Value: The Four Cornerstones of Corporate Finance

Value: The Four Cornerstones of Finance – Koller, Dobbs and Huyett

Valueable lessons from Koller, Dobbs and Huyett

Shareholder value is created when companies invest capital to generate future cash flows at rates of return that exceed their cost of capital. Empirical evidence would also suggest that stock performance correlates positively with a company’s ability to generate cash-flows, growth and high returns on invested capital over the long-term. Hence, the value-oriented investor should understand the drivers of value creation to identify and capitalise on attractive investment opportunities. Authors Tim Koller, Richard Dobbs and Bill Huyett have written such a book, aptly named: Value: The Four Cornerstones of Corporate Finance. Their book provides an accessible introduction to important topics in corporate finance and asset management. We review their key ideas briefly in this post, focusing particularly on their principles of value creation.

The four cornerstones of corporate finance

Simply put, Koller et al suggest that there are four central ideas to value creation and corporate finance: (1) growth and returns on invested capital; (2) conservation of value; (3) expectations treadmill; and (4) the best owner. While straight forward in principle, analysts often neglect these cornerstones when assessing the value of an asset or opportunity. Here’s a quick outline before we explore each principle in more detail:

Growth and return on capital

Companies that grow their revenues and invest free cash flows at high rates of return create value. That is, value creation is driven by growth and return on invested capital (ROIC). Companies with high ROIC create relatively more value through growth while companies with lower ROIC create more value through improvements in ROIC.

We can estimate value by taking the difference in cash inflows and outflows made, with adjustments (discounts) to recognise time value of money and the riskiness of future flows. This is essentially a discounted cash flow analysis (DCF) that many professionals learn in Finance 101.

Value through growth

Companies achieve growth through five common strategy strategies:

Introduce new products to market;
Expand an existing market;
Increase share in a growing market;
Compete for share in a stable market; and
Acquire businesses.

Koller notes that a growth strategy’s effectiveness is linked to its return on capital and risk of failure. For example, the introduction of new products may require less upfront capital but impose a higher risk of failure. Similarly, expansions in stable markets tend to attract retaliation from competitors, while expansions in growing markets may have lower risk of price-wars by contrast. However, expansion in existing markets might be value creating if new customers can be found easily at low incremental costs and capital requirements. Koller cites empirical studies (omitted here for brevity) that found the introduction of new products to create the most value, and acquisitions the least, for consumer-product companies.

Our growth bias

Additionally, Koller suggests it helpful to distinguish between revenue growth and ROIC when discussing free cash flows. When ROIC exceeds the cost of capital, greater growth leads to value creation. By contrast, value is destroyed through growth if the ROIC is below the cost of capital. Hence, our bias for growth is not necessarily value creating. Instead, Koller suggests that companies with consistently low ROIC are more likely to have a poor business model, managerial execution and/or industry structure. Professor Bruce Greenwald shared similar sentiments in Value Investing, From Graham to Buffett and Beyond.

Conservation of value

Value creation is driven by the generation of higher cash flows for claimholders and not by the rearrangement of claims to such cash flows. This is also known as the conservation of value. Changes in accounting techniques for example cannot create value since it does not improve revenue generation or returns on capital invested.

Buybacks and acquisitions

The conservation of value is in some ways just a corollary of the first cornerstone. For example, share repurchases do not create value by themselves. Even if shares are believed to be undervalued, repurchases only shift value from shareholders that sell to shareholders that do not sell. Likewise, acquisitions only create value when the combined cash flows of the parent company and acquisition increase due to some combination of improved revenue growth, cost reductions and use of capital.

Financial engineering

Furthermore, if options are valuable to employees, they are likely to be costly to shareholders. For example, executive stock options can reduce the amount of cash flows available to current shareholders through dilution of ownership. Other forms of financial engineering such as derivatives, structured debt, securitisation and off-balance-sheet financing rarely create value. However, they are popular for its short-term illusory benefits. While leverage can have a multiplier effect on total returns to shareholders, it does not necessarily create value because leverage amplifies both stronger and weaker performance.

Expectations treadmill

The performance of a company’s stock depends not only on the company’s performance (i.e. growth, returns on capital, etc.), but on the market’s expectations as well. The stock market capitalizes the future value of improvements in a higher stock price when the company beats expectations and the market believes such improvements are sustainable. Koller reminds readers that this expectations treadmill implies that it is difficult for management to meet accelerating expectations consistently and indefinitely. This also means that it is difficult for a company to outperform the stock market for a long time.

Good companies, bad investments

In theory, a company’s total return to shareholders should match the cost of equity if expectations perfectly mirror the company’s performance. It is helpful to understand whether the current share price is justified relative to current performance, required future performance and company plans to achieve such results. Good companies are not necessarily good investments if future expectations are already incorporated into prevailing prices. The higher the market expectation and prevailing price, the better the company needs to perform to meet expectations.

Measuring performance

One implication of the expectations-treadmill is that total shareholder returns are not necessarily a useful performance measurement tool to compensate and incentivize management. Koller suggests that remuneration measures should focus instead on growth and return on capital. If compensation systems are linked to total shareholder returns, they should be measured relative to peers than on an absolute basis.

The best owner

Finally, Koller et al suggest business value is not inherent to the company. Instead, it depends very much on the owners and managers operating in charge. While different owners and managers have different abilities, the very best owners will maximise shareholder value by generating the highest possible cash flows and allocating resources to its highest value use.

Value-adding managers

Koller cites studies that have found best owners to add value in one or more of the following ways: (1) Unique links within the value chain and/or with other businesses; (2) Distinctive skills; (3) Better insight and foresight; (4) Better governance; and (5) Access to talent, capital, government, suppliers and customers.

Right owner for the right time

Koller also notes that a business’ best owner is likely to change over time and during different stages of its lifecycle. It also means that executives should look for acquisitions that they could be the best owner of. Managers should also ask what is the lowest amount that they need to pay to close the deal and create maximum value. Koller notes that many managers do not consider whether they are the best owner for a target acquisition and how the acquisition will create value. Likewise, many do not consider divestment when they are no longer the best owner either.

Value: The Four Cornerstones of Finance – Koller, Dobbs and Huyett