Value: The Four Cornerstones of Corporate Finance
Challenging convention
Value challenges a variety of half-truths and conventional wisdom, offering alternative constructs and practices for today's business leaders. Understanding the four cornerstones explains why, for example:
- Growth isn't always the key to value creation, despite the business world's obsession with it.
- Share repurchases, currently much in favor, rarely create value.
- Companies and investors should spend less time worrying about earnings guidance.
- The voices of a certain investors should be heeded, and the rest should be generally ignored.
- Near-term changes in a company's market valuation—often used to assess corporate performance and management compensation—are mostly due to factors beyond executives' control.
- Earnings are inevitably variable, so trying to smooth them is a fool's game.
- Divesting high-performing businesses can sometimes create more value than retaining them.
- Predicted EPS accretion or dilution is no indicator of an acquisition's potential to create value.
Insights from the book
The four cornerstones are meant to give executives, managers, and corporate leaders a firm grasp of what matters most in managing for value. Here are some insights derived from the book:
- Many companies pursue growth indiscriminately, not prioritizing the types of growth that create the most value. Value spells out how different types of growth create different amounts of value. Introducing a new product or increasing share in a growing market, for instance, yields between three and eight times more value than acquisitions do.
- The idea that high growth is needed to achieve a high P/E multiple and better returns to shareholders is a myth. What usually matters more is improving return on capital. At the end of 2009, for example, Hershey Company's P/E was 18, higher than 70 percent of the 400 largest US nonfinancial companies. Yet Hershey's revenue growth rate has been in the 3 to 4 percent range.
- Although companies often engage in financial engineering, this rarely creates value, and sometimes it erodes or destroys value. More often than not, financial engineering merely redistributes investors' claims on cash flow, and it isn't worth the trouble. One only has to look at the recent financial crisis for a glaring example of how financial engineering (complex CDOs) can destroy enormous value for companies and even entire economies.
- Great strategy and competitive advantage start with understanding the one or two drivers of a company's return on capital. Yet most executives struggle to articulate the advantages they have, or could have, based on an understanding of what drives return on capital and why some companies earn 5 percent returns while others earn over 30 percent. Value provides some frameworks and rules of thumb to help executives understand what drives returns and competitive advantage.
- The metrics of earnings, earnings growth, and returns to shareholders can mislead executives and investors in more than one way. One, they take attention away from more fundamental performance and health metrics that lead to strong returns that are more sustainable in the longer run. Two, they pressure executives to forgo necessary expenses when investors clamor for immediate results, often leading to lost market position down the road. Three, they're used as a basis for compensating executives, even though the financial performance of companies in the short term is largely disconnected from anything executives do or don’t do.