Guide To Finance
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The CEO's Guide to Corporate Finance outlines four principles, or cornerstones, to help executives make strong financial decisions independently of the CFO. The four cornerstones are: 1) the core-of-value principle focuses on returns on capital and growth as drivers of value, 2) the conservation-of-value principle states that only improving cash flows creates value, 3) the expectations treadmill principle explains how share prices reflect changing expectations rather than just performance, and 4) the best-owner principle states that a business's value depends on its owner and strategy. Applying these principles can help executives evaluate acquisitions, divestitures, projects, and compensation to make decisions that create rather than destroy value.
Guide To Finance
- 1. insight insight The CEO’s Guide to Corporate Finance by Richard Dobbs, Bill Huyett, and Tim Koller, McKinsey Four principles can help you make great financial decisions-even when the CFO’s not in the room. The problem apply. Misconceptions like these—which can lead companies to make Strategic decisions can be complicated by competing, often value-destroying decisions and slow down entire economies—take spurious notions of what creates value. Even executives with solid hold with surprising and disturbing ease. Only instincts can be seduced by the allure of financial engineering, What we hope to do in this article is show how four principles, or improving high leverage, or the idea that well-established rules of economics cornerstones, can help senior executives and board members make cash flows no longer apply. some of their most important decisions. The four cornerstones are disarmingly simple: will create Why it matters value. Such misconceptions can undermine strategic decision-making 1. The core-of-value principle establishes that value creation is a and slow down economies. function of returns on capital and growth, while highlighting some important subtleties associated with applying these concepts. What you should do about it Test decisions such as whether to undertake acquisitions, make 2. The conservation-of-value principle says that it doesn’t matter divestitures, invest in projects, or increase executive compensation how you slice the financial pie with financial engineering, share against four enduring principles of corporate finance. Doing so repurchases, or acquisitions; only improving cash flows will create will often require managers to adopt new practices, such as value. justifying mergers on the basis of their impact on cash flows rather than on earnings per share, holding regular business exit 3. The expectations treadmill principle explains how movements in reviews, focusing on enterprise-wide risks that may lurk within a company’s share price reflect changes in the stock market’s individual projects, and indexing executive compensation to the expectations about performance, not just the company’s actual growth and market performance of peer companies. performance (in terms of growth and returns on invested capital). The higher those expectations, the better that company must I t’s one thing for a CFO to understand the technical methods of perform just to keep up. valuation—and for members of the finance organization to apply them to help line managers monitor and improve company 4. The best-owner principle states that no business has an inherent performance. But it’s still more powerful when CEOs, board members, value in and of itself; it has a different value to different owners or and other nonfinancial executives internalize the principles of value potential owners—a value based on how they manage it and what creation. Doing so allows them to make independent, courageous, strategy they pursue. and even unpopular business decisions in the face of myths and misconceptions about what creates value. Ignoring these cornerstones can lead to poor decisions that erode the When an organization’s senior leaders have a strong financial value of companies. Consider what happened during the run-up to compass, it’s easier for them to resist the siren songs of financial the financial crisis that began in 2007. Participants in the securitized- engineering, excessive leverage, and the idea (common during boom mortgage market all assumed that securitizing risky home loans times) that somehow the established rules of economics no longer made them more valuable because it reduced the risk of the assets. TMI | Issue 192 33
- 2. insight insight But this notion violates the conservation- of-value rule. Securitization did not increase Exhibit 1 - To create value, an acquirer must achieve the aggregated cash flows of the home performance improvements that are greater than the loans, so no value was created, and the premium paid initial risks remained. Securitizing the assets Acquisitions simply enabled the risks to be passed on to create value other owners: some investors, somewhere, when the had to be holding them. cash flows of Obvious as this seems in hindsight, a great many smart people missed it at the time. the And the same thing happens every day in combined executive suites and board rooms as companies managers and company directors evaluate are greater acquisitions, divestitures, projects, and executive compensation. As we’ll see, the than they four cornerstones of finance