Keep it Simple to Understand Value

My Financial Times column 11/15/10

Value is one of those terms better understood outside business than inside. Any household bill payer knows the difference between good and bad value. Most of us have a keen sense of whether goods are priced fairly or not. But step into the corporate world, and suddenly the term goes wobbly.

There is shareholder value, but also stakeholder value; there is not one bottom line but multiple ones; there is intangible value and the value of potential synergies, which bump up acquisition prices before frequently turning to dust. When Warren Buffett talks of “value investing” he is talking about buying great companies at good prices, rather than investing on the basis of all the other mind-bending signals and stimuli in the markets.

What managers need to do is block out the noise and return to a simpler, less confusing idea of value. At its most basic, the value of a business is the sum of the present value of its future expected cash flows. But as anyone who has ever tried to build a discounted cash flow model can attest, bankers and corporate finance professors could dance on the head of this one intellectual pin for eternity. How do you price risk? Do different cash flows carry different levels of risk? How do you know what the future really holds?

So, managing for value has to mean something more specific. Three management consultants at McKinsey – Tim Koller, Richard Dobbs and Bill Huyett – grapple with this in a new bookValue: The Four Cornerstones of Corporate Finance. This is definitely one best read in a hard chair with a sharp pencil as it marches the reader through the very practical issues that affect value: from the nature of owners and investors to the behaviour of the stock market, good and bad ways to divest and acquire, all the way to risk management and investor communications.

The four cornerstones are uncontroversial. The first is “the core of value”, the fact that companies create value by investing capital to generate future cash flows at higher rates of return than the cost of capital. The second is the “conservation of value” – companies create value by generating higher cash flows, not by rejigging the capital structure. The third is “the expectations treadmill”. Expectations drive a company’s stock price as well as its actual performance, so the higher your expectations, the faster you must run to keep up. The fourth is that the value of a business depends on who is managing it and the strategy they pursue, the “best owner” cornerstone.

I asked Mr Koller why these points even need to be made. Surely, the prospective audience of this book – senior managers, chief executives and chief financial officers – know all this? “CEOs and CFOs are often influenced by noise rather than reason,” he says. The book serves as a helpful reminder of what matters and is intended to “convince companies to be more thoughtful when they listen to investors”. It is also a prop for those who think they understand value when they are asked to explain what they mean.

There are, Mr Koller continues, good and bad investors. The good ones are focused on long-term value. They do not twitch in response to every crumb of news flashing by on their Bloomberg terminal. Instead, they think about value in terms of the four cornerstones. Do we have the best managers and owners in place? Are they pursuing the right strategy? And are they producing returns that exceed our cost of capital and will they continue to do so? If so, over time the value of our investment will be properly priced, regardless of any fleeting swoons and spasms exhibited by the markets.

But it is not just investors who need to understand value. A manager whose performance is being measured by his company’s share price needs to know what makes that share price move and whether it is a fair measure. Peter Löscher, chief executive of Siemens, is now in the process of unlocking the value of his company after 10 years in which managers have been trying to turn the company round. After a decade in which Siemens’ share price barely moved, investors are now bubbling with expectation and the price is rising accordingly. Mr Löscher and his predecessors were not rewarded by the markets while their overhaul of the company was going on. It is only happening now that Siemens is fixed and ready to grow. Recognition of value is not a linear process. The manager sees it one day, everyone else the next.

Mr Koller says a misunderstanding of value is leading many companies to be “recklessly cautious”. They are so focused on today’s earnings per share, and frozen by the fear of punishment by the stock market if that number drops, they are passing up terrific opportunities to create long-term value. It is not just individual managers and companies that suffer when this condition takes hold, but entire economies now hankering for growth.

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