How a company allocates its capital refers to how it uses its resources to generate value for the shareholders. When capital is efficiently allocated, it means that it is being used in such a way that it can generate the most value.
The following diagram summarizes the various capital allocation decisions that a company’s management must make. Note that the various steps are also the constituents of the DuPont ROE equation.
The life cycle can be succinctly summarised by the famous Du Pont Model:
The Du Pont model illustrates that value creation (measured by return on equity or ROE) is a result of 3 main decisions to be made by the company and how they are being measured respectively:
- Net profit margin – marketing decisions
- Asset turnover – operating decisions
- Leverage – financing decisions
Going a step further, this model also summarises the 3 types of business model undertaken by any company:
- High margin, low turnover – e.g. Luxury goods company
- Low margin, high turnover – e.g. Supermarkets, Retail
- High leverage – e.g. Commercial Banks