provide a would perennially stable frame of reference for otherwise managerial decisions like these. have been. Mergers and acquisitions Acquisitions are both an important source of growth for companies and an important element of a dynamic economy. Acquisitions that put companies in the hands of better owners or managers or that operating improvements, so the value of be, it’s likely to increase Company A’s value reduce excess capacity typically create Company B to Company A is $1.4 billion. by only 3 percent—the $100 million of value substantial value both for the economy as a Subtracting the purchase price of $1.3 creation depicted in Exhibit 1, divided by whole and for investors. billion from $1.4 billion leaves $100 million Company A’s value, $3 billion. You can see this effect in the increased of value creation for Company A’s Finally, it’s worth noting that we have not combined cash flows of the many shareholders. mentioned an acquisition’s effect on companies involved in acquisitions. But In other words, when the stand-alone earnings per share (EPS). Although this although they create value overall, the value of the target equals the market value, metric is often considered, no empirical link distribution of that value tends to be the acquirer creates value for its shows that expected EPS accretion or lopsided, accruing primarily to the selling shareholders only when the value of dilution is an important indicator of companies’ shareholders. In fact, most improvements is greater than the premium whether an acquisition will create or destroy empirical research shows that just half of paid. With this in mind, it’s easy to see why value. Deals that strengthen near-term EPS the acquiring companies create value for most of the value creation from acquisitions and deals that dilute near-term EPS are their own shareholders. goes to the sellers’ shareholders: if a equally likely to create or destroy value. The conservation-of-value principle is an company pays a 30 percent premium, it Bankers and other finance professionals excellent reality check for executives who must increase the target’s value by at least know all this, but as one told us recently, want to make sure their acquisitions create 30 percent to create any value. many nonetheless “use it as a simple way to value for their shareholders. The principle While a 30 or 40 percent performance communicate with boards of directors.” To reminds us that acquisitions create value improvement sounds steep, that’s what avoid confusion during such when the cash flows of the combined acquirers often achieve. For example, Exhibit communications, executives should remind companies are greater than they would 2 highlights four large deals in the themselves and their colleagues that EPS otherwise have been. Some of that value consumer products sector. Performance has nothing to say about which company is will accrue to the acquirer’s shareholders if improvements typically exceeded 50 percent the best owner of specific corporate assets it doesn’t pay too much for the acquisition. of the target’s value. or about how merging two entities will Exhibit 1 shows how this process works. Our example also shows why it’s difficult change the cash flows they generate. Company A buys Company B for $1.3 for an acquirer to create a substantial billion—a transaction that includes a 30 amount of value from acquisitions. Let’s Divestitures percent premium over its market value. assume that Company A was worth about Executives are often concerned that Company A expects to increase the value of three times Company B at the time of the divestitures will look like an admission of Company B by 40 percent through various acquisition. Significant as such a deal would failure, make their company smaller, and TMI | Issue 192 35
- 3. Project analysis and downside Exhibit 2 - Dramatic performance improvement created significant value in risks these four acquisition Reviewing the financial attractiveness of project proposals is a common task for senior executives. The sophisticated tools used to support them—discounted cash flows, scenario analyses—often lull top management into a false sense of security. For example, one company we know analyzed projects by using advanced statistical techniques that always showed a zero probability of a project with negative net present value (NPV). The organization did not have the ability to discuss failure, only varying degrees of success. Such an approach ignores the core-of- value principle’s laserlike focus on the future cash flows underlying returns on reduce its stock market value. Yet the executive agenda and that each unit capital and growth, not just for a project research shows that, on the contrary, the receives a date stamp, or estimated time of but for the enterprise as a whole. Actively stock market consistently reacts positively exit. This practice has the advantage of considering downside risks to future cash to divestiture announcements.1 The divested obliging executives to evaluate all flows for both is a crucial subtlety of project The business units also benefit. Research has businesses as the “sell-by date” approaches. analysis—and one that often isn’t shown that the profit margins of spun-off Executives and boards often worry that undertaken. attractiveness businesses tend to increase by one-third divestitures will reduce their company’s