An inexpensive book (US $25) on valuation is to read: Interpretation of Financial Statements by Mary Buffett and David Clark. The strength, they argue, is based on the Durable Competitive Advantage which provided 60B$ cash to Warren Buffett. Why not follow his compelling and unfailing proof of his success in the evaluation of businesses?

Missed two big points: trust and innovation.

Intrinsic to WACC is the value of credit reflected in both the cost of debt as well as the cost of equity. The disconnect occurs when variables are massaged with the experiences of life. WACC is only as valuable as the variables considered when measuring the weighted risk factors on equity and debt beyond a market risk premium on equity and relative cost of debt against a RFR. WACC works best if you also know that it has been layered with a range of ERM factors, including default and recovery of residual value in scenarios where unlikely events are in fact likely. These will tailor the WACC to include liquidity risk which seems to be the crux of the added solvency measures. (Go back in history to the treatment of sovereign debt across illiquid markets...)

Hence, WACC is credit, credit is cash, and cash is king. And when the king dies, we all cry out, “long live the new king.”

This is yet another time that I’ve come across the McKinsey’s analysis showing that acquisitions are generally the poorest mode of value creating growth. I come from the M&A industry and as a result I am obviously biased, but I wonder about the quality and the robustness of that research. In my mind the mere existence of the Private Equity industry, a trillion dollar industry whose success is based upon good acquisitions, and its rapid growth over the last three decades should do enough to counter this notion. Has McKinsey included Private Equity in this analysis? Is there evidence to suggest that there are systemic differences between the quality of PE-type and strategic acquisitions?

Increasing firm value while just improving the ROI has its advantages of making a company highly competitive. I agree with the fact that this is only true up to a certain level, after which other innovations are required to increase the underlying measure: revenue.

Thank you for the many thoughtful comments on the four guiding principles of corporate finance. In many cases, in-depth answers to your questions and comments may be found in our book, Value: The Four Cornerstones of Corporate Finance. Here I’ve taken two of the four cornerstones and written brief responses to some of the more interesting—and the more frequently posted—ideas among your submissions.

Core of value principle

One reader commented that we ignored the cost of capital in our discussion of the core of value. The cost of capital is an important driver of value, but for the most part, a company’s cost of capital is determined by its industry. Therefore a company cannot influence its cost of capital (except to a minor extent by adjusting its capital structure). So while it’s important, it’s not a management lever for value creation.

Some readers mentioned that we ignored the dimension of time. While we didn’t say it specifically, when we speak of revenue growth, we mean both short- and long-term growth. One of the key challenges for companies is to get the balance right between achieving high, short-term ROIC and earnings and investing enough to ensure attractive long-term revenue growth. In chapter 17 of our book we discuss these challenges in more detail.

A few readers asked whether sustainability is important for companies to consider. We explore this issue in the latter part of chapter one. For more information, see our July 2009 article, “Valuing social responsibility programs.”

Conservation of value principle

Several readers commented that, in discussing the conservation of value, we ignored the benefits of debt in lowering the cost of capital. As a company takes on more debt, however, its equity becomes riskier, so the lower cost of debt relative to the cost of equity by itself does not reduce the weighted average cost of capital. The tangible benefit from debt is its tax benefit. By introducing debt, the cash flows to all investors collectively (debt and equity investors) increase because the company pays lower taxes. But in practice, most large companies benefit from the flexibility of being investment grade rated (at least BBB). The additional value gained by moving from, say, a single A rating to BBB is modest—the only way to get a significant tax benefit from debt is to take on enough debt to go into high-yield territory. By then the loss of flexibility typically outweighs the tax benefits.

Even before the crisis, we recommended that most companies maintain their investment grade rating as a precaution (although we certainly didn’t predict how important that would become). Most large, non-financial companies entered the crisis with strong balance sheets and so weathered the crisis well. In fact, many have more cash and borrowing capacity then they can invest at attractive returns. The need to deleverage that one reader comments on applies to the public sector, the consumer sector, and the banking sector, but not to large, non-financial companies.

