Automating compliance provides a significant opportunity – It allows us to shift our focus from past reporting to strategic, forward-looking discussions with clients. Connecting the worlds of running a business and investing in one.
Two concepts sit at the heart of this conversation: Return on equity (ROE) and Capital allocation. In its simplest form, ROE helps you measure how hard your capital is working. Capital allocation then guides your next investment decision.
Step one: Measuring the return
ROE measures how effectively a business turns owners’ capital into profit (i.e. net income after tax). Think of it like choosing between three bank accounts paying 5%, 6%, and 7% interest. You would obviously prefer the 7%. The same logic applies to your business, divisions, or products.
The two biggest challenges in calculating ROE:
- Multiple entities – Consolidating results across your group to get an accurate net income and equity figure.
- Defining equity – Treating all owner contributions (share capital, loan accounts, UPE’s and sub trusts) as equity and netting them off.
Why ROE can surprise you:
Net profit margin tells you how much you earn per $1 of sales. This is useful for benchmarking, but it ignores how much capital was required. Two businesses may have the same profit, but if one uses less capital, it’s delivering a higher ROE and freeing up more cash for reinvestment.
Successful investor Warren Buffett famously looks for businesses with a long-term ROE above 20%, with no worse than 15% in any year. For multi-division businesses, a ROE analysis per product line can help you to guide capital towards the highest-returning areas.
Step two: Capital allocation
Once you know your ROE, the next question is: where should you allocate your next dollar? This is where capital allocation – one of the most important yet under-discussed CEO responsibilities – comes in.
Buffett says “a company’s management should first examine reinvestment possibilities in its current business – projects that improve efficiency, expand reach, extend product lines, or widen the moat”.
Options for capital allocation
Reinvest in the current business:
- Capital expenditure – Upgrade facilities, expand capacity, improve products or services.
- Research & development and new products – Develop new offerings or technology to stay competitive.
- Operational improvements – Streamline processes, update equipment, enhance systems.
The key is to accurately forecast the expected return on each project and compare them. If product three generates 30% ROE and product one generates 10%, the choice on where to reinvest next, becomes clear.
- Acquisitions
- Same industry – Usually less risky, can expand market share or create synergies.
- New industry – Higher risk, often with lower forecast returns; requires careful due diligence.
- Return funds to shareholders
- Share buybacks – Increase ownership percentage for remaining shareholders, this is especially attractive if shares are undervalued.
- Dividends – Allow shareholders to redeploy capital themselves, often at ~10% expected returns in conservative portfolios.
- Raise capital or debt
- Increases the pool of funds to allocate — but only valuable if projects exceed the hurdle rate.
Setting a hurdle rate
If shareholders can earn around 10% elsewhere, your business projects must comfortably exceed this to justify reinvestment. Buffett uses 15% as a guide, while others prefer to see at least 20% ROE before retaining funds.
Avoiding the “scattergun” approach
The best capital allocators have a clear plan:
- They compare estimated returns across all options
- They choose the highest-returning, lowest-risk opportunities
- They say “no” to projects that don’t meet the hurdle rate.
What you don’t want to see is a business doing too many things without a clear plan. Simultaneously taking on debt, paying dividends, doing buybacks, and investing in multiple unrelated projects.
Your advisor’s role
When automation frees up your time, having these conversations with an experienced advisor is key to supporting you with –
- Calculating and interpreting ROE
- Identifying the best capital allocation opportunities
- Setting hurdle rates and strategic priorities
- Holding management accountable for past capital allocation decisions
Next steps
Going forward, it is advisable that you:
- Measure the return.
- Allocate to the highest and best use.
- Repeat – deliberately and with discipline.
That’s how business ownership meets investing — and how long-term value is created.
If you would like help reviewing your investment strategies and support to create long-term value, speak with your Nexia advisor today.
