Review – Value: The Four Cornerstones of Corporate Finance

by Tim Koller, Richard Dobbs and Bill Huyett; published 2011

Part I is about the four cornerstones of value. In a footnote in Chapter 1, authors Koller, Dobbs and Huyett define value as:

the sum of the present values of future expected cash flows– a point-in-time measure. Value creation is the change in value due to company performance… we use the market price of a company’s shares as a proxy for value and total return to shareholders as a proxy for value creation.

Further, they explain that the book explores the “four cornerstones of corporate finance” which are:

  1. companies create value by investing capital from investors to generate future cash flows at rates of return exceeding the cost of capital
    1. the combination of growth and return on invested capital (ROIC) drives value and value creation
    2. 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
  2. value is created for shareholders when companies generate higher cash flows, not by rearranging investors’ claims on those cash flows
  3. the expectations treadmill– 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; 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
  4. the value of a business depends on who is managing it and what strategy they pursue

For a real-life application of these principles, the authors highlight the recent housing bubble, namely, that the mortgage-securitization model violated the conservation-of-value principle because it rearranged risk without affecting the aggregate cash flows of home loans, while the belief that levering up these types of investments increased their value was similarly erroneous because “leverage doesn’t increase the cash flows from an investment.”

Chapter 2 explores return on invested capital (ROIC) which the authors define in simple terms  in a footnote as:

return on capital is after-tax operating profit divided by invested capital (working capital plus fixed assets)

ROIC and revenue growth “determine how revenues get converted into cash flows.” Mathematically, growth, ROIC and cash flow (represented by the investment rate) look like this:

Investment Rate = Growth / ROIC

However, Growth and ROIC have an uneven relationship:

for any level of growth, value always increases with improvements in ROIC. When all else is equal, higher ROIC is always good.

When ROIC is high, faster growth increases value, but when ROIC is low, faster growth decreases value. The dividing line between whether growth creates or destroys value is when the return on capital equals the cost of capital. When returns are above the cost of capital, faster growth increases value.

The authors advise that “most often, a low ROIC indicates a flawed business model or an unattractive industry structure.” The growth-at-all-costs mentality is flawed.

high-return companies should focus on growth, while low-return companies should focus on improving returns before growing.

In Chapter 3, the authors focus on the conservation of value, namely,

value is conserved when a company shifts the ownership of claims to its cash flows but doesn’t change the total available.

To see how managerial decisions affect the value of the business look for the cash flow impact.

On share buybacks,

when the likelihood of investing cash at low returns is high, share repurchases make sense as a tactic for avoiding value destruction.

Caution, however, because

studies of share repurchases have shown that companies aren’t very good at timing share repurchases, often buying when their share prices are high, not low.

And why should they be any better at timing their purchases than any other market timer?

As far as acquisitions are concerned, they

create value only when the combined cash flows of the two companies increase due to accelerated revenue growth, cost reductions or better use of fixed and working capital.

In Chapter 4, the authors discuss the expectations treadmill, stating that

smart investors often prefer weaker-performing companies because they have more upside potential, as the expectations are easier to beat.

The key seems to be finding companies with a high ROIC and a low P/E ratio.

Chapter 5 discusses the best owner principle. For example, some owners add value:

  • linkages with other activities in their portfolio
  • by replicating such distinctive skills as operational or marketing excellence
  • by providing better governance and incentives for the management team
  • through distinctive relationships they hold with governments, regulators or customers
Further, there is a “best owner lifecycle”, meaning that most owners are only the “best” at a given stage in a business’s development. Some excel at the start-up stage, others the growth, others still the maintenance of empire and finally a group is best at the terminal stage where a business is dismantled and its assets are sold off to other enterprises, each owner finding unique ways to increase cash flows at each stage. The implication of this is that
executives need to continually look for acquisitions of which they could be the best owner; they also need to continually examine opportunities for divesting businesses of which they might no longer be the best owner.

Empirically, “the stock market consistently reacts positively to divestitures, both sales and spin-offs.”