This is a good starting point but leaves out important areas not contributing to value—for example, cost of capital, one of the two most important building blocks, is derived from the Capital Asset Pricing model, not a comprehensive credit model as set forth in landmark “Security Valuation and Risk Analysis.” ROIC in the article is not based on free cash flow after important adjustments, as set forth in this textbook.

Unfortunately in the emerging economies, two value creation principles are often difficult for business owners to comprehend: first, that of Corporate Governance; and second, that of The Best Ownership Principle.

Addition to the above value creation principles, intangible assets like brands or patents of any particular company would add to the value of a new company after acquisition. It might not be seen under financial/accounting flows of company.

Very nicely put. However, it leads to the world we live in today. Not a very nice picture. I do agree that creating value should be a result of future expected or actual cash flows, but it must be clear that those cash flows arise from value added through the company to people, society, or the environment. They arise out of answering a need to the defined client through innovative solutions that are at a different level of consciousness that created the need in the first place. For example, ideas that result in reduced time, money, or effort, or just better ease of use.

I didn’t take away that he’s saying value creation is solely defined by cash flows, just that it’s the clearest way to project value potential of strategic initiatives (and later to measure actual value created).

Strategic initiatives related to driving growth, controlling costs, retaining customers, and increasing operational productivity are the engines of value creation.

Investments are made in support of strategic initiatives, and innovation initiatives require use cases —defining the “how” of cash flow generation—that contrast the current and future state. And risk-adjusted cash flow should be a principal metric of initiatives and a primary goal of all investments.

The point isn’t that you’d never invest without a clear cash flow upside; rather that you’d always prefer to have it. I’ve never met a top manager who doesn’t want to buy low-risk cash flow.

Also worth highlighting is how often overlooked risk is. Otherwise sound investments (strong IRR projected from discounted cashflows) die on the drawing board if top management cannot get a sufficient handle on risk. There can be both qualitative and quantitative means to embrace the real issues of risk in any prospective investment, and again, to the extent you can define risk quantitatively, the firmer ground you’re on.

Cash flow is the ultimate metric for value, because it takes into account all tangible and intangible factors that might affect the process of value creation, including brand name, rate of innovation, etcetera. While CEOs need to recognize the need for sustainable development, corporations are for-profit organizations and must be run as such.

I fully agree with what Don Piper is saying and I would also mention the full spectrum values-based work of Richard Barret. His book “Liberating the corporate soul” (Butterworth Heinemann, 1998) discuses the model of 7 levels of corporate values that great companies must master in order to become “the best companies for the world.”

Cash flow and profit are must-have values, we all know that. Still, they are values on the first level. Real value in the 21st Century will come to those that function on all the 7 levels.

To those who critisize this in the context of sustainability:

When I was introduced to corporate finance in 1998, my first response to ‘maximize shareholder value’ goal of firm ‘golden rule principle’ was exactly the same as you present here. But if your own argument is that friends of the environment show 10 times higher cumulative investor return than S&P500s, that just means that these firms do a better tactical job in increasing long-term cash flow. We can call it sustainable, but it does not conflict with the value-maximizing principle. In fact it confirms it. And that is exactly how I was told off 12 years ago.

I highly appreciate the work of Mr. Koller, Mr. Dobbs, and Mr. Huyett. However, I would like to state my comments and reservations as below;

Core of value: Although Mr. Koller takes into account, it seems that the importance of cost of capital is underestimated. Core of value should be derived from growth, return on capital, and the cost of capital. This will also be useful in the next cornerstone.

Conservation of value: You can increase the cash flows by taking debt, rather than equity. This will increase the company value as long as the cost of debt is less than the proceeds of the investment financed by the debt. Obvioulsy, how much leverage the company will use is a key decision to be made, taking into consideration the risk.

