Value: The Four Cornerstones of Corporate Finance

by Tim Koller

“Capital Structure,” share repurchases have become a popular way for companies to return cash to investors. Until the early 1980s, more than 90 percent of the total distributions made by large U.S. companies to shareholders were dividends and less than 10 percent were share repurchases. However, since 1998, about 50 to 60 percent of total distributions have been share repurchases.

Some argue that management should repurchase shares when its shares are undervalued. Let's suppose management believes that the current share price of the company doesn't reflect its underlying potential, so it buys back shares today. One year later, the market price adjusts to reflect management's expectations. Has value been created? Once again the answer is no, value has not been created; it's only been shifted from one set of shareholders (those that sold) to the shareholders that did not sell. So the holding shareholders may have benefited, but the shareholders as a whole were not affected.

As a rule, executives need to exercise caution when presented with transactions that appear to create value by boosting EPS. Always ask, where is the source of the value creation?

The return on invested capital (ROIC) that a company earns is not the same as what its shareholders earn.

Although all the investors collectively will earn the same return as the company (on a time-weighted average), individual groups of investors will earn very different returns because they pay different prices for the shares based on their expectations of future performance.

The expectations treadmill describes the difficulty of continuing to outperform the stock market. At some point it becomes impossible for management to deliver on accelerating expectations without faltering, just as anyone will eventually stumble on a treadmill that moves ever faster.

Tina's been caught by the expectations treadmill: she and her team have done such a good job that the expectation of continued high performance is already incorporated into the company's share price. As long as she delivers results in line with the market's expectations, her company's share-price performance will be no better or worse than average.

The expectations treadmill is the dynamic behind the adage that a good company and a good investment may not be the same. In the short term, good companies may not be good investments because future great performance might already be built into the share price. On the other hand, smart investors often prefer weaker-performing companies because they have more upside potential, as the expectations are easier to beat.

Yes, some companies can take advantage of their high share prices to make acquisitions, but that probably wasn't a good idea for Home Depot because its organic growth was 11 percent—a large management challenge to maintain in and of itself.

In addition to focusing on growth and return on capital, compensation systems should be linked to TRS performance relative to peers rather than absolute TRS. That would eliminate much of the TRS that is not driven by company-specific performance.

Executives also need to move away from the practice of incessantly monitoring their stock prices, because TRS is largely meaningless over short periods. In a typical three-month time frame, more than 40 percent of companies experience a share-price increase or decrease by more than 10 percent4—movements that are nothing more than random. Therefore, executives shouldn't even try to understand share-price changes unless they move more than 2 percent in a single day or 10 percent in a quarter (versus a relevant benchmark).

We call this cornerstone the best owner because value is maximized when it's owned by whomever can generate the highest cash flows from it. A corollary is that there is no such thing as an inherent value for a business; it always depends on who's operating it.

Owners who have insight into how a market and industry will evolve, and can then capitalize on that insight, can sometimes expand existing businesses or develop new ones as innovators. One example is Intuit, which noticed in the late 1990s that many small businesses were using its Quicken software, originally designed to help individual consumers manage their personal finances. The observation led to an important insight: most business-accounting software was too complex for the small business owner. So Intuit designed a new product for small business accounting, and within two years it had claimed 80 percent of this burgeoning market.

Private equity firms don't have the time or skills to run their portfolio companies on a day-to-day basis, but they do govern these companies very differently than many listed companies, and this is a big source of outperformance. Typically, firms introduce a stronger performance culture and make quick management changes when necessary. They encourage managers to abandon sacred cows and give them leeway to focus on a five-year horizon rather than the typical one year for a listed company. Also, the boards of private equity companies spend three times as many days in their roles than those at public companies, and most of their time is spent on strategy and performance management rather than compliance and risk avoidance as at public companies.

At each stage of the company's life, the next best owner took actions to increase its cash flows, thereby adding value. The founder came up with the idea for the business. The VC firm provided capital and professional management. Going public provided the early investors a way to realize the value of their work and raised more cash. The large company accelerated the company's growth with a global distribution capability. The private equity firm restructured the company when growth slowed. The last best-owner company applied its skills in managing low-growth brands.

So if we can't explain the market over one month, but we can explain it over 100 years, over what time frame can we reasonably expect to explain the market?

But the fact that investors behave irrationally doesn't necessarily lead to a market with a lot of mispriced shares and bubbles. Individual investor irrationality must be combined with herding behavior and structural constraints for bubbles to occur.

Paradoxically, given such market deviations, it's even more important for corporate managers and investors to understand the true, intrinsic value of companies. This allows them to exploit any market deviations if and when they occur, for example, by using shares to pay for acquisitions when those shares are overvalued by the market, or repurchasing shares when the market value is too low.

