Book Summary: Value – Four Cornerstones of Corporate Finance

Book: Value – Four Cornerstones of Corporate Finance

Author: Tim Koller, Richard Dobbs, Bill Huyett

Key takeaways: There’s nothing ground-breaking about this book, which is why I love it. It is an amazing tool to bring the valuation concepts home, and to root logic in simple tenets.

Four Cornerstones:

  1. Companies create value by investing capital at rates of return higher than the cost of capital (8-10% for large cos.). Business with high returns of capital, improvements in growth create the most value. But for businesses with low returns, improvements in RoIC provide the most value. It is a fallacy that RoIC can grow as a company grows (it happens only for young start-up companies and business with very low CUR).
  2. Total value doesn’t change simply by rearranging claims on the cash. (this is why the claim that no matter what, high P/E company acquiring a low P/E company will lead to re-rating of the low P/E co’s earning is specious). Often, people think that P/E is driven only by earnings growth, but they forget RoIC as the other key factor.
  3. Expectations treadmill
  4. Value depends on who’s managing it and the strategy that they pursue.
    1. Unique Links with Other Businesses: often obvious.
    2. Distinctive Skills: Very hard to measure, but a significant factor
    3. Better Insight/Foresight: Again, very to measure. Often is the case of being lucky or significant capital investments paid for by previous owners.
    4. Better Governance: PE firms often succeed at this, and this is a component of how they add value. Stronger performance culture is introduced and quick management changes are made. Also, board of PE firms spend 3x time on strategy and performance management, as opposed to compliance or risk avoidance.
    5. Distinctive Access to Talent, Capital, Government, Suppliers, Customers etc: this is far more important in the emerging markets.

Useful Exercise When Handicapping Market Expectations:

It is useful to use a DCF model to see the revenue growth that is being implied in the market valuation for  constant margins and RoIC.

Managerial Implications for Public Companies:

Compensation: Because the majority of the short-term total return to shareholders (TRS) is driven by recent market performance, it is inappropriate to use this measure as a metric to reward executives. In the 80s and 90s, many executives became rich from stock options simply because the market went up and not necessarily because they performed very well, or even at the average corporate performance. If at all TRS is included, it makes sense to include TRS relative to peers rather than absolute TRS. Growth and RoIC makes more sense as performance measurement metrics.

Guidance: The valuation metric does not change, but it incentivizes managers to do the wrong thing to meet the guidance (80% of CFOs said that they would reduce discretionary capex to meet ST earnings targets). Operation measures shaping volume/earnings etc are more useful, as are cost reduction initiatives.

Investor Communications: Per McK, companies often listen to the wrong investors. Also companies that give guidance such as 10% EPS growth are too top-down in terms of strategic planning and often signal lack of a strategic direction.

Stock Market:

People often talk about the market as if it were a monolithic entity with a single point of view. Of course, this is not true, because if it were, it wouldn’t be a market. Retail investors own about 40% of the market, but they rarely matter when it comes to influencing the share price of a company because they don’t trade very much.

The market is made up of –

  • Intrinsic investors: hold 20% of assets and account for 10% of the trading volume – drive the valuation levels.
  • Traders: 35% of assets
  • Indexers (and closer indexers) and Quants

Shareholder returns over the past 100 years is 6.5 – 7% p.a., which is no accident. This is made up of 3 – 3.5% real corporate profit growth rate, ~2% inflation, and the rest coming from dividends and share repurchases (with the total payout ratio in the vicinity of ~50%).

The differentiation between growth and value stocks is artificial. According to a McK study that looked at cos. in value and growth sub-indexes of the S&P, median revenue growth of the value cos. was only slightly less than growth cos. and 46% of value cos. grew faster than the median growth rate of the growth cos. In fact the primary differentiating factor was RoIC (35% vs. 15% for value cos.). The reason that this artificial differentiation came into place because when academics were categorizing the various companies, they assumed that RoIC was the same across the two sets, and that the differences in multiples reflected only different growth expectations.

What Drives RoIC?

  • RoIC = Op. Profit / Capital = (Price – Cost)/Capital (driven by the SCP model)
  • Predictability of return matters; tech companies have a high RoIC, but they may not exist in 20 years.
  • In terms of competitors, industries with only two competitors avoid damaging competition, industries with 6 or more cos. will have trouble behaving cooperatively, and industries with 3 – 5 competitors can go either way.
  • High RoIC companies tend to maintain their high returns, and low RoIC companies tend to retain theirs

Performance Measurement:

Intrinsic Value is made of –

  • Long-term Growth
    • Sales Productivity (ST driver) – market share, pricing power, sales force
      • Commercial Health (MT driver) – brand value, customer satisfaction, product pipeline etc.
  • RoIC
    • Operating Cost productivity (ST driver) – component costs, rate of rework etc.
      • Cost Structure Health (MT driver) – continuous improvement programs
    • Capital productivity (ST driver)
      • Asset Health (MT driver) – avrg. time between remodeling projects etc.
  • Cost of Capital
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