Expectations treadmill: I would agree with this principle. However, expectations and how they impact share price has another element to be factored in: risk. The investors do take the risk into account when they are making their investments. And this risk is incorporated into their decision by changing the cost of capital. Think of an extreme example; a lottery. The expectation of a 6-digit return exists, however a lottery ticket is very cheap. Obviously this is due to the extreme risk in investing in lottery.

Best owner: I agree with the argument.

Note: One other implicit factor is time. Especially with reference to the cash flow, the time must be considered. This should also explain the link between cash flows and sustainability, i.e. sustainability is not a matter of social responsibility, but is a critical component of both the future cash flows and the cost of capital (by decreasing the risk factor) which derive the current market price. As Friedman once said ‘the business of the business is business’.

Might be a good idea to produce a follow-up piece on non-tangible ways to create value such as creativity, innovation, IP, talent management, etcetera. In the end, this might make for a tastier (more valuable) pie.

Agree with Don Piper and would add to the works he cites Joseph Bragdon’s “Profit for Life” which uses a quasi-experimental design to show that firms focused on sustainability hugely outperformed comparable controls in the same sectors. Cash flow is an important form of value, but so is brand, the rate of innovation, and the loyalty of people who work for the firm.

I have a question about the conservation of value section.

Tim argues that the capital structure does not change the value of the company as it is dividing up the pizza in different size slices while the overall pizza’s size remains the same. Given that the cost of debt is lower than equity, prudent addition of debt can lower the cost of capital of the overall company. Does this not increase the value of the firm as argued in the first section “Core-of-value principle”?

A very succintly presented matter—very useful for also those who seek private equity investments.

The discussion highlights the faultlines in the blatant ‘get bigger at any cost’ thought process in vogue in this part of the world.

@ Don Piper, I couldn’t agree more. This is brilliant but so old school!

As an appreciative consumer of Mr. Koller’s writing and speaking on the topic of value creation over the years, I was struck by his more conservative tone in this latest article and video. I think it’s a fair observation to say that leverage played a more prominent role in his earlier writings and advice about creating value. He was at least a describer of various financial engineering methodologies, if not an outright advocate.

This latest piece accurately points out that financial engineering isn’t a substitute for a sound balance sheet, healthy cash flows and growth, but it really doesn’t address the problem that many CEOs face: deciding how much leverage is appropriate in a deleveraging world. The four principles he lays our here are a good back-to-basics start, but I don’t think that most CEOs and investors have the luxury of limiting themselves to the basics. They will inevitably be drawn back into a competition for returns that reward the least cautious players (for a while).

I’d be interested to hear how Mr. Koller advises CEOs who start with the frank admission that she would like to be more conservative, but her competitors and board demand more.

I am amazed and disappointed that McKinsey views value creation exclusively on financial metrics. While this may be the dominant perspective held by most large company management teams (and boards of directors) and Wall Street analysts, it’s clear to most us in the trenches that perpetual growth without an understanding of sustainability issues is no longer a tenable strategy. I would expect that any strategic consulting firm, in order to maintain a sustainable competitive advantage, would want to take the high ground on recognizing the value created through social and environmental responsibility as well and make sure that their clients have the opportunity to create value beyond the financial bottom line.

Sisodia, Wolfe, and Sheth have documented the value created by companies who recognize this in their book Firms of Endearment (FOE), Wharton School Publishing, 2007. The results show that FOE’s generate more than 10x cumulative investor return compared to the S&P 500 over a ten year period, and 3x Jim Collins’ “Great Companies.” Any company failing to recognize the significance of these other bottom lines will do so at their own peril.

Mr. Koller’s brings “Creating Value” to life. The Total Return to Shareholders TRS topic was great and the first time I have seen it laid out as part of a creating value discussion.

My takeaway is “The top three things that create value are (1) cash flow, (2) cash flow and (3) cash flow”. Thank you for the tutorial.