Part II is about the stock market. Chapter 6 explores who the stock market is. There are a lot of different participants with differing aims, skill sets and knowledge levels but the authors conclude that ultimately

professional investors–whether they manage hedge funds, mutual funds, or pension funds– are the real drivers of share prices, accounting for virtually all large trades.

The authors estimate that “intrinsic” investors hold 20% of US assets and contribute 10% of the trading volume in the U.S. market. “Intrinsic investors ultimately drive share price, because when they buy, they buy in much larger quantities.”

intrinsic investors are resources for executives, providing an objective, circumspect view of their companies, industries, and competitors by virtue of their buying and selling decisions.

Chapter 7 is about the stock market and the real economy. Here are some aggregate observations:

  • much of the stock market’s stellar performance between 1983 and 1996 was driven by the decline in interest rates and inflation, and the resultant increase in P/E ratios engineered by Federal Reserve Chairman Paul Volcker
  • by 1996, if executives understood what was driving shareholder returns, they would have known returns had to revert to normal levels
  • adjusted for inflation, large U.S. equities have earned returns to shareholders of about 6.5 to 7 percent annually, over the last 100 years
  • this number is derived from the long-term performance of companies in the aggregate, and the relationship between valuation and performance as described by the core-of-value principle
  • over the longer term, shareholder returns are unlikely to deviate much from this number unless there are radical changes in investor risk preferences or radical changes in the performance of the economy
  • long-term GDP growth would have to increase or decrease significantly, or the ratio of corporate profits to GDP would need to change (it has been constant for at least 75 years)
If, as the authors state, “high interest rates increase the nominal cost of capital, while high inflation increases the proportion of earnings that must be invested for growth”, then the implications for the coming period in the markets where we might finally face a high interest rate environment with simultaneously accelerated money printing spells falling P/E ratios across the broad market.
This means that the market as a whole has a more narrow band of longer-term performance than many realize, and that exceptional bull markets will usually be followed by a down market, and vice versa

Chapter 9 deals with earnings management. The authors state that “excessive smoothness raises concerns” that earnings are being actively managed by company leaders. Further, “consensus forecasts aren’t very good” and “analysts’ earnings estimates are not accurate; they tend to be too optimistic, and they almost never identify inflection points.” Importantly, “there is no meaningful relationship between earnings variability and TRS or valuation multiples.”

Part III deals with managing value creation. Chapter 10 is about return on capital.
A company that has a competitive advantage earns a higher ROIC because it either charges a price premium or it produces its products more efficiently (having lower costs or capital per unit) — or both. Price premiums offer the greatest opportunity to achieve an attractive ROIC, but are more difficult to achieve than cost efficiencies.

Low ROIC industries are those with undifferentiated products, high capital intensity and fewer opportunities for innovation.

There are 5 major ways to get a price premium:

  • innovative products
  • quality
  • brand
  • customer lock-on
  • rational price discipline

There are 4 major ways to get cost/capital efficiency:

  • innovative business methods
  • unique resources
  • economies of scale
  • scalability/flexibility
Ultimately, the longer a company can sustain a high ROIC the more value it will create.
ROIC excluding goodwill reflects the underlying economics of an industry or company. ROIC including goodwill reflects whether management has been able to extract value from acquisitions.

Therefore, it might be useful to study both metrics to get a better understanding of management’s competence.

Chapter 11 is about growth.

growth from creating whole new product categories tends to create more value than growth from pricing and promotion tactics to gain market share from peers.

This intuitively makes sense because the former requires the bringing into the production system of previously untapped resources, while the former simply represents the freeing up of existing resources.

There are 4 sources of revenue growth:

  • market-share increase
  • price increase
  • growth in underlying market
  • acquisitions

The limits to the pursuit of growth:

  • sustaining high growth is much more difficult than sustaining high ROIC.
  • history suggests that many mature firms will shrink in real terms
  • U.S. companies have been globalizing, which is responsible for faster sustained growth rates of some U.S. companies than the growth of the economy as a whole
  • portfolio treadmill effect: for each product that matures and declines in revenues, the company needs to find a similar-sized replacement product to stay level in revenues, and even more to keep growing
Chapter 12 examines business portfolios. One study found that “it was better to have a competitive advantage (horse) than to have a good management team (jockey).” Another study found that “companies with a passive portfolio approach underperformed companies with an active portfolio approach.” This means “buy and hold” is a flawed strategy in the long-run, because the value of businesses change according to predictable cycles of birth, growth, flat-lining and death.