As long as your company's share price will eventually return to its long-run, intrinsic discounted cash flow (DCF) value, you should rely on using the DCF approach for making strategic decisions. What matters is the long-term behavior of your company's share price, not whether it's 5 or 10 percent undervalued this week.

ACCOUNTING TREATMENT WON'T CHANGE UNDERLYING VALUE

sophisticated investors don't take reported earnings at face value; instead they try to ascertain the underlying economic performance of the company. Although we can't prove a negative (that accounting treatment doesn't matter) directly, we can show specific examples of how investors have seen through accounting results and focused on underlying economic performance.

Since 2001 under U.S. GAAP, and since 2005 under International Financial Reporting Standards (IFRS), goodwill is no longer amortized on the income statement according to fixed schedules. Instead, companies must write off goodwill only when the goodwill is impaired based on business valuations by independent auditors. What effect did changes in accounting for goodwill have on share prices? To answer this question, we looked at this accounting change's impact on share price in two ways.

As for the debate over whether employee stock options should be expensed in the income statement, much of the concern centers on whether the negative earnings impact would drive stock prices lower. From a capital market perspective, the answer is clear: as long as investors have sufficient information on the amount, terms, and conditions of the options granted, new expensing rules will not drive down share prices. In fact, according to a recent study, companies that voluntarily began expensing their employee options before it became mandatory experienced positive share-price reactions when they announced their intentions to expense options, despite the negative impact on reported earnings.7

Timing the market perfectly isn't possible, of course. But a simple rule of thumb can improve a company's timing considerably: sell sooner. For the vast majority of divestitures we've studied, it's clear that an earlier sale would have generated a much higher price.

One of the most difficult tasks for executives is identifying new businesses to add to their portfolios, either by starting them from scratch or through acquisitions. The track record of most companies isn't good, which is why 50% of the Fortune 500 drop off the list every 10 years. Companies typically reach the size of a Fortune 500 company on the strength of one or several key businesses or products, but then those products or businesses mature and they are unable to find the next source of major growth (this is compounded by the fact that the next source of growth must be larger to have a meaningful impact on the already large company).

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.

Improving the performance of the target company is one of the most common sources of value creation. Put simply, you buy a company and radically reduce costs to improve margins and cash flows. In some cases, the acquirer may also take steps to accelerate revenue growth.

As executives decide how to tackle risk management, they need to consider that investors in their companies view risk differently than they do, and their boards of directors may have a third perspective on risk.

The primary objective of a company's capital structure should be to make sure it has enough capital to pursue its strategic objectives and to weather any potential cash flow shortfalls along the way. If a company doesn't have enough capital, it will either pass up opportunities, or worse, fall into financial distress or bankruptcy (or need a government bailout). Having too much capital can always be remedied by increasing future distributions to shareholders.

Capital structure can be boiled down to three issues: (1) What is the right mix of debt and equity in a company's capital structure? (2) When should a company go beyond simple debt and equity and use complex capital structures (i.e., financial engineering)? (3) What combination of dividends and/or share repurchases should a company use to return cash to shareholders?

Debt can also increase a company's cash flows by imposing discipline on its management. A company must make regular interest and principal payments, so it has less excess cash flow for pursuing frivolous investments or acquisitions that don't create value. Although this argument has been used over the years to support the high levels of debt in leveraged buyout transactions, it has a problem: a company needs to employ very large amounts of debt to get this discipline and, therefore, such debt is only useful for companies with very stable, predictable cash flows and limited investment opportunities.

Most successful companies eventually find that they generate more cash flow than they can reinvest in their business at attractive returns on capital. Because building up unused cash on the balance sheet doesn't make sense, these companies need to return cash to their shareholders.

Finding $700 million of value-creating new investment opportunities every year in most sectors of the economy is no simple task. Furthermore, at a 20 percent ROIC, the company would need to grow its revenues by 20 percent per year to absorb all of its cash flow. The company has no choice but to return a substantial amount of cash to shareholders. A number of leading companies have adopted the sensible approach of regularly returning all cash they don't need, and using regular share repurchases to pay out the difference between the total payout and dividends. Although these companies don't have formal published policies, you can deduce their policies from their practices.

There are three ways to return cash: regular dividends, share repurchases, and special dividends.

As we mentioned in Chapter 3, until the early 1980s less than 10 percent of distributions to shareholders were share repurchases. Now, about 50 to 60 percent of total distributions are share repurchases. Why the shift? It's primarily about flexibility. Companies, especially in the United States, have conditioned investors to expect that they will cut dividends only in the most dire circumstances. From 2004 to 2008, only five percent of U.S.-listed companies with revenues greater than $500 million cut their dividend, and in almost every case the company faced a severe financial crisis. So companies are reluctant to establish a dividend level that they aren't confident of sustaining—opting, rather, to buy back shares.

