Value

The Four Cornerstones of Corporate Finance

Tim Koller, Richard Dobbs, Bill Huyett

• Publisher: Wiley
• Year: 2010
• ISBN:
  9780470949085
• Edition: 1
• Topic: Business
• Subtopic: Valutazione
• Index: Business

An accessible guide to the essential issues of corporate finance

While you can find numerous books focused on the topic of corporate finance, few offer the type of information managers need to help them make important decisions day in and day out.

Value explores the core of corporate finance without getting bogged down in numbers and is intended to give managers an accessible guide to both the foundations and applications of corporate finance. Filled with in-depth insights from experts at McKinsey & Company, this reliable resource takes a much more qualitative approach to what the authors consider a lost art.

• Discusses the four foundational principles of corporate finance
• Effectively applies the theory of value creation to our economy
• Examines ways to maintain and grow value through mergers, acquisitions, and portfolio management
• Addresses how to ensure your company has the right governance, performance measurement, and internal discussions to encourage value-creating decisions

A perfect companion to the Fifth Edition of Valuation, this book will put the various issues associated with corporate finance in perspective.

Part One

The Four Cornerstones

1

Why Value Value?

There's no disputing that value is the defining metric in a market economy. When people invest, they expect the value of their investment to increase by an amount that sufficiently compensates them for the risk they took, as well as for the time value of their money. This is true for all types of investments, including bonds, bank accounts, real estate, or company shares.1

Therefore, knowing how to create and measure value is an essential tool for executives. If we've learned anything from the latest financial crisis, and from periods of economic bubbles and bursts in our history, it's that the laws of value creation and value measurement are timeless. Financial engineering, excessive leverage, the idea during inflated boom times that somehow the old rules of economics no longer apply—these are the misconceptions upon which the value of companies are destroyed and entire economies falter.

In addition to their timelessness, the ideas in this book about creating and measuring value are straightforward. Mathematics professor Michael Starbird is noted for his saying: “The typical 1,200 page calculus text consists of two ideas and 1,198 pages of examples and applications.” Corporate finance is similar. In our view, it can be summarized by four principles or cornerstones.2 Applying these principles, executives can figure out the value-creating answers to most corporate finance questions, such as which business strategy to pursue, whether to undertake a proposed acquisition, or whether to repurchase shares.

The cornerstones are intuitive as well. For example, most executives understand that it doesn't affect a company's value whether executive stock options are recorded as an expense in a company's income statement or cited separately in the footnotes of the financial statements, because cash flow doesn't change. Executives are rightly confused when it takes more than a decade of bickering over the accounting rules to reflect the economics of these options.

THE FOUR CORNERSTONES

What are the four cornerstones of finance and how do they guide the creation of lasting corporate value?

The first and guiding cornerstone is that companies create value by investing capital from investors to generate future cash flows at rates of return exceeding the cost of that capital (that is, the rate investors require to be paid for the use of their capital). The faster companies can grow their revenues and deploy more capital at attractive rates of return, the more value they create. In short, the combination of growth and return on invested capital (ROIC) drives value and value creation.3

Named, in short, the core of value, this combination of growth and ROIC explains why some companies typically trade high price to earnings (P/E) multiples despite low growth. In the branded consumer-products industry, for instance, the global confectioner Hershey Company's P/E was 18 times at the end of 2009, which was higher than 70 percent of the 400 largest U.S. nonfinancial companies. Yet, Hershey's revenue growth rate has been in the 3 to 4 percent range.

What's important about this is that where a business stands in terms of growth and ROIC can drive significant changes in its strategy. For businesses with high returns on capital, improvements in growth create the most value. But for businesses with low returns, improvements in ROIC provide the most value.

The second cornerstone of finance is a corollary of the first: Value is created for shareholders when companies generate higher cash flows, not by rearranging investors’ claims on those cash flows. We call this the conservation of value, or anything that doesn't increase cash flows via improving revenues or returns on capital doesn't create value (assuming the company's risk profile doesn't change).

When a company substitutes debt for equity or issues debt to repurchase shares, for instance, it changes the ownership of claims to its cash flows. However, this doesn't change the total available cash flows or add value (unless tax savings from debt increase the company's cash flows). Similarly, changing accounting techniques may create the illusion of higher performance without actually changing the cash flows, so it won't change the value of a company.

We sometimes hear that when a high P/E company buys a low P/E company, the earnings of the low P/E company get rerated at the P/E of the higher company. If the growth, ROIC, and cash flows of the combined company don't change, why would the market revalue the target company's earnings? In addition to bad logic, the rerating idea has no empirical support. That said, if the new, combined earnings and cash flows improve as a result of the acquisition, then real value has been created.

The third cornerstone is that a company's performance in the stock market is driven by changes in the stock market's expectations, not just the company's actual performance (growth, ROIC, and resulting cash flow). We call this the expectations treadmill—because the higher the stock market's expectations for a company's share price become, the better a company has to perform just to keep up.

The large American retailer Home Depot, for instance, lost half the value of its shares from 1999 through 2009, despite growing revenues by 11 percent per year during the period at an attractive ROIC. The decline in value can mostly be explained by Home Depot's unsustainably high value in 1999 at $132 billion, the justification of which would have required revenue growth of 26 percent per year for 15 years (a very unlikely, if not impossible, feat).

In a reverse example, Continental AG's (the German-based global auto supplier) shareholders benefited from low expectations at the beginning of 2003, when Continental's P/E was about six. Over the next three years, the shareholders earned returns of 74 percent per year, about one-third of which can be attributed to the elimination of the negative expectations and the return of Continental's P/E to a more normal level of 11.

