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Monday, November 8, 2010

The CEO's guide to corporate finance

Four principles can help you make great financial decisions—even when the CFO’s not in the room.

McKinsey Quarterly
NOVEMBER 2010 • Richard Dobbs, Bill Huyett, and Tim Koller


corporate finance, CEO's guide article, value creation, corporate performance, financial engineering, core-of-value principle, expectations treadmill principle, conservation of value principle, best owner principle, cash flow, cash flows, securitization of assets, shareholder value, Corporate Finance
It’s one thing for a CFO to understand the technical methods of valuation—and for members of the finance organization to apply them to help line managers monitor and improve company performance. But it’s still more powerful when CEOs, board members, and other nonfinancial executives internalize the principles of value creation. Doing so allows them to make independent, courageous, and even unpopular business decisions in the face of myths and misconceptions about what creates value.
When an organization’s senior leaders have a strong financial compass, it’s easier for them to resist the siren songs of financial engineering, excessive leverage, and the idea (common during boom times) that somehow the established rules of economics no longer apply. …
What we hope to do in this article is show how four principles, or cornerstones, can help senior executives and board members make some of their most important decisions. The four cornerstones are disarmingly simple:
1. The core-of-value principle establishes that value creation is a function of returns on capital and growth, while highlighting some important subtleties associated with applying these concepts.
2. The conservation-of-value principle says that it doesn’t matter how you slice the financial pie with financial engineering, share repurchases, or acquisitions; only improving cash flows will create value.
3. The expectations treadmill principle explains how movements in a company’s share price reflect changes in the stock market’s expectations about performance, not just the company’s actual performance (in terms of growth and returns on invested capital). …
4. The best-owner principle states that no business has an inherent value in and of itself; it has a different value to different owners or potential owners—a value based on how they manage it and what strategy they pursue.
View these principles and their implications at a glance.
Ignoring these cornerstones can lead to poor decisions that erode the value of companies. Consider what happened during the run-up to the financial crisis that began in 2007. Participants in the securitized-mortgage market all assumed that securitizing risky home loans made them more valuable because it reduced the risk of the assets. …Securitization did not increase the aggregated cash flows of the home loans, so no value was created, and the initial risks remained. Securitizing the assets simply enabled the risks to be passed on to other owners: …
Obvious as this seems in hindsight, a great many smart people missed it at the time. …

Mergers and acquisitions

Acquisitions are both an important source of growth for companies and an important element of a dynamic economy. Acquisitions that put companies in the hands of better owners or managers or that reduce excess capacity typically create substantial value both for the economy as a whole and for investors.
… But although they create value overall, the distribution of that value tends to be lopsided, accruing primarily to the selling companies’ shareholders. In fact, most empirical research shows that just half of the acquiring companies create value for their own shareholders.
The conservation-of-value principle is an excellent reality check for executives who want to make sure their acquisitions create value for their shareholders. The principle reminds us that acquisitions create value when the cash flows of the combined companies are greater than they would otherwise have been. Some of that value will accrue to the acquirer’s shareholders if it doesn’t pay too much for the acquisition.
Exhibit 1 shows how this process works. Company A buys Company B for $1.3 billion—a transaction that includes a 30 percent premium over its market value. Company A expects to increase the value of Company B by 40 percent through various operating improvements, so the value of Company B to Company A is $1.4 billion. Subtracting the purchase price of $1.3 billion from $1.4 billion leaves $100 million of value creation for Company A’s shareholders.

  • Exhibit 1: To create value, an acquirer must achieve performance improvements that are greater than the premium paid.

