“The typical 1,200 page calculus text consists of two ideas and 1,198 pages of examples and applications.” —Michael Starbird
Value, Value, Value…
Right now to the left from where I sit at my writing desk, I have the physical version of the sixth edition of Valuation: Measuring and Managing the Value of Companies. I ordered the book a few weeks ago, and I haven’t really had the time to read through it yet. But anyways, I came to think of another book—Value: The Four Cornerstones of Corporate Finance—from the same authors, which basically contains the same fundamental financial theories, but instead of about 800 pages, this one (only) contains around 230 pages.
I don’t really know why I started to think of this particular book, but it might be because of the four fundamental principles that’s covered by the authors in the preface, and that the remaining part of the book is all about; the four principles, the so-called cornerstones of corporate finance.
These four principles, which we call the cornerstones of corporate finance, start with the axiom that companies exist to meet customer needs in a way that translates into reliable returns to investors. Together, the cornerstones form a foundation upon which executives can ground decisions about strategy, mergers and acquisitions, budgets, financial policy, technology, and performance measurement—even as markets, economies, and industries change around them.
The authors also point to the risk of failing to adhere to these principles.
For executives with functional, business, or corporate responsibilities, ignoring the cornerstones can lead to decisions that erode value or lead to outright corporate disaster.
Both investors, corporate managers as well as bords of directors need to always remember what really creates value and what destroys it, and what are the financial theories that have stood the test of time.
Internalizing the four cornerstones of finance, understanding how they relate to the real economy and the public stock markets (or private-owner expectations), and having the courage to apply them across the enterprise have significant upside and little downside. At least, the four cornerstones can prevent executives from making strategic, financial, and business decisions that undermine value creation. At best, the cornerstones can encourage a more constructive, value-oriented dialogue among executives, boards, investors, bankers, and the press—resulting in courageous and even unpopular decisions that build lasting corporate value.
The authors wrap up the preface to the book by warning the reader about “seductive new theories” that sometimes, at least for a while, catch the attention of “journalists, traders, boards, investors, and executives … even though they’re blatantly at odds with the tenets of finance that have held true for more than 100 years.”
Before we look at the four cornerstones of value, let’s have a look at two paragraphs from the first chapter of the book that captures the essence of it all.
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. 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.
Below, an except from the book about the four cornerstones of corporate finance that every investor and businessman should be familiar with when analyzing or managing the business (underlining and emphasis added).
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.
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.
“I am a better investor because I am a businessman and a better businessman because I am an investor.” —Warren Buffett
Disclosure: I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company or individual mentioned in this article. I have no positions in any stocks mentioned.