Value: The Four Cornerstones of Corporate Finance
While you can find numerous books focused on the topic of corporate finance, few offer the type of information managers need to help them make important decisions day in and day out.
Value explores the core of corporate finance without getting bogged down in numbers and is intended to give managers an accessible guide to both the foundations and applications of corporate finance. Filled with in-depth insights from experts at McKinsey & Company, this reliable resource takes a much more qualitative approach to what the authors consider a lost art.
- Discusses the four foundational principles of corporate finance
- Effectively applies the theory of value creation to our economy
- Examines ways to maintain and grow value through mergers, acquisitions, and portfolio management
- Addresses how to ensure your company has the right governance, performance measurement, and internal discussions to encourage value-creating decisions
A perfect companion to the Fifth Edition of Valuation, this book will put the various issues associated with corporate finance in perspective.
About the Authors ix
Part One The Four Cornerstones
1 Why Value Value? 3
Many companies make decisions that compromise value in the name of creating value. But with courage and independence, executives can apply the four cornerstones of finance to make sound decisions that lead to lasting value creation.
2 The Core of Value 15
Return on capital and growth are the twin drivers of value creation, but they rarely matter equally. Sometimes raising returns matters more, whereas other times accelerating growth matters more.
3 The Conservation of Value 29
You can create the illusion of value or you can create real value. Sometimes acquisitions and financial engineering schemes create value, and sometimes they don’t. No matter how you slice the financial pie, only improving cash flow creates value.
4 The Expectations Treadmill 41
No company can perpetually outperform the stock market’s expectations. When a company outperforms, expectations rise, forcing it to do better just to keep up. The treadmill explains why the share prices of high performing companies sometimes falter, and vice versa.
5 The Best Owner 51
No company has an objective, inherent value. A target business is worth one amount to one owner and other amounts to other potential ownersdepending on their relative abilities to generate cash flow from the business.
Part Two The Stock Market
6 Who Is the Stock Market? 63
Conventional wisdom segments investors into pigeonholes like growth and value, but these distinctions are erroneous. There’s a more insightful way to classify investors, and doing so culls out those who matter most to the value-minded executive.
7 The Stock Market and the Real Economy 73
The performance of stock markets and real economies are typically aligned, hardly ever perfectly aligned, and rarely very misaligned. Executives and investors who understand this are better able to make value-creating decisions.
8 Stock Market Bubbles 89
Stock market bubbles are rare and usually confined to specific industry sectors and companies. Knowing why and when bubbles occur can keep management focused on making sound strategic decisions based on a company’s intrinsic value.
9 Earnings Management 103
Trying to smooth earnings is a fool’s game that can backfire and, in some cases, destroy value. Creating value in the longer run sometimes necessitates decisions that reduce earnings in the shorter run.
Part Three Managing Value Creation
10 Return on Capital 119
A company can’t sustain a high return on capital in the absence of an attractive industry structure and a clear competitive advantage. Yet it’s surprising how few executives can pinpoint the competitive advantages that drive their companies’ returns.
11 Growth 139
It’s difficult to create value without growing, but growth alone doesn’t necessarily create value. It all depends on what type of growth a company achieves and what the returns on that growth are.
12 The Business Portfolio 153
A company’s destiny is largely synonymous with the businesses it owns, and actively managed portfolios outperform passively managed portfolios. Sometimes companies can create value by selling even high performing businesses.
13 Mergers and Acquisitions 169
Most acquisitions create value, but typically the acquirer’s shareholders only get a small portion of that value, while the lion’s share goes to the target’s shareholders. But there are archetypal ways that acquirers can create value.
14 Risk 183
Nothing in business is more clear yet complex than the imperative to manage risk. Clear because risk matters greatly to the company, its board, its investors, and its decision makers. Complex because each of these groups has a different perspective.
15 Capital Structure 197
Getting capital structure right is important but doesn’t necessarily create valuewhile getting capital structure wrong can destroy tremendous value. When it comes to financial structures, companies are best to keep them as simple as possible.