As the old adage says, good companies aren't necessarily good investments. In a world where executive compensation is heavily linked to share-price performance over relatively short time periods, it's often easier for executives to earn more by turning around a weak performer than by taking a high-performing company to an even higher level.

The fourth and final cornerstone of corporate finance is that the value of a business depends on who is managing it and what strategy they pursue. Otherwise called the best owner, this cornerstone says that different owners will generate different cash flows for a given business based on their unique abilities to add value.

Related to this is the idea that there is no such number as an inherent value for a business; rather, a business has a given value only relative to who owns and operates it. Some, for instance, add value through unique links with other businesses in their portfolios, such as those with strong capabilities for accelerating the commercialization of products formerly owned by upstart technology companies.

The four cornerstones of finance provide a stable frame of reference for making sound managerial decisions that lead to lasting value creation. Conversely, ignoring the cornerstones leads to poor decisions that erode the value of companies and, in some cases, create widespread stock market bubbles and painful financial crises.

CONSEQUENCES OF NOT VALUING VALUE

The first cornerstone of value creation—that ROIC and growth generate value—and its corollary, the conservation of value, have stood the test of time. Alfred Marshall wrote about return on capital relative to its cost in 1890.4 When managers, boards of directors, and investors have forgotten these simple truths, the consequences have been disastrous.

The rise and fall of business conglomerates in the 1970s, hostile takeovers in the United States in the 1980s, the collapse of Japan's bubble economy in the 1990s, the Southeast Asian crisis in 1998, the Internet bubble, and the economic crisis starting in 2007—all of these can be traced to a misunderstanding or misapplication of the cornerstones. During the Internet bubble, for instance, managers and investors lost sight of what drives ROIC, and many even forgot its importance entirely.

When Netscape Communications went public in 1995, the company saw its market capitalization soar to $6 billion on an annual revenue base of just $85 million—an astonishing valuation. The financial world was convinced by this phenomenon that the Internet could change the basic rules of business in every sector, setting off a race to create Internet-related companies and take them public. Between 1995 and 2000, more than 4,700 companies went public in the United States and Europe, many with billion-dollar-plus market capitalizations.

Some of the companies born in this era, including Amazon, eBay, and Yahoo!, have created and are likely to continue creating substantial profits and value. But for every solid, innovative new business idea, there were dozens of companies (including Netscape) that couldn't similarly generate revenue or cash flow in either the short or long term. The initial stock market success of these companies represented a triumph of hype over experience.

Many executives and investors either forgot or threw out fundamental rules of economics in the rarified air of the Internet revolution. Consider the concept of increasing returns to scale, also known as “network effects” or “demand-side economies of scale.” The idea enjoyed great popularity during the 1990s after University of California-Berkeley professors Carl Shapiro and Hal Varian described it in their book, Information Rules: A Strategic Guide to the Network Economy.5

The basic idea is this: in certain situations, as companies get bigger, they can earn higher margins and return on capital because their product becomes more valuable with each new customer. In most industries, competition forces returns back to reasonable levels; but in increasing-return industries, competition is kept at bay by the low and decreasing unit costs of the market leader (hence the tag “winner takes all” in this kind of industry).

The concept of increasing returns to scale is sound economics. What was unsound during the Internet-bubble era was its misapplication to almost every product and service related to the Internet and, in some cases, to all industries. The history of innovation shows how difficult it is to earn monopoly-sized returns on capital except in very special circumstances.

Many market commentators ignored history in their indiscriminate recommendation of Internet stocks. They took intellectual shortcuts to justify absurd prices for shares of technology companies, which inflated the Internet bubble. At the time, those who questioned the new economics were branded as people who simply didn't get it—the new-economy equivalents of those who would defend Ptolemaic astronomy.

When the laws of economics prevailed, as they always do, it was clear that Internet businesses (such as online pet food or grocery delivery) didn't have the unassailable competitive advantages required to earn even modest returns on capital. The Internet has revolutionized the economy, as have other innovations, but it didn't and can't change the rules of economics, competition, and value creation.

Ignoring the cornerstones also underlies financial crises, such as the one that began in 2007. When banks and investors forgot the conservation-of-value principle, they took on a level of risk that was unsustainable.

First, homeowners and speculators bought homes—essentially illiquid assets. They took out mortgages with interest set at artificially low teaser rates for the first few years, but then those rates rose substantially. Both the lenders and buyers knew that buyers couldn't afford the mortgage payments after the teaser period. But both assumed that either the buyer's income would grow by enough to make the new payments, or the house value would increase enough to induce a new lender to refinance the mortgage at similarly low teaser rates.

Banks packaged these high-risk debts into long-term securities and sold them to investors. The securities, too, were not very liquid, but the investors who bought them, typically hedge funds and other banks, used short-term debt to finance the purchase, thus creating a long-term risk for those who lent the money.

When the interest on the homebuyers’ adjustable rate increased, many could no longer afford the payments. Reflecting their distress, the real estate market crashed, pushing the value of many homes below the value of loans taken out to buy them. At that point, homeowners could neither make the required payments nor sell their houses. Seeing this, the banks that had issued short-term loans to investors in securities backed by mortgages became unwilling to roll those loans over, prompting all the investors to sell their securities at once.

The value of the securities plummeted. Finally, many of the large banks themselves had these securities on their books, which they, of course, had also financed with short-term debt that they could no longer roll over.

This story reveals two fundamental flaws in the ...