For a moment, put yourself in the mind of of a business during the three years after the transactions size and thus cut its value in the capital an executive deciding whether to undertake and its best are complete.2 markets. There follows a misconception a project with an upside of $80 million, a owner will These findings illustrate the benefit of that the markets value larger companies downside of –$20 million, and an expected continually applying the best-owner more than smaller ones. But this notion value of $60 million. Generally accepted probably principle: the attractiveness of a business holds only for very small firms, with some finance theory says that companies should change and its best owner will probably change evidence that companies with a market take on all projects with a positive expected over time. over time. At different stages of an capitalization of less than $500 million value, regardless of the upside-versus- industry’s or company’s lifespan, resource might have slightly higher costs of capital.3 downside risk. decisions that once made economic sense Finally, executives shouldn’t worry that a But what if the downside would bankrupt can become problematic. For instance, the divestiture will dilute EPS multiples. A the company? That might be the case for an company that invented a groundbreaking company selling a business with a lower P/E electric-power utility considering the innovation may not be best suited to exploit ratio than that of its remaining businesses construction of a nuclear facility for $15 it. Similarly, as demand falls off in a mature will see an overall reduction in earnings per billion (a rough 2009 estimate for a facility industry, companies that have been in it a share. But don’t forget that a divested with two reactors). Suppose there is an 80 long time are likely to have excess capacity underperforming unit’s lower growth and percent chance the plant will be successfully and therefore may no longer be the best ROIC potential would have previously constructed, brought in on time, and worth, owners. depressed the entire company’s P/E. With net of investment costs, $13 billion. A value-creating approach to divestitures this unit gone, the company that remains Suppose further that there is also a 20 can lead to the pruning of good and bad will have a higher growth and ROIC percent chance that the utility company will businesses at any stage of their life cycles. potential—and will be valued at a fail to receive regulatory approval to start Clearly, divesting a good business is often correspondingly higher P/E ratio.4 As the operating the new facility, which will then not an intuitive choice and may be difficult core-of-value principle would predict, be worth –$15 billion. That means the net for managers—even if that business would financial mechanics, on their own, do not expected value of the facility is more than be better owned by another company. It create or destroy value. By the way, the $7 billion—seemingly an attractive therefore makes sense to enforce some math works out regardless of whether the investment.5 discipline in active portfolio management. proceeds from a sale are used to pay down The decision gets more complicated if the One way to do so is to hold regular review debt or to repurchase shares. What matters cash flow from the company’s existing meetings specifically devoted to business for value is the business logic of the plants will be insufficient to cover its exits, ensuring that the topic remains on the divestiture. existing debt plus the debt on the new plant 36 TMI | Issue 192
- 4. insight insight Exhibit 3 - The four cornerstones of corporate finance Don’t do anything that has large negative spillover effects on the rest of the company. if it fails. The economics of the nuclear plant CEO and the senior team and for human- expectations of new shareholders, so the will then spill over into the value of the rest resource leaders and other executives company has to improve ever faster just to of the company—which has $25 billion in focused on, say, the top 500 managers. keep up and maintain its new stock price. At existing debt and $25 billion in equity Although an entire industry has grown up some point, it becomes difficult if not market capitalization. Failure will wipe out around the compensation of executives, impossible for managers to deliver on these all the company’s equity, not just the $15 many companies continue to reward them accelerating expectations without faltering, billion invested in the plant. for short-term total returns to shareholders much as anyone would eventually stumble As this example makes clear, we can (TRS). TRS, however, is driven more by on a treadmill that kept getting faster. extend the core-of-value principle to say movements in a company’s industry and in This dynamic underscores why it’s difficult that a company should not take on a risk the broader market (or by stock market to use TRS as a performance-measurement that will put its future cash flows in danger. expectations) than by individual tool: extraordinary managers may deliver In other words, don’t do anything that has performance. For example, many executives only ordinary TRS because it is extremely large negative spillover effects on the rest who became wealthy from stock options difficult to keep beating ever-higher share of the company. This caveat