- August 16, 2020
- Posted by: Ramkumar
- Category: Strategy
Why Valuing Value is Critical Today
The guiding belief of business value creation is a refreshingly simplistic construct: firms that expand and gain a return on capital that surpasses their cost of capital build value. After the COVID19 pandemic, many people are repeatedly challenging the foundations of capitalism, particularly shareholder-oriented capitalism. Hurdles such as globalization, climate change, income inequality, and the increasing influence of technology titans have swayed public belief in large enterprises. Politicians and pundits force for added regulation and significant changes in corporate governance. Some have moved so far as to assert that “capitalism is ruining the planet. In this post, I provide my insights on why valuing value is critical today.
What Does It Imply to Build Shareholder Value?
Especially at this moment of reflection on the merits and vices of capitalism, managers and board directors must have a definite knowledge of what value creation implies. For value-minded executives, generating value cannot be confined to merely maximizing today’s share price. Instead, the data denotes a higher purpose: maximizing a company’s combined value to its shareholders, immediately and in eternity.
However, it would be a blunder to conclude that the stock market is not “effective” as they do a great job with information available to them, but markets are not all-knowing. Investors cannot price data they don’t have. Consider the analogy of selling an older home. The seller may acknowledge that the boiler is defective. Still, unless the seller reveals those facts, a potential buyer may have significant trouble identifying them, even with the guidance of a licensed house inspector.
Companies that have generated long-term revenue growth—mostly organic revenue growth have delivered maximum shareholder returns. Firms who build value for the long term do not double down on today’s share price if these activities harm the company down the road. For instance, they don’t shortchange product development, lessen product quality, or sacrifice on safety. When analyzing investments, they consider future reforms in regulation or consumer habits, particularly environmental and health concerns. Today’s managers face unpredictable markets, rapid executive turnover, and intense performance pressures, so shaping long-term value-creating decisions needs guts.
Why EPS is no longer relevant
Many firms proceed to devise and execute strategy—and then communicate their performance—against shorter-term measures, particularly earnings per share (EPS). As a consequence of their focus on EPS, significant companies regularly pass up long-term value-creating opportunities. For instance, assume that a new CFO of one large organization has launched a standing dictate: every business unit required to grow its profits quicker than its revenues. A few business units already have profit margins over 30% and return on capital of 50%. That’s a tremendous result if your horizon is the following annual report. But for units to match that performance bar right now, they are abandoning growth opportunities that have 25%profit margins in the years to come.
Post-COVID, many businesses have decreased discretionary spending on likely value-creating activities such as marketing and R&D to adhere to their short-term earnings objectives. Some are willing to provide customers discounts to make purchases this quarter rather than next to hit quarterly EPS targets. That’s no way to operate a railroad—or any business.
As an instance of how companies get stuck in a short-term EPS focus, examine companies analyzing a planned acquisition. The most common question firms ask is whether the transaction will dilute EPS over the initial year or two. Given the prevalence of EPS as a standard for company decisions, you might reason that predicted improvement in EPS would be vital to an acquisition’s potential to generate value. However, no experiential data is linking increased EPS with the value created by a transaction. Deals that increase EPS and mergers that dilute EPS are reasonably likely to produce or destroy value.
Consequences of Ignoring Value-Creation Principles
When businesses overlook the simple value-creation principles, the adverse outcomes to the economy can be monstrous. Two recent cases of many managers abandoning in their commitment to concentrate on actual value creation are the Internet bubble of the 1990s and the financial disaster of 2008. Through the Internet bubble, investors dropped sight of what runs return on invested capital (ROIC); yes, many ignored the significance of this ratio completely. Many managers and investors overlooked the cardinal rules of economics in the thin air of the Internet revolution. The idea of “winner take all” led businesses and investors to conclude that all that mattered was getting big quick, thinking that they could wait until later to bother about building a valuable business model.
The thesis of realizing ever-increasing returns was also wrongly employed to grocery delivery operations, even though these firms had to fund (unsustainably, finally) in more drivers, trucks, warehouses, and inventory when their customer base increased. When the laws of economics controlled, as they forever do, it was explicit that many Internet businesses did not have the protected competitive advantages needed to earn even modest returns on invested capital. The Internet has transformed the economy, as have other innovations, but it did not and could not obsolete the laws of economics, competition, and value creation.
Myopic focus can cause disgraceful dealing, and sometimes the results can shake trust in capitalism to its institutions. In 2008, too many financial organizations neglected core principles. Banks loaned money to people at inexpensive teaser rates, thinking that housing prices would only rise. Financial institutions packaged these high-risk loans into long-term securities and traded them to investors who used short-term debt to fund the purchase, generating a long-term risk for whoever loaned them the money. When the home buyers could no longer sustain the payments, the real estate market crashed, driving the values of many homes below the costs of the loans taken out to purchase them. At that point, homeowners could not make the needed payments nor auction their homes. Banks that had issued short-term advances to investors in securities backed by mortgages became reluctant to roll over those loans, urging them to sell all such bonds at once. The value of the securities plunged. Ultimately, many of the large banks themselves held these securities, which they had also funded with short-term debt they could no longer rollover.
The blend of growth and return on invested capital (ROIC), corresponding to its cost, drive cash flow, and value. Anything that doesn’t improve ROIC or growth at an attractive ROIC doesn’t generate value. This section can include actions that alter the ownership of claims to cash flows and accounting methods that may vary the profits’ timing without really increasing cash flows.
The guiding belief of value creation connects straight to competitive advantage, the core concept of business strategy. Only if companies have a distinct competitive advantage, can they support steady growth and high returns on invested capital?
Employing the principles of value creation sometimes implies going against the mob. It involves admitting that there are no easy lunches. It suggests relying on data, careful analysis, a profound comprehension of your industry’s competitive dynamics, and a well-informed outlook on how society invariably influences and is affected by your business.