Fundamental Principles of Value Creation

Fundamental Principles of Value CreationFundamental Principles of Value Creation – Companies create value by investing capital to generate future cash flows at rates of return that exceed their cost of capital. The faster they can grow and deploy more capital at attractive rates of return, the more value they create.

The mix of growth and return on invested capital (ROIC) relative to the cost of capital is what drives the creation of value. A corollary of this principle is the conservation of value: any action that doesn’t increase cash flows doesn’t create value. Fundamental Principles of Value Creation

The principles imply that a company’s primary task is to generate cash flows at rates of return on invested capital greater than the cost of capital.

Following these principles helps managers decide which investments will create the most value for shareholders in the long term. The principles also help investors assess the potential value of alternative investments.

Managers and investors alike need to understand in detail what relationships tie together cash flows, ROIC, and value; what consequences arise from the conservation of value; and how to factor any risks attached to future cash flows into their decision making. Fundamental Principles of Value Creation

Growth and ROIC

Fundamental Principles of Value Creation

Companies create value for their owners by investing cash now to generate more cash in the future. The amount of value they create is the difference between cash inflows and the cost of the investments made, adjusted to reflect the fact that tomorrow’s cash flows are worth less than today’s because of the time value of money and the riskiness of future cash flows. A company’s return on invested capital and its revenue growth together determine how revenues are converted to cash flows. Fundamental Principles of Value Creation

That means the amount of value a company creates is governed ultimately by its ROIC, revenue growth, and of course its ability to sustain both over time. Fundamental Principles of Value Creation

One might expect universal agreement on a notion as fundamental as value, but this isn’t the case: many executives, boards, and financial media still treat accounting earnings and value as one and the same and focus almost obsessively on improving earnings. However, while earnings and cash flow are often correlated, earnings don’t tell the whole story of value creation, and focusing too much on earnings or earnings growth often leads companies to stray from a value-creating path. Fundamental Principles of Value Creation

For example, earnings growth alone can’t explain why investors in drugstore chain Walgreens, with sales of $54 billion in 2007, and global chewing-gum maker Wm. Wrigley Jr. Company, with sales of $5 billion the same year, earned similar shareholder returns between 1968 and 2007.3 These two successful companies had very different growth rates. During the period, the net income of Walgreens grew at 14 percent per year, while Wrigley’s net income grew at 10 percent per year.

Even though Walgreens was one of the fastest-growing companies in the United States during this time, its average annual shareholder returns were 16 percent, compared with 17 percent for the significantly slower-growing Wrigley. The reason Wrigley could create slightly more value than Walgreens despite 40 percent slower growth was that it earned a 28 percent ROIC, while the ROIC for Walgreens was 14 percent (a good rate for a retailer). Fundamental Principles of Value Creation

Further analysis – What can also happen?

The first cornerstone of value creation—that ROIC and growth generate value—and its corollary, the conservation of value, have stood the test of time. Alfred Marshall wrote about return on capital relative to its cost in 1890 1.

When managers, boards of directors, and investors have forgotten these simple truths, the consequences have been disastrous. The rise and fall of business conglomerates in the 1970s, hostile takeovers in the United States in the 1980s, the collapse of Japan’s bubble economy in the 1990s, the Southeast Asian crisis in 1998, the Internet bubble, and the economic crisis starting in 2007—all of these can be traced to a misunderstanding or misapplication of the cornerstones. During the Internet bubble, for instance, managers and investors lost sight of what drives ROIC, and many even forgot its importance entirely.

When Netscape Communications went public in 1995, the company saw its market capitalization soar to $6 billion on an annual revenue base of just $85 million—an astonishing valuation. The financial world was convinced by this phenomenon that the Internet could change the basic rules of business in every sector, setting off a race to create Internet-related companies and take them public. Between 1995 and 2000, more than 4,700 companies went public in the United States and Europe, many with billion-dollar-plus market capitalizations.

Many market commentators ignored history in their indiscriminate recommendation of Internet stocks. They took intellectual shortcuts to justify absurd prices for shares of technology companies, which inflated the Internet bubble. At the time, those who questioned the new economics were branded as people who simply didn’t get it—the new- economy equivalents of those who would defend Ptolemaic astronomy. When the laws of economics prevailed, as they always do, it was clear that Internet businesses (such as online pet food or grocery deliv- ery) didn’t have the unassailable competitive advantages required to earn even modest returns on capital.

The Internet has revolutionized the economy, as have other innovations, but it didn’t and can’t change the rules of economics, competition, and value creation (I am not sure if we still agree).

Ignoring the cornerstones also underlies financial crises, such as the one that began in 2007. When banks and investors forgot the conservation-of-value principle, they took on a level of risk that was unsustainable.