The ideal multibusiness company [think, investment portfolio] is one in which each business earns an attractive ROIC with good growth prospects, where the company helps each business achieve its potential, and where executives are continually developing or acquiring similarly high-ROIC businesses and disposing of businesses that are in decline.

To avoid depressed exit prices,

a simple rule of thumb can improve a company’s timing considerably: sell sooner

“When companies do divest, they almost always do so too late, reacting to some kind of pressure.” And a process suggestion for active portfolio management:

hold regular, dedicated business exit review meetings, ensuring in the process that the topic remains on the executive agenda and that each unit receives a date stamp, or estimated time of exit

As far as diversification is concerned:

  • diversification is neither good nor bad; it depends on whether the parent company adds more value to the businesses it owns than any other potential owner could, making it the best owner of those businesses under the circumstances
  • no evidence that diversified companies generate smoother cash flows
  • there is no evidence that investors pay higher prices for less volatile companies
  • diversified companies tend to respond to opportunities more slowly than less diversified companies
  • the business units of diversified companies often don’t perform as well as those of more focused peers, partly because of added complexity and bureaucracy

I noted in the margins that “even for investors, diversification raises transaction costs and provides more opportunities to make errors in decision process.”

Chapter 13 is about M&A. A few points about M&A value creation:

  • strong operators are more successful
  • low transaction premiums are better
  • being the sole bidder helps

Chapter 15 explores capital structure.

large amounts of debt reduce a company’s flexibility to make value-creating investments, including capital expenditures, acquisitions, R&D, and sales and marketing.

Before assuming debt, an investor or business owner needs to ask:

  • what are my expected cash flows?
  • what could go wrong?
  • what unexpected opportunities could arise?
Then, “set your debt level so that you can live through bad times in your industry while having the capacity to take advantage of unexpected opportunities.”
With complex structures and financial engineering, always identify the impact on a company’s operating cash flows and the distribution of cash flows among investors.
Finally, Chapter 17 addresses managing for value.
the only way to continually grow earnings faster than revenues is to cut necessary costs for growing the business, or to not invest in new markets that will have low or negative margins for several years
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Review – The 4-Hour Work Week

by Timothy Ferriss; published 2009

A few important takeaway quotes from Chapter 1, “Rules That Change The Rules”:

  1. Retirement is an unsustainable notion: implies you do what you dislike during the most physically capable years of your life; the math doesn’t work; you’ll probably opt to look for a new job or start another company as soon as you retire, out of boredom
  2. Alternating periods of activity and rest is necessary to survival, as well as “thrival”; work only when you are most effective to be more productive and happier overall
  3. “Someday” is a disease that will take your dreams to the grave with you; if it’s important to you and you want to do it “eventually”, just do it and course correct along the way
  4. Ask for forgiveness, not permission; if the potential damage is moderate or in any way reversible, don’t give people the chance to say no
  5. It’s better to emphasize strengths than repair weaknesses; identify your best weapons and focus on wielding them more wisely
  6. The positive use of free time implies doing what you want as opposed to what you feel obligated to do
  7. Relative income uses two variables: money and time
  8. Eustress: role models who push us to exceed our limits, physical training, risks that expand our sphere of comfortable action; people who avoid all criticism fail

The value of money spent is determined by:

  • what you do
  • when you do it
  • where you do it
  • with whom you do it

In other words, quality, not quantity, is the major consideration in “psychic yield” from money spent.

In Chapter 2, Ferriss proposes some “rules that change the rules”. To start with, the concept of saving and sacrificing for an old-age retirement is a broken one because:

  • it assumes up to that point you spend a majority of your time doing something you dislike during the most physically capable years of your life
  • the math doesn’t work and you end up reliving your low-income lifestyle in old-age
  • you’ll likely get bored and look for a job or start a company just to keep yourself busy, negating the whole point

Instead, Ferriss proposes taking periodic “mini-retirements” throughout your life. This concept is consistently applied even down to the weekly and daily level, as he suggests that,

Alternating periods of activity and rest is necessary to survive, let alone thrive… By working only when you are most effective, life is both more productive and more enjoyable.

