value : the four cornerstones of corporate · pdf filemckinsey’s corporate ﬁnance...

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VALUETHE FOURCORNERSTONESOF CORPORATEFINANCE

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VALUETHE FOURCORNERSTONESOF CORPORATEFINANCE

McKinsey & Company

Tim KollerRichard DobbsBill Huyett

JOHN WILEY & SONS, INC.

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Copyright c© 2011 by McKinsey & Company. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.Published simultaneously in Canada.

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Library of Congress Cataloging-in-Publication Data:

Value : the four cornerstones of corporate finance / McKinsey and Company ; Tim Koller,Richard Dobbs, Bill Huyett.

p. cm.Includes index.ISBN 978-0-470-42460-5 (cloth); ISBN 978-0-470-94906-1 (ebk);ISBN 978-0-470-94907-8 (ebk); ISBN 978-0-470-94908-5 (ebk)1. Corporations—Valuation. 2. Corporations—Finance. 3. Stockholder wealth.

I. Koller, Tim. II. Dobbs, Richard. III. Huyett, Bill. IV. McKinsey and Company.HG4028.V3V36 2010658.15–dc22

2010032747

Printed in the United States of America

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Contents

About the Authors ix

Preface xi

Acknowledgments xv

Part One The Four Cornerstones

1 Why Value Value? 3Many companies make decisions that compromise value inthe name of creating value. But with courage andindependence, executives can apply the four cornerstonesof finance to make sound decisions that lead to lastingvalue creation.

2 The Core of Value 15Return on capital and growth are the twin drivers of valuecreation, but they rarely matter equally. Sometimes raisingreturns matters more, whereas other times acceleratinggrowth matters more.

3 The Conservation of Value 29You can create the illusion of value or you can create realvalue. Sometimes acquisitions and financial engineeringschemes create value, and sometimes they don’t. No matterhow you slice the financial pie, only improving cash flowcreates value.

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4 The Expectations Treadmill 41No company can perpetually outperform the stock market’sexpectations. When a company outperforms, expectationsrise, forcing it to do better just to keep up. The treadmillexplains why the share prices of high performingcompanies sometimes falter, and vice versa.

5 The Best Owner 51No company has an objective, inherent value. A targetbusiness is worth one amount to one owner and otheramounts to other potential owners—depending on theirrelative abilities to generate cash flow from the business.

Part Two The Stock Market

6 Who Is the Stock Market? 63Conventional wisdom segments investors into pigeonholeslike growth and value, but these distinctions are erroneous.There’s a more insightful way to classify investors, anddoing so culls out those who matter most to thevalue-minded executive.

7 The Stock Market andthe Real Economy 73The performance of stock markets and real economies aretypically aligned, hardly ever perfectly aligned, and rarelyvery misaligned. Executives and investors who understandthis are better able to make value-creating decisions.

8 Stock Market Bubbles 89Stock market bubbles are rare and usually confined tospecific industry sectors and companies. Knowing why andwhen bubbles occur can keep management focused onmaking sound strategic decisions based on a company’sintrinsic value.

9 Earnings Management 103Trying to smooth earnings is a fool’s game that can backfireand, in some cases, destroy value. Creating value in thelonger run sometimes necessitates decisions that reduceearnings in the shorter run.


CONTENTS vii

Part Three Managing Value Creation

10 Return on Capital 119A company can’t sustain a high return on capital in theabsence of an attractive industry structure and a clearcompetitive advantage. Yet it’s surprising how fewexecutives can pinpoint the competitive advantages thatdrive their companies’ returns.

11 Growth 139It’s difficult to create value without growing, but growthalone doesn’t necessarily create value. It all depends onwhat type of growth a company achieves and what thereturns on that growth are.

12 The Business Portfolio 153A company’s destiny is largely synonymous with thebusinesses it owns, and actively managed portfoliosoutperform passively managed portfolios. Sometimescompanies can create value by selling even high-performing businesses.

