Hurdle Rate as Supreme Filter

"With her board, she subjected all potential transactions to a rigorous, analytical test. As Tom Might summarized it, “Acquisitions needed to earn a minimum 11 percent cash return without leverage over a ten-year holding period.” Again, this seemingly simple test proved a very effective filter, and as Might says, “Very few deals passed through this screen. The company’s whole acquisition ethos was to wait for just the right deal.”"

"he relied on simple but powerful rules in evaluating transactions. For Murphy, that benchmark was a double-digit after-tax return over ten years without leverage. As a result of this pricing discipline, he never prevailed in an auction, although he participated in many. Murphy told me that his auction bids consistently ended up at only 60 to 70 percent of the eventual transaction price."

"Under the leadership of CEO Rex Tillerson and his curmudgeonly predecessor, Lee Raymond, ExxonMobil has exhibited similar discipline, requiring a minimum 20 percent return on all capital projects. During the recent financial crisis, as energy prices fell, Tillerson and his team were criticized by Wall Street analysts for lowering production levels. They simply refused, however, to pump additional oil from projects with insufficient returns, even if it meant lower near-term profits."

"1. The allocation process should be CEO led, not delegated to finance or business development personnel. 2. Start by determining the hurdle rate—the minimum acceptable return for investment projects (one of the most important decisions any CEO makes). Comment: Hurdle rates should be determined in reference to the set of opportunities available to the company, and should generally exceed the blended cost of equity and debt capital (usually in the midteens or higher). 3. Calculate returns for all internal and external investment alternatives, and rank them by return and risk (calculations do not need to be perfectly precise). Use conservative assumptions. Comment: Projects with higher risk (such as acquisitions) should require higher returns. Be very wary of the adjective strategic—it is often corporate code for low returns. 4. Calculate the return for stock repurchases. Require that acquisition returns meaningfully exceed this benchmark. Comment: While stock buybacks were a significant source of value creation for these outsider CEOs, they are not a panacea. Repurchases can also destroy value if they are made at exorbitant prices. 5. Focus on after-tax returns, and run all transactions by tax counsel. 6. Determine acceptable, conservative cash and debt levels, and run the company to stay within them. 7. Consider a decentralized organizational model. (What is the ratio of people at corporate headquarters to total employees—how does this compare to your peer group?) 8. Retain capital in the business only if you have confidence you can generate returns over time that are above your hurdle rate. 9. If you do not have potential high-return investment projects, consider paying a dividend. Be aware, however, that dividend decisions can be hard to reverse and that dividends can be tax inefficient. 10. When prices are extremely high, it’s OK to consider selling businesses or stock. It’s also OK to close under-performing business units if they are no longer capable of generating acceptable returns."