Many people push their dreams into the future and thereby let “someday” become “never.” Instead of waiting for the perfect time to take a break, Ferriss recommends following a passion as soon as you are aware of it and course correcting along the way.

To use your time wisely in life, focus on the things you are best at, rather than wasting time shoring up your weaknesses. This is an economic concept known as “competitive advantage” and it works for individuals just as well as companies or countries (obviously). Using free time efficiently implies doing what you want to do with your free time, not what you feel obligated to do. Finally, it’s important to seek out eustress, which is healthy stress that results in testing our limits and then pushing them out a little further afterward. In other words,

People who avoid all criticism fail.

Chapter 3 is about overcoming the fear of realizing your dreams. Ferriss opens with the quote,

Many a false step was made by standing still.

To overcome fear, we must define it. Often, we realize that what we fear going wrong is an unlikely, temporary 3 or 4 (on a scale of ten) disaster, in return for a probable and permanent 9 or 10 success. If you don’t like what you’re doing now, and you stick with it, how likely is your situation to be improved one year from now?

Instead of seeing how much definite pain you can tolerate now, Ferriss advises you to pull the cord, take a leap and try something different while you still have a chance. You must develop a habit of doing things you fear on a daily basis because “what we fear doing most is usually what we most need to do.” You should ask yourself,

If I don’t pursue those things that excite me, where will I be in one year, five years and ten years?

If you’re bored and dissatisfied with your life and not following your passions, and you define risk as “the likelihood of an irreversible negative outcome”, then it follows that “inaction is the greatest risk of all.”

You’ve decided to face your fears and challenge yourself by demanding more. What should you do? As Chapter 4 recommends, aim as high as you can, and never let admonitions that what you are attempting is “unreasonable” stop you.

The reasonable man adapts himself to the world; the unreasonable one persists in trying to adapt the world to himself. Therefore all progress depends on the unreasonable man.

The bigger the goal, the less competition you will face. The less competition, the better your chances of bagging the big one– “the fishing is best where the fewest go.”

When choosing goals and objectives, ask yourself, “What would excite me?” and then do that thing.

Ferriss’s preferred method for envisioning your future, exciting lifestyle is called “dreamlining”. You are to come up with a number of “having, being and doing” items, and then try to convert the “beings” into “doings” by coming up with specific actionable steps you could take (lessons, events, workshops, etc.) that will transform you into that kind of person. Then, you estimate the cost of these different items and divide each amount by 12 (or however many months you’re giving yourself to realize these dreams, though the shorter the better to avoid “someday”-fatigue) to get your monthly cost for each.

Adding the monthly costs of your dreamline to your current monthly expenses (multiplied by 1.3 to give yourself a savings buffer for something going wrong) gives you your Target Monthly Income (TMI) and gives you a real goal to shoot for in helping you understand how much more you need to make on a monthly basis to start realizing your dreamlines. This is the part where you get creative– sell stuff you don’t need and aren’t using anymore, reduce your expenses by not getting that latte every morning, and think up new sources of income by starting a side business or other passive income stream. You’ll often be amazed how close you are to your dreams when you look at them as a monthly figure and consider ways in which your current spending doesn’t really satisfy your dream desires.

Living your dream is about doing, and making bold decisions for yourself. This is why Ferriss ends the chapter by stating:

To have an uncommon lifestyle, you need to develop the uncommon habit of making decisions, both for yourself and others.

The next time someone asks you for a decision on something (where to go for lunch, what to do about that client, etc.), MAKE ONE and course correct if necessary. Almost everything is reversible.

Chapter 5 develops the theme of time management. The focus is on the 80/20 principle of Italian economist Vilfredo Pareto, namely, focus on eliminating the 20% of sources causing 80% of your problems while spending that freed up time on the 20% of sources responsible for 80% of your desired outcomes and happiness. Productive efficiency is about doing more by doing less ineffective stuff via selectivity.