should be during the 1980s and 1990s saw these gains price expectations. Conversely, if markets enough to guide managers in the earlier wiped out in 2008. Yet the underlying have low performance expectations for a example of a project with an $80 million causes of share price changes—such as company, its managers might find it easy to upside, a –$20 million downside, and a $60 falling interest rates in the earlier period earn a high TRS, at least for a short time, by million expected value. If a $20 million loss and the financial crisis more recently—were raising market expectations up to the level would endanger the company as a whole, frequently disconnected from anything for its peers. the managers should forgo the project. On managers did or didn’t do. Instead, compensation programs should the other hand, if the project doesn’t Using TRS as the basis of executive focus on growth, returns on capital, and TRS endanger the company, they should be compensation reflects a fundamental performance, relative to peers (an important willing to risk the $20 million loss for a far misunderstanding of the third cornerstone point) rather than an absolute target. That greater potential gain. of finance: the expectations treadmill. If approach would eliminate much of the TRS investors have low expectations for a that is not driven by company-specific Executive compensation company at the beginning of a period of performance. Such a solution sounds simple Establishing performance-based stock market growth, it may be relatively but, until recently, was made impractical by compensation systems is a daunting task, easy for the company’s managers to beat accounting rules and, in some countries, tax both for board directors concerned with the them. But that also increases the policies. Prior to 2004, for example, TMI | Issue 192 37
- 5. insight insight companies using US generally accepted Since 2004, a few companies have moved lunches. It means relying on data, accounting principles (GAAP) could avoid to share-based compensation systems tied thoughtful analysis, and a deep listing stock options as an expense on their to relative performance. GE, for one, understanding of the competitive dynamics income statements provided they met granted its CEO a performance award based of an industry. None of this is easy, but the certain criteria, one of which was that the on the company’s TRS relative to the TRS of payoff—the creation of value for a exercise price had to be fixed. To avoid the S&P 500 index. We hope that more company’s stakeholders and for society at taking an earnings hit, companies avoided companies will follow this direction. large—is enormous. I compensation systems based on relative Applying the four cornerstones of finance performance, which would have required sometimes means going against the crowd. more flexibility in structuring options. It means accepting that there are no free Richard Dobbs is a director in McKinsey’s Seoul office and a director of the McKinsey Global Institute; Bill Huyett is a director in the Boston office, and Tim Koller is a principal in the Notes New York office. This article has been excerpted from Value: 1. J.Mulherin and Audra Boone. “Comparing acquisitions and divestitures,” Journal of Corporate The Four Cornerstones of Corporate Finance, by Richard Dobbs, Finance, 2000, Volume 6, Number 2, pp117-39. Bill Huyett, and Tim Koller (Wiley, October 2010). Koller is also 2. Patrick Casatis, James Miles, and J.Woolridge. “Some new evidence that spinoffs create value,” a coauthor of Valuation, Measuring and Managing the Value of Journal of Applied Corporate Finance, 1994, Volume 7, Number 2, pp100-107. Companies (fifth edition, Wiley, July 2010). 3. See Robert S.McNish and Michael W. Palys, “Does scale matter to capital markets?” McKinsey on Finance, Number 16, Summer 2005, pp21-23 (also available on mckinseyquarterly.com). 4. Similarly, if a company sells a unit with a high P/E relative to other units, the earnings per share (EPS) will increase but the P/E will decline proportionately. This article was originally published in McKinsey Quarterly, 5. The expected value is $7.4 billion, which represents the sum of 80 percent of $13 billion ($28 billion, the expected value of the plant, less the $15 billion investment) and 20 percent of -$15 www.mckinseyquarterly.com. billion ($0, less the $15 billion investment). Copyright© 2010 McKinsey & Company. All rights reserved. Reprinted by permission. …we have an Leveraging Opportunities in Latin America TMI 186 - June 2010 App for that Issue 186 June 10 Cash Management in Brazil, Leveraging opportunities in Latin America Argentina and Mexico Insights into Cash Management in Brazil, Argentina and Mexico BY HELEN SANDERS, EDITOR Marking the establishment of LatAm Treasury Association (LTA), we have three articles on the ins and outs... Financing the Business BY PETER VAN ROOD Interview #4 with Peter van Rood, Group Treasurer, Brune Singh, Director, External Markets and Harry Blok, Director Corporate Finance, AKZO Nobel... Plus: TenneT’s High-Voltage Financing Strategy Going for Growth with J.P. Morgan in Middle Hybrid Innovation at TenneT East and North Africa BY OTTO JAGER EON’s divestment of its high voltage business, Transpower, strategy for European integration of high voltage grids... Visit the iTunes App store to download for free 38 TMI | Issue 192