The McKinsey Quarterly website offers a chief executive's guide to corporate finance, revealing four principles to help leaders make great financial decisions "even without the help of the chief financial officer".
The authors, Richard Dobbs, Bill Huyett, and Tim Koller, explain: "It's one thing for a CFO to understand the technical methods of valuation – and for members of the finance organisation to apply them to help line managers monitor and improve company performance. But it's still more powerful when CEOs, board members, and other non-financial executives internalise the principles of value creation.
"Doing so allows them to make independent, courageous, and even unpopular business decisions in the face of myths and misconceptions about what creates value."
Dobbs, Huyett and Koller add that a strong "financial compass" will enable senior leaders to avoid the pitfalls of financial engineering and excessive leverage, as well as the misconception that somehow the proven laws of economics no longer apply during boom times. They observe that follies such as these can lead to "value-destroying decisions" that can take hold with "surprising and disturbing ease" and slow down entire economies.
The authors insist that their four principles to help executives make their most important financial decisions are "disarmingly simple". They are as follows:
1) The core-of-value principle: "Value creation is a function of returns on capital and growth, highlighting some important subtleties associated with applying these concepts".
2) The conservation-of-value principle: "It doesn’t matter how you slice the financial pie with financial engineering, share repurchases, or acquisitions; only improving cash flows will create value".
3) The expectations treadmill principle: "Movements in a company's share price reflect changes in the stock market's expectations about performance, not just the company's actual performance". (The performance of the company will have to match those expectations to keep up.)
4) The best-owner principle: "No business has an inherent value in and of itself; it has a different value to different owners or potential owners – a value based on how they manage it and what strategy they pursue".
Dobbs, Huyett and Koller say that ignoring these principles, or "cornerstones" can result in poor decisions and erosion in company value. They give the example of what happened in the run-up to the financial crisis that started in 2007:
"Participants in the securitised-mortgage market all assumed that securitising risky home loans made them more valuable because it reduced the risk of the assets. But this notion violates the conservation-of-value rule. Securitisation did not increase the aggregated cash flows of the home loans, so no value was created, and the initial risks remained.
"Securitising the assets simply enabled the risks to be passed on to other owners: some investors, somewhere, had to be holding them."
The authors say the same thing occurs every day in executive suites as managements evaluate acquisitions, divestitures, projects, and executive compensation.
MERGERS AND ACQUISITIONS
Dobbs, Huyett and Koller insist that the conservation-of-value principle can help leaders ensure their acquisitions create value for their shareholders because it "reminds us that acquisitions create value when the cash flows of the combined companies are greater than they would otherwise have been". Some of that value, they say, will accrue to the acquirer’s shareholders if the acquisition hasn't cost too much.
However, the authors warn that you should be wary of mergers that are justified – or dismissed – on the strength of their impact on earnings per share (EPS). They say that although this metric is often considered, there is no empirical data to suggest EPS has any say in how merging two entities will change the cash flows they generate.
The best-owner principle can help leaders take a value-creating approach to divestitures, pruning good and bad businesses at various stages of their lifespans. The authors say resource decisions that once made economic sense can become obsolete.
For instance, as demand drops in a mature industry, companies that have been in it for long time will probably have excess capacity, so they might not be the best owners any more.
The authors warn that divesting a good business is "often not an intuitive choice and may be difficult for managers – even if that business would be better owned by another company".
Therefore, they say it makes sense to "enforce some discipline in active portfolio management". They suggest holding regular review meetings dedicated to business exits, making sure that the issue stays on the executive agenda and that every unit gets a date stamp, or "estimated time of exit".
When it comes to reviewing the financial merits of project proposals, the core-of-value principle comes into play. A company should not take risks that could put future cash flows in danger. But while you shouldn't do anything that could have a large, negative effect on the rest of the company, an organisation shouldn't pass up a potentially high-return project because there is a moderate downside risk.
Dobbs, Huyett and Koller observe that many companies continue to reward executives for short-term total returns to shareholders (TRS).
However, TRS is driven more by movements in a company's industry and in the broader market than by individual performance, so using it as a basis for executive compensation shows a "fundamental misunderstanding" the expectations treadmill principle.
The authors explain: "If investors have low expectations for a company at the beginning of a period of stock market growth, it may be relatively easy for the company’s managers to beat them. But that also increases the expectations of new shareholders, so the company has to improve ever faster just to keep up and maintain its new stock price.
"At some point, it becomes difficult if not impossible for managers to deliver on these accelerating expectations without faltering, much as anyone would eventually stumble on a treadmill that kept getting faster."
Compensation programmes should therefore focus on growth, returns on capital, and TRS performance relative to peers rather than an absolute target.
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