Theory says that share repurchases and dividend increases send signals from the managers of a company to investors, and this will drive a change in the company's share price. For share repurchases, there are three potential signals, two with positive implications for the company's value and one with negative implications. The negative signal of a repurchase is that the company has run out of investment opportunities and can find nothing better to do with its cash than return it to shareholders. This assumes that stock market investors didn't already know that the company was generating more cash flow than it could reinvest. We've never seen a situation in which the stock market was surprised that the company couldn't reinvest its cash flow. Typically, investors are anticipating share repurchases long before managers make that decision, because there aren't many alternatives.

The first positive signal is that a share repurchase tells investors that management realizes it can't invest all its cash flow, and by returning cash to shareholders it won't squander the cash by investing in value-compromising opportunities. Sophisticated investors typically focus on this aspect of share repurchases.

A second positive signal is that management is more optimistic about the company's prospects and believes its shares are undervalued by the marketplace. There is some academic evidence to back up this idea, because share prices have historically risen upon repurchase program announcements. However, the increase isn't permanent. At best, th...

Although share repurchases send a positive signal, so do dividend increases. Since managers only cut dividends as a last resort, increasing a dividend signals confidence that they can continue to pay the new higher dividend level. The signaling effect of dividends is probably stronger than share repurchases because it's a commitment to future payments, unlike share repurchases, which don't need to be repeated in future years.

In summary, returning excess cash flow to shareholders is generally good, but it doesn't create value itself. A better way to think of returning cash to shareholders is that it prevents that cash from being invested in low-return projects.

We fall somewhere in between. It's virtually impossible to interpret short-term price movements with any useful insights. And even if you could talk up your share price beyond its intrinsic value, you probably shouldn’t.

On the other hand, good investor communications can ensure that your share price doesn't get out of line with its intrinsic value, can build a base of loyal investors, and can ensure that executives don't make poor strategic decisions based on misunderstanding what investors are saying to them.

Good investor communications must be grounded in the right objectives, and achieving the highest possible share price through investor communications is not a wise objective. Instead, the overriding objective of investor communications should be to align a company's share price with management's perspective on the intrinsic value of the company.

A gap between a company's market value and its intrinsic value brings significant disadvantages to all the company's stakeholders. If the share price exceeds its intrinsic value, the price will eventually fall as the company's real performance becomes evident to the market. When that fall comes, employee morale will suffer, and management will have to face a concerned board of directors who may not understand why the price is falling so far so fast.

In the view of many executives, the ritual of issuing guidance on their expected earnings per share (EPS) in the next quarter or year is a necessary, if sometimes onerous, part of communicating with financial markets. We surveyed executives about guidance and found that they saw three primary benefits of issuing earnings guidance: higher valuations, lower share price volatility, and improved liquidity. Yet our analysis found no evidence that those expected benefits materialize.

Our conclusion was that issuing guidance offers companies and investors no real benefits. On the contrary, it can trigger real costs and unfortunate unintended consequences. The difficulty of predicting earnings accurately, for example, frequently causes management teams to endure the painful experience of missing quarterly forecasts. That, in turn, can be a powerful incentive for management to focus excessive attention on the short term, at the expense of longer-term investments, and to manage earnings inappropriately from quarter to quarter to create the illusion of stability. Moreover, according to our research with intrinsic investors, they realize that earnings are inherently unpredictable. For that reason, they prefer that companies not issue quarterly EPS guidance. When

As an alternative, we believe executives will gain advantages from providing guidance at the start of the financial year on the real short-, medium-, and long-term value drivers of their businesses, giving ranges rather than point estimates. They should update this guidance whenever there is a meaningful change in their targets.

A common shortfall of most large-company management processes is that they often function at a level that is too high. Value is created by the cash flows from individual products or services in specific customer segments, not at the corporate level (although multibusiness enterprises augment that value with mechanisms we discussed in Chapter 12). Therefore, management processes—like performance measurement, compensation, and planning—need to be conducted in a way that helps the company make decisions at an appropriate level of granularity.

We see numerous ways to improve how strategic planning contributes to value creation. First, break the links between strategic planning and budgeting. The strategic planning process should operate under a different time line than budgeting to ensure that it doesn't reemerge as a glorified three- to five-year budget.

According to our colleagues, “the nature and intensity of the performance-management culture is perhaps the most striking difference between the two environments. Private equity boards have what one respondent described as a ‘relentless focus on value creation levers.’ … In contrast, public boards were described as much less engaged in detail. … Public boards focus much less on fundamental value creation levers and much more on meeting quarterly profit targets. … [Public boards] are focused more on budgetary control, the delivery of short-term accounting profits, and avoiding surprises for investors.”