13 Mergers and Acquisitions 169Most acquisitions create value, but typically the acquirer’sshareholders only get a small portion of that value,while the lion’s share goes to the target’s shareholders.But there are archetypal ways that acquirers can createvalue.

14 Risk 183Nothing in business is more clear yet complex than theimperative to manage risk. Clear because risk mattersgreatly to the company, its board, its investors, and itsdecision makers. Complex because each of these groups hasa different perspective.

15 Capital Structure 197Getting capital structure right is important but doesn’tnecessarily create value—while getting capital structurewrong can destroy tremendous value. When it comes tofinancial structures, companies are best to keep them assimple as possible.


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16 Investor Communications 209Good investor communications can ensure that acompany’s share price doesn’t become misaligned with itsintrinsic value. And communication isn’t just one way:executives should listen selectively to the right investors asmuch as they tell investors about the company.

17 Managing for Value 223It’s not easy to strike the right balance between shorter-termfinancial results and longer-term value creation—especiallyin large, complex corporations. The trick is to cut throughthe clutter by making your management processes moregranular and transparent.

Appendix A The Math of Value 237

Appendix B The Use of Earnings Multiples 241

Index 245


About the Authors

McKinsey & Company is a management-consulting firm that helpsleading private, public, and social sector organizations make distinc-tive, lasting, and substantial performance improvements. Over the pastseven decades, the firm’s primary objective has remained constant: toserve as an organization’s most trusted external advisor on critical is-sues facing senior management. With consultants deployed from morethan 90 offices in over 50 countries, McKinsey advises companies onstrategic, operational, organizational, financial, and technological is-sues. The firm has extensive experience in all major industry sectorsand primary functional areas.

McKinsey’s corporate finance practice, along with the firm’s strat-egy and risk practices, uniquely integrates industry insights, the firm’sglobal presence, and proprietary knowledge as it advises clients.Together, these practices help clients set corporate portfolio direc-tion, manage risk in investment choices, and build effective value-management capabilities.

Tim Koller is a partner in McKinsey’s New York office, the head ofthe firm’s Corporate Performance Center, and a member of the lead-ership group of the firm’s global corporate finance practice. Duringhis 25 years of consulting based in New York and Amsterdam, Timhas served clients globally on corporate strategy and capital markets,mergers and acquisitions, and value-based management. He is the co-author of Valuation: Measuring and Managing the Value of Companies,

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which is now in its fifth edition and used around the world by banks,corporations, and leading business schools as the authoritative text onthe subject. Tim leads the firm’s research activities in valuation andcapital markets. Prior to joining McKinsey, Tim was with Stern Stewart& Company and Mobil Corporation. He received an MBA from theUniversity of Chicago.

Richard Dobbs is a partner in McKinsey’s Seoul office and a directorof the McKinsey Global Institute, the firm’s business and economicsresearch arm. Prior to this, Richard oversaw R&D for McKinsey’s cor-porate finance practice. Since joining McKinsey in London in 1988,Richard has served clients globally on corporate strategy and capitalmarkets, mergers and acquisitions, and value-based management. Heis a graduate of Oxford University, an associate fellow of the Saı̈d Busi-ness School at Oxford and, as a Fulbright Scholar, received an MBAfrom the Stanford Graduate School of Business.

Bill Huyett is a partner in McKinsey’s Boston office and a leader of thefirm’s strategy, corporate finance, and health care practices. During his23 years in consulting based in Boston, Zurich, and Washington D.C.,Bill has served clients globally on product development and commer-cialization, growth, innovation, corporate strategy, mergers and acqui-sitions, and corporate leadership. Before joining McKinsey, Bill held avariety of line management positions in the electronics industry. Hisdegrees in electronics engineering and computer science are from theUniversity of Virginia, as is his MBA.


Preface

Most executives have figured out how to create value for shareholders.Through experience, observation, and intuition, they’ve developed awealth of personal wisdom that, with some luck, typically takes themin the right direction.

But let’s face it: that wisdom doesn’t always prevail. Indeed, therun-up to the financial crisis of 2008 is but one example of how easilyfinance myths, fads, and misconceptions overwhelm wisdom, even inthe most sophisticated organizations.

