seventh edition. 2020. McKinsey & Company, Tim Koller, Marc Goedhart and David Wessels. Wiley.
What is “value”? This is a pressing query for investors: translating investment theory right into a successful value-oriented equity strategy has proven difficult over the past decade.
Tim Koller, Marc GoedhartAnd David Wessels sets out the core principles of valuation and provides a step-by-step guide to measuring the worth of an organization. This seventh edition (the primary was published in 1990) also addresses three aspects that challenge many value strategies today: the increasing share of investments in intangible assets, the network effects that profit leading technology corporations, and the incorporation of an environmental, social and governance (ESG) perspective in value determination.
The core principles of business valuation are general economic rules that apply under all market conditions. The guideline is easy: “Companies that grow and generate a return on capital that exceeds their cost of capital create value.”
The authors argue that too many investors use the mistaken yardstick by specializing in earnings per share. In practice, “expected cash flows, discounted at the cost of capital, drive value,” the authors explain. Moreover, “the stock market is not so easily fooled when companies take actions to increase reported earnings without increasing cash flow.” In fact, rising accruals normally indicate that the corporate will report lower earnings in the long run.
The book, originally written as a handbook for McKinsey & Company consultants, offers a guide to valuation. The heart of the book is a set of step-by-step methods for calculating value using discounted corporate money flow (DCF) and discounted economic profit approaches. The authors claim that “a good analyst will focus on the key drivers of value: return on capital, revenue growth, and free cash flow.” Analysts ought to be willing to delve into the footnotes to “re-classify each balance sheet into three categories: operating items, non-operating items, and sources of funding.” Where can one find that ideal analyst? Detailed work on the dimensions described takes time and judgment. The authors cite the instance of Maverick Capital as a practitioner: they fill just five positions per investment skilled, lots of whom have covered the identical industry for greater than a decade.
I have to be clear: this just isn’t me. My ten-year profession as an equity fund manager ended 20 years ago. Instead, I bring the sensible lessons this book offers from the angle of a multi-asset investor – and there are many them.
First, corporations that find a technique to generate a lovely return on invested capital (ROIC) have likelihood of sustaining that above-market return. In a study of U.S. corporations between 1963 and 2017, the highest quintile of corporations rated by ROIC saw declining returns toward the mean, but 15 years later they were still about 5% above average.
According to the authors, these “high ROIC companies should focus on growth, while low ROIC companies should focus on improving returns.” Growth is never an answer for low-ROIC corporations. “For mature companies, low ROIC indicates a flawed business model or an unattractive industry structure.”
ROICs are generally stable across industries, so industry rankings don’t change significantly over time.
Over the past 35 years, higher market valuations have been driven by steadily increasing margins and returns on capital. For asset managers, the upper valuations of U.S. corporations relative to other countries reflect higher ROIC.
Companies with the best returns mix quite a lot of competitive benefits. The authors discover five sources of premium prices: revolutionary products, quality (real or perceived), brand, customer loyalty, similar to alternative razor blades, and rational pricing discipline (avoiding commoditized products). And they discover 4 sources of cost competitive advantage: revolutionary business practices (similar to IKEA stores), unique resources (when mining, gold in North America is closer to the surface than in South Africa and is due to this fact cheaper to extract), economies of scale, and network economics.
The second lesson is that it is way less common for above-average growth to persist than for above-average returns to be achieved. The authors indicate that “high growth rates decay very quickly. Companies growing at more than 20 percent in real terms typically grew only 8 percent over five years and 5 percent over 10 years.” Yet some sectors have consistently been among the many fastest growing, including life sciences and technology. Others, similar to chemicals, reached maturity long before the Nineties.
Third, based on the authors, analysts evaluating fast-growing web and technology stocks should “think ahead, … think in scenarios, and compare the economics of the business models to those of other companies.” This requires an assessment of the long run economic development of the corporate and its industry. DCF stays crucial tool since it calculates a worth for every of the numerous possible scenarios. The largest increases in value have been achieved in industries where the winner takes all. The authors state: “In industries with network effects, competition is kept in check by the low and falling unit costs of the market leader.” Investors have to have a 10- or 15-year plan to properly value a fast-growing company, which regularly means looking beyond the mounting losses within the early stages.
Digital applications can provide obvious performance advantages for all corporations. McKinsey & Company identified a minimum of 33 opportunities, from digital marketing to robotic process automation.
Fourth, the most effective owner of an organization often changes over its life cycle. The authors explain, “A company… is likely to start out owned by its founders and may end up in the portfolio of a firm that specializes in extracting money from companies in declining industries.” The chapter on corporate portfolio strategy provides framework for understanding the explanations for mergers, acquisitions, and divestments.
And fifth, “One-third or more of acquiring companies destroy value for their shareholders because they transfer all the benefits of the acquisition to the shareholders of the selling companies,” say the authors. Buyers typically pay about 30% greater than the pre-announcement price. Nevertheless, acquisitions can create value, and this book offers six archetypes for successful deals.
In contrast, divestitures normally actually create value, a sixth lesson. The authors note that “the stock market consistently reacts positively to divestitures, both sales and spin-offs. Research has also shown that spun-off companies tend to increase their profit margins by one-third in the three years after the transactions close.”
Finally, a company strategy that takes ESG issues into consideration can increase money flow in five ways:
- Promoting sales growth
- reduce costs
- Minimizing regulatory and legal interventions
- Increasing worker productivity
- Optimization of investments and capital expenditure
For example, one study found that gold miners avoided planning or operational delays through social engagement. A do-nothing approach is not free either. Better performance on ESG issues reduces downside risk. For example, it could help avoid stranded assets. A powerful ESG offering can create more sustainable opportunities and increase DCF value.
However, ESG reporting just isn’t included within the investor communications chapter. I’d urge authors to handle this topic of their next edition. Asset owners need to grasp the impact of their investments.
In conclusion, neither the web nor the increasing concentrate on ESG issues have made the foundations of economics, competition and value creation obsolete. As the authors note: “The faster companies can increase their sales and deploy more capital at attractive returns, the more value they create.”
This well-written book gives CEOs, business leaders and financial managers insights into the strategies they’ll use to create value and provides investors with tools to measure their success.
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