysts demand should not lead to failure in the market -- but often, it does.

For years, Ryder System treated top-line sales growth as the drive-train of its business. Why? That's what analysts demanded. So Ryder complied, pegging bonus and compensation programs to sales. Its people delivered what they were paid for. Ryder got sales, all right -- but on terms that actually destroyed economic value over the long term.

Its reward for doing what analysts demanded was a failing stock price and a hail of criticism from analysts. A new management team is now refocusing the company on value-building business, but so far the analyst reaction can fairly be described as lukewarm.

In a similar vein, the senior management team at much-admired office furniture-maker Herman Miller faced a tough choice when they decided to build a new business for the New Economy. Even though shareholders would be better off in the long haul, in the short term, earnings would take a hit. Chief financial officer Elizabeth Nickel didn't have to ask to know what analysts would say about that. Wall Street had already been pressuring the company to do an acquisition that would build earnings even while it destroyed economic value.

When Nickel talks about how it can be tough to look at things differently, she means making decisions that build long-term wealth for shareholders even when those decisions look bad when measured by popular analytical standards. The first thing aspiring managers learn in business school is that regardless of what they do, their job is to make money for shareholders.

But in the real world, that's often not what they're praised and paid for. Few CEOs face facts as forthrightly as Berkshire Hathaway's Warren Buffett, who in his most recent letter to shareholders said, "My 'one subject' is capital allocation." Buffett, of course, is a legendary value investor, and value investors assume that the market eventually recognizes and rewards companies that build real economic value.

But like the heroine in a Jane Austen novel, GFOs and CEOs take a big risk when they hew to that principle: the risk that at the end of the day they'll be alone with their principle. Analysts don't clamor for value, but rather for acquisitions at almost any cost and earnings growth seemingly regardless of quality.

Even Bennet Stewart, co-founder of New York consulting firm Stern Stewart, says, "Sometimes you just have to take your medicine and hope for the best." Stewart and partner Joel Stern developed and trademarked EVA, which stands for Economic Value Added. More than a mere metric, EVA is a whole philosophy of managing a business, combined with an incentive system mat pays people to deliver economic value and penalizes them when they don't.

"What makes it powerful in capital budgeting is that you can't increase EVA unless you increase profit by enough to cover the cost of the additional capital you invest, so it provides a natural cost audit of projects," says Stewart. At most companies, he adds, managers who propose new investments have to justify the investments initially on a net present value (NPV) basis. But once the investment has been made, the managers are evaluated by some other yardstick, such as earnings or sales growth, and the cost of capital no longer factors in to their performance review.

"So managers have an incentive to get all the capital they can," Stewart says. "The head office knows this, so it installs hurdle rates. Managers respond by raising their assumptions. The whole process of capital budgeting is characterized by mutual deception. It's like kabuki theater -- everyone is wearing a mask -- and it creates a poisonous atmosphere of checking and...