Executives don’t have it easy. It’s tough to hold steady when share-holders expect absurdly high returns during periods of relative align-ment between companies’ share prices and underlying economic value.It’s even tougher to stick with fundamentals as peers’ profits skyrocketin seemingly irrational ways, as they did in 2008, or when share pricesreach unprecedented and unsustainable levels, as they did during theInternet-bubble era.

During such periods, seductive new economic theories emerge.These theories catch the attention of journalists, traders, boards, in-vestors, and executives—even though they’re blatantly at odds withthe tenets of finance that have held true for more than 100 years.

These episodes of wishful thinking have only reinforced the im-mutable principles of value creation. These four principles, which wecall the cornerstones of corporate finance, start with the axiom that com-panies exist to meet customer needs in a way that translates into reli-able returns to investors. Together, the cornerstones form a foundation

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upon which executives can ground decisions about strategy, merg-ers and acquisitions, budgets, financial policy, technology, and per-formance measurement—even as markets, economies, and industrieschange around them.

For executives with functional, business, or corporate responsibil-ities, ignoring the cornerstones can lead to decisions that erode valueor lead to outright corporate disaster. Let’s take two examples.

First, leverage: As the market heated up in 2007 and 2008, manysavvy financial services executives thought leverage could be used tocreate (as opposed to merely redistribute) value. That misconceptionclashes with the cornerstones. Leverage is a quick way to manufactureaccounting profits, but it doesn’t add real value to the company orthe economy, because it merely rearranges claims on cash flow andincreases risk.

Second, volatility: Some say companies are better valued whenthey deliver steady, predictable earnings growth. That, too, is an as-sumption that doesn’t emerge from the cornerstones. The truth is thatthe most sophisticated investors—the ones who should matter mostto executives—expect some earnings volatility, if only as recognitionof changing economic dynamics beyond any one company’s control.Related is a belief that earnings per share guidance, and the signif-icant executive time consumed by managing guidance, is valued byinvestors even though empirical evidence clearly shows otherwise.

Compounding the misconceptions are apparent disconnects in howfinancial performance reflects economic theory and empirical data.These disconnects can cloud top-management judgments about busi-ness strategies and investment cases. Basic economics suggest, for ex-ample, that above-cost-of-capital returns will be competed away. Datashow, though, that some companies earn consistently superior returnsusing business models that vaccinate themselves against competitorsand new entrants.

In our practice we see uneven development of finance capabilitiesamong general managers and functional leaders. All too often, theseleaders have picked up their finance knowledge without a groundingin the cornerstones, leading to such overly simplistic refrains as “Weneed to grow earnings faster than revenue.” Or the ungrounded mightoveremphasize earnings per share at the expense of capital productivityor growth.

When we combine the misconceptions, the contradictions betweenfinance and economics, and the uneven development of finance skills,


PREFACE xiii

we understand the roots of decisions that diverge from the perennialprinciples. The voices of the media don’t often shed light, the views ex-pounded by investors about what constitutes value and what doesn’tare splintered, and traders cause further confusion by unnaturally bid-ding up or down stock prices of individual companies and even entiresectors.

Internalizing the four cornerstones of finance, understanding howthey relate to the real economy and the public stock markets (or private-owner expectations), and having the courage to apply them across theenterprise have significant upside and little downside. At least, the fourcornerstones can prevent executives from making strategic, financial,and business decisions that undermine value creation. At best, the cor-nerstones can encourage a more constructive, value-oriented dialogueamong executives, boards, investors, bankers, and the press—resultingin courageous and even unpopular decisions that build lasting corpo-rate value.

To this end we offer you Value: The Four Cornerstones of CorporateFinance.

Our hope is that this book will be a catalyst and concrete guide forimproving how executives plan strategy, make decisions, and build thenext generation of leaders. Ultimately, we hope the collective impact ofmore companies embracing these principles creates a more stable andproductive economy.

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