16 Investor Communications 209
Good investor communications can ensure that a company’s share price doesn’t become misaligned with its intrinsic value. And communication isn’t just one way: executives should listen selectively to the right investors as much as they tell investors about the company.
17 Managing for Value 223
It’s not easy to strike the right balance between shorter-term financial results and longer-term value creationespecially in large, complex corporations. The trick is to cut through the clutter by making your management processes more granular and transparent.
Appendix A The Math of Value 237
Appendix B The Use of Earnings Multiples 241
TIM KOLLER leads the firm's research activities in valuation and capital market issues. He advises clients globally on corporate strategy, capital markets, M&A, and value-based management. Tim is a coauthor of Valuation: Measuring and Managing the Value of Companies.
RICHARD DOBBS is a director of the McKinsey Global Institute, the firm's business and economics research arm. He advises Korean and other Asian companies and governments on strategy, economics, and M&A issues. Richard is an associate fellow of University of Oxford's Saïd Business School.
BILL HUYETT advises clients in healthcare and other technology-intensive industries on corporate strategy, M&A, product development and commercialization, and corporate leadership. Bill is active on several not-for-profit boards in basic life sciences research.
It’s surprising how often executives and boards make decisions that defy their own intuition about what creates lasting shareholder value. Market pressure, new financial engineering techniques, and misconceptions dressed as conventional wisdom all conspire against them. As all too recently witnessed, such misconceptions can damage companies and even the economies of entire countries.
A new book by McKinsey & Company, VALUE: The Four Cornerstones of Corporate Finance (Wiley; November 2010; $29.95; 978-047042460-5; Hardcover), provides a clean view into what drives corporate value creation—and what doesn’t—offering CEOs and other senior executives a stable basis for making sound, courageous, and sometimes unpopular strategic and financial decisions, even in the face of flawed thinking.
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 minority of investors should be heeded, and the rest should be 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 create more value than retaining them.
- Predicted EPS accretion or dilution is no indicator of an acquisition’s potential to create value.
The four cornerstones are built upon deep and broad McKinsey research and are illuminated with anecdotes, examples and company cases. The cornerstones are:
- The core of value: The combination of growth and return on capital, and resulting cash flow, drives value creation. This explains why some companies typically trade at high P/E multiples despite low growth. What’s important about this is that where a business stands in terms of growth and return on invested capital (ROIC) can drive significant changes in its strategy. For businesses with high returns on capital, improvements in growth create the most value; for businesses with low returns, improvements in ROIC provide the most value.
- The conservation of value: Value is created when companies generate higher cash flows, not by rearranging investors’ claims on those cash flows. When a company substitutes debt for equity or issues debt to repurchase shares, for instance, it changes the ownership of claims to its cash flows—but it typically doesn’t change the total available cash flows or add value, unless taxes change. Similarly, changing accounting techniques may create the illusion of higher performance without actually changing the cash flows, so it won’t change the value of a company.
- 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 (growth, ROIC and resulting cash flow). 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. Although certain companies can deliver unusually high total returns to shareholders for some period of time (usually no more than three years), they eventually hit a wall and disappoint.
- The best owner: There is no such number as an inherent value for a business; rather, a business’s value is relative to who owns it or might own it. Different owners will generate different cash flows for a business based on the strategies they pursue and their unique abilities to add value. Some, for instance, add value through unique links with other businesses in their portfolios, such as those with strong capabilities for accelerating the commercialization of products formally owned by upstart technology companies.
Value draws on research from the definitive reference on corporate finance and value creation, McKinsey’s Valuation: Measuring and Managing the Value of Companies. That book is now in its fifth edition, having sold more than 500,000 copies in 10 languages. But McKinsey came to see the need for a more accessible work to guide senior executives and board members through the quagmires of strategy formulation, business portfolio configuration and decisions about mergers and acquisitions.
“It’s one thing for a CFO to understand the mathematically based laws of valuation and apply them to the tools and processes that drive company performance. But it’s more powerful still when CEOs, board members and other non-financial executives understand the principles and practices of value,” says author Tim Koller. “Companies dedicated to value creation are more robust and build stronger economies, higher living standards, and more opportunities for individuals.”