First, homeowners and speculators bought homes—essentially illiquid assets. They took out mortgages with interest set at artificially low teaser rates for the first few years, but then those rates rose substantially. Both the lenders and buyers knew that buyers couldn’t afford the mortgage payments after the teaser period. But both assumed that either the buyer’s income would grow by enough to make the new payments, or the house value would increase enough to induce a new lender to refinance the mortgage at similarly low teaser rates.

Banks packaged these high-risk debts into long-term securities and sold them to investors. The securities, too, were not very liquid, but the investors who bought them, typically hedge funds and other banks, used short-term debt to finance the purchase, thus creating a long-term risk for those who lent the money.

When the interest on the homebuyers’ adjustable rate increased, many could no longer afford the payments. Reflecting their distress, the real estate market crashed, pushing the value of many homes below the value of loans taken out to buy them. At that point, homeowners could neither make the required payments nor sell their houses. See- ing this, the banks that had issued short-term loans to investors in securities backed by mortgages became unwilling to roll those loans over, prompting all the investors to sell their securities at once.

The value of the securities plummeted. Finally, many of the large banks themselves had these securities on their books, which they, of course, had also financed with short-term debt that they could no longer roll over.

This story reveals two fundamental flaws in the decisions taken by participants in the securitized mortgage market. First, they all assumed that securitizing risky home loans made them more valuable because it reduced the risk of the assets—but this violates the conservation- of-value rule. The aggregated cash flows of the home loans were not increased by securitization, so no value was created and the initial risks remained.

Securitizing the assets simply enabled risks to be passed on to other owners; some investors, somewhere, had to be holding them. Yet the complexity of the securities chain made it impossible to know who was holding precisely which risks. After the housing market turned, financial service companies feared that any of their counterparties could be holding massive risks and almost ceased to do business with one an- other. This was the start of the credit crunch that triggered a protracted recession in the real economy.

The second flaw in thinking made by decision makers during the past economic crisis was believing that using leverage to make an investment in itself creates value. It doesn’t because, according to the conservation-of-value principle, leverage doesn’t increase the cash flows from an investment. Many banks, for example, used large amounts of short-term debt to fund their illiquid long-term assets. This debt didn’t create long-term value for shareholders in those banks. On the contrary, it increased the risks of holding their equity.

Market bubbles and crashes are painfully disruptive, but we don’t need to rewrite the rules of competition and finance to understand and avoid them. Certainly the Internet changed the way we shop and communicate—but it didn’t create a materially different economic mechanism, the so-called new economy. On the contrary, the Internet made information, especially about prices, transparent in a way that intensifies market competition in many real markets.

Similarly, the financial crisis triggered in 2007 will wring out some of the economy’s recent excesses, such as enabling people to buy houses they can’t afford, and uncontrolled credit card borrowing by consumers. But the key to avoiding the next crisis is to reassert the fundamental economic rules, not to revise them.

Advantages of valuing value

There has long been vigorous debate on the importance of shareholder value relative to a company’s record on employment and social responsibility—also measures of success. In their ideology and legal frameworks, the United States and the United Kingdom have given most weight to the idea that the main function of a corporation is to maximize shareholder value.

An explicitly broader view of a corporation’s purpose, governance structures, and forms of organization has long been influential in continental Europe. In the Netherlands and Germany, for example, the board of a large corporation has a duty to support the continuity of the business in the interests of all the corporation’s stakeholders, including employees and the local community, not just shareholders.

There are analysis and experience that suggest that for most companies any-where in the world, pursuing the creation of long-term shareholder value doesn’t mean that other stakeholders suffer. We would go fur- ther and argue that companies dedicated to value creation are more robust and build stronger economies, higher living standards, and more opportunities for individuals.

Consider employee stakeholders. A company that tries to boost profits by providing a shabby work environment, underpaying employees, and skimping on benefits will have trouble attracting and retaining high-quality employees. With today’s more mobile and more educated workforce, such a company would struggle in the long term against competitors offering more attractive environments. While it may feel good to treat people well, it’s also good business.

Fundamental Principles of Value Creation

Fundamental Principles of Value Creation

Annualreporting provides financial reporting narratives using IFRS keywords and terminology for free to students and others interested in financial reporting. The information provided on this website is for general information and educational purposes only and should not be used as a substitute for professional advice. Use at your own risk. Annualreporting is an independent website and it is not affiliated with, endorsed by, or in any other way associated with the IFRS Foundation. For official information concerning IFRS Standards, visit or the local representative in your jurisdiction.

Something else -   Cash Flow Risk Management

Fundamental Principles of Value Creation Fundamental Principles of Value Creation Fundamental Principles of Value Creation Fundamental Principles of Value Creation Fundamental Principles of Value Creation Fundamental Principles of Value Creation Fundamental Principles of Value Creation Fundamental Principles of Value Creation Fundamental Principles of Value Creation Fundamental Principles of Value Creation

Leave a comment