      In other words, when the stand-alone value of the target equals the market value, the acquirer creates value for its shareholders only when the value of improvements is greater than the premium paid. …
      While a 30 or 40 percent performance improvement sounds steep, that’s what acquirers often achieve. For example, Exhibit 2 highlights four large deals in the consumer products sector. Performance improvements typically exceeded 50 percent of the target’s value.
    • Exhibit 2: Dramatic performance improvement created significant value in these four acquisitions.
        Our example also shows why it’s difficult for an acquirer to create a substantial amount of value from acquisitions. Let’s assume that Company A was worth about three times Company B at the time of the acquisition. Significant as such a deal would be, it’s likely to increase Company A’s value by only 3 percent—the $100 million of value creation depicted in Exhibit 1, divided by Company A’s value, $3 billion.
        Finally, it’s worth noting that we have not mentioned an acquisition’s effect on earnings per share (EPS). Although this metric is often considered, no empirical link shows that expected EPS accretion or dilution is an important indicator of whether an acquisition will create or destroy value. …To avoid confusion during such communications, executives should remind themselves and their colleagues that EPS has nothing to say about which company is the best owner of specific corporate assets or about how merging two entities will change the cash flows they generate.

        Divestitures

        Executives are often concerned that divestitures will look like an admission of failure, make their company smaller, and reduce its stock market value. Yet the research shows that, on the contrary, the stock market consistently reacts positively to divestiture announcements.1 The divested business units also benefit. Research has shown that the profit margins of spun-off businesses tend to increase by one-third during the three years after the transactions are complete.2
        These findings illustrate the benefit of continually applying the best-owner principle: … At different stages of an industry’s or company’s lifespan, resource decisions that once made economic sense can become problematic. …
        A value-creating approach to divestitures can lead to the pruning of good and bad businesses at any stage of their life cycles. …  One way to do so is to hold regular review meetings specifically devoted to business exits, ensuring that the topic remains on the executive agenda and that each unit receives a date stamp, or estimated time of exit. This practice has the advantage of obliging executives to evaluate all businesses as the “sell-by date” approaches.
        Executives and boards often worry that divestitures will reduce their company’s size and thus cut its value in the capital markets. … But this notion holds only for very small firms, with some evidence that companies with a market capitalization of less than $500 million might have slightly higher costs of capital.3
        Finally, executives shouldn’t worry that a divestiture will dilute EPS multiples. A company selling a business with a lower P/E ratio than that of its remaining businesses will see an overall reduction in earnings per share. … With this unit gone, the company that remains will have a higher growth and ROIC potential—and will be valued at a correspondingly higher P/E ratio.4 As the core-of-value principle would predict, financial mechanics, on their own, do not create or destroy value. By the way, the math works out regardless of whether the proceeds from a sale are used to pay down debt or to repurchase shares. What matters for value is the business logic of the divestiture.

        Project analysis and downside risks

        Reviewing the financial attractiveness of project proposals is a common task for senior executives. … For example, one company we know analyzed projects by using advanced statistical techniques that always showed a zero probability of a project with negative net present value (NPV). …
        Such an approach ignores the core-of-value principle’s laserlike focus on the future cash flows underlying returns on capital and growth, not just for a project but for the enterprise as a whole. Actively considering downside risks to future cash flows for both is a crucial subtlety of project analysis—and one that often isn’t undertaken.
        For a moment, put yourself in the mind of an executive deciding whether to undertake a project with an upside of $80 million, a downside of –$20 million, and an expected value of $60 million. Generally accepted finance theory says that companies should take on all projects with a positive expected value, regardless of the upside-versus-downside risk.
        But what if the downside would bankrupt the company? That might be the case for an electric-power utility considering the construction of a nuclear facility for $15 billion … Suppose there is an 80 percent chance the plant will be successfully constructed, … and worth, net of investment costs, $13 billion. Suppose further that there is also a 20 percent chance that the utility company will fail to receive regulatory approval to start operating the new facility, which will then be worth –$15 billion. That means the net expected value of the facility is more than $7 billion—seemingly an attractive investment.5
        The decision gets more complicated if the cash flow from the company’s existing plants will be insufficient to cover its existing debt plus the debt on the new plant if it fails. … Failure will wipe out all the company’s equity, not just the $15 billion invested in the plant.
        As this example makes clear, we can extend the core-of-value principle to say that a company should not take on a risk that will put its future cash flows in danger. … On the other hand, if the project doesn’t endanger the company, they should be willing to risk the … loss for a far greater potential gain.