The most important lesson: lack of time is actually lack of priorities.

Give yourself short, clear deadlines to work out critical tasks that contribute the most to your work or quality of life. Ignore or eliminate the rest. A few other tips:

  • Ask yourself, “If this is the only thing I accomplish today, will I be satisfied with my day?”
  • Never arrive at the office, your computer or anywhere else without a clear list of priorities– otherwise you’ll make up distractions to fill your time
  • Compile your to-do list for tomorrow no later than this evening
  • You should never have more than two mission-critical items to complete each day
  • Do not multitask

Chapter 6, The Low Information Diet, takes these principles and applies them further. Stop wasting time reading the news; start using, “Tell me, what’s new in the world?” as a conversation starter and let others read the news and summarize headlines for you.

If you need to learn how to do something, read the autobiography of someone who has done it. If you’re suffering from information overload, ask yourself, “Will I definitely use this information for something immediate and important?” And practice the art of nonfinishing– if something is boring or not useful, stop reading it/listening to it/watching it, etc.

Stop asking people “How are you?” and instead ask them, “How can I help you?” The former invites interruptions, the latter invites action.

Living The New Rich Lifestyle Starts With Mini-Retirement Jet-setting Practice

Paraphrasing (in Ferriss’s words) the first few paragraphs of the chapter about doing a life-reset by traveling abroad:

Some jobs are simply beyond repair. Improvements would be like adding a set of designer curtains to a jail cell. Most people aren’t lucky enough to get fired and die a slow spiritual death over 30-40 years of tolerating the mediocre. Being able to quit things that don’t work is integral to being a winner. The person who has more options has more power. Don’t wait until you need options to search for them. Take a sneak peek at the future now and it will make both action and being assertive easier.

Begin your new lifestyle of mini-retirements and following your life’s passion by relocating to one place for one to six months before going home or moving to another locale. This will give you time to relax and enjoy the new experiences without having to worry about catching your flight home, and without shortchanging yourself by assuming you won’t be around long enough to really submerse yourself in the local culture and language.

Chose a location where your money will go further than back home (such as Argentina, Thailand or Eastern Europe). To get there, use credit card miles or buy your tickets either far in advance or at the last minute, comparison shopping with Orbitz.com or Kayak.com and the airlines’ own websites and then bidding on Priceline.com for 50% off, moving up in increments of $50 at a time. Consider using major airlines to get to travel hubs in foreign countries and then buying a local airline ticket to make the final leg(s) of the trip from there.

When you arrive, stay in a hostel or cheap hotel and query fellow travelers and hostel/hotel owners for the lay of the land. Tour around local neighborhoods with hop on/hop off bus tours or public transit, or rent a bike. Go look for an apartment (fully furnished and full of amenities) and set up your base for a few months.

If you’re relocating to a country where you can use dollar-arbitrage to your advantage, you can likely live much better than you do back home, enjoying a nice apartment, eating out at fancy restaurants and enjoying entertainment and nightlife you couldn’t dream of back home.

You should also look into local, private language instruction (several hours per week), as well as other local activities such as cultural dance, music, athleticism and exercise, that will allow you to learn from experts, mix with locals, learn the language and do it all for less money than you’d spend back home for equivalent experiences.

Practice taking less with you: take one week of clothes, no toiletries and allocate $100-300 to buy the rest of what you need when you get there. When you come home, leave the excess behind. You should be able to travel internationally with a carry-on and a backpack.

Final Remarks About Living Life Well

If you can’t define it or act upon it, forget about it.

Have at least one 2-to-3 hour dinner and/or drinks per week with those who make you smile and feel good.

Eat a high-protein breakfast within 30 minutes of waking and go for a 10-to-20 minute walk outside afterward, ideally bouncing a handball or tennis ball.

A good question to revisit whenever overwhelmed: Are you having a breakdown, or a breakthrough?

Rehearse poverty regularly. (You’ll fear it less when you know what it’s like and that you can handle it.)