        Executive compensation

        Establishing performance-based compensation systems is a daunting task, …[Many] companies continue to reward [executives] for short-term total returns to shareholders (TRS). TRS, however, is driven more by movements in a company’s industry and in the broader market (or by stock market expectations) than by individual performance. …
        Using TRS as the basis of executive compensation reflects a fundamental misunderstanding of the third cornerstone of finance: the expectations treadmill. If investors have low expectations for a company at the beginning of a period of stock market growth, it may be relatively easy for the company’s managers to beat them. But that also increases the expectations of new shareholders, so the company has to improve ever faster just to keep up and maintain its new stock price. At some point, it becomes difficult if not impossible for managers to deliver on these accelerating expectations without faltering, much as anyone would eventually stumble on a treadmill that kept getting faster.
        This dynamic underscores why it’s difficult to use TRS as a performance-measurement tool: extraordinary managers may deliver only ordinary TRS because it is extremely difficult to keep beating ever-higher share price expectations. Conversely, if markets have low performance expectations for a company, its managers might find it easy to earn a high TRS, at least for a short time, by raising market expectations up to the level for its peers.
        Instead, compensation programs should focus on growth, returns on capital, and TRS performance, relative to peers (an important point) rather than an absolute target. That approach would eliminate much of the TRS that is not driven by company-specific performance. Such a solution sounds simple but, until recently, was made impractical by accounting rules and, in some countries, tax policies. …
        Since 2004, a few companies have moved to share-based compensation systems tied to relative performance. GE, for one, granted its CEO a performance award based on the company’s TRS relative to the TRS of the S&P 500 index. We hope that more companies will follow this direction.
        Applying the four cornerstones of finance sometimes means going against the crowd. … None of this is easy, but the payoff—the creation of value for a company’s stakeholders and for society at large—is enormous.



        In a new book, Value: The Four Cornerstones of Corporate Finance, McKinsey’s Richard Dobbs, Bill Huyett, and Tim Koller show the power of four disarmingly simple but often-ignored financial principles. Here are some practical applications.
      • Exhibit 3: Four cornerstones of value creation at a glance

          About the Authors

          Richard Dobbs is a director in McKinsey’s Seoul office and a director of the McKinsey Global Institute; Bill Huyett is a director in the Boston office; and Tim Koller is a principal in the New York office. This article has been excerpted from Value: The Four Cornerstones of Corporate Finance, by Richard Dobbs, Bill Huyett, and Tim Koller (Wiley, October 2010). Koller is also a coauthor of Valuation: Measuring and Managing the Value of Companies, (fifth edition, Wiley, July 2010). To learn more about both books, please visit our information page on the McKinsey & Company Web site.

          Notes

          1 J. Mulherin and Audra Boone, “Comparing acquisitions and divestitures,” Journal of Corporate Finance, 2000, Volume 6, Number 2, pp. 117–39.
          2 Patrick Cusatis, James Miles, and J. Woolridge, “Some new evidence that spinoffs create value,” Journal of Applied Corporate Finance, 1994, Volume 7, Number 2, pp. 100–107.
          3 See Robert S. McNish and Michael W. Palys, “Does scale matter to capital markets?” mckinseyquarterly.com, June, 2005.
          4 Similarly, if a company sells a unit with a high P/E relative to its other units, the earnings per share (EPS) will increase but the P/E will decline proportionately.
          5 The expected value is $7.4 billion, which represents the sum of 80 percent of $13 billion ($28 billion, the expected value of the plant, less the $15 billion investment) and 20 percent of –$15 billion ($0, less the $15 billion investment).
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