Many investors cannot accurately define value if put on the spot. Even in an efficient market economy, one would be hard-pressed to find a manager, investor, or consultant who can quickly and succinctly place parameters on what makes a valuable company 'valuable'.
What is evident, however, is the notion that meeting quarterly earnings forecasts and boosting earnings-per-share makes a company 'valuable' or 'successful'. Unfortunately, this is a hamster-wheel-like mentality as accounting earnings measure performance in the short term.
Near-term results delight shareholders and arbitrage strategists only. All stakeholders must be taken into account when investigating total return (a mixture of growth, return on invested capital, market pricing and shareholder return), or the essential value that a company brings to the market.
How Do Companies Create Long-Term, Sustained Value
Those looking for a complex explanation will just have to go elsewhere. The fundamental creation of value principle is simple: value is created when companies invest capital in order to generate future cash flows at a return that is more than the cost of that capital. Write it down, put it on a plaque, or get a tattoo.
Such a foundational view gives managers the ability to:
- Communicate value effectively and directly with investors of all backgrounds
- Minimize financial risk using effective capital structures showcasing real benefits
- Improve the performance management system
- Discover the true value of an acquisition, divestiture, or restructuring
- Eliminate strategic choices which don't align
Faster growth combined with more attractive return rates equals more value. Actions that don't increase cash flow have no bearing on fundamental value creation.
The rule is to invest cash now (point in time) in exchange for more in the future, particularly in light of decreasing purchasing power. Managers everywhere ought to keep the links between growth, cash flow, and return on invested capital at the forefront of their decision-making framework.
Fundamental Value Creation & Additional Return Measures
A simple concept doesn't equate to easy execution. Value creation expresses a constant need for balancing short-term objectives and long-term goals. There's a reason why the vast amount of managerial talent falls short when it comes to sustaining healthy returns through financial crises, tight credit markets, and uncertain equity environments. Being able to achieve the feat puts you and the business in an elite group of entities that should serve as a yardstick for value.
Correlation isn't causation, but there seems to be an overwhelming amount of evidence supporting the connection linking high shareholder returns and value factors. For instance, better companies provide better work environments; employees tend to be happier as a result. The same can be said about the general standard of living where they operate as well. Basically, the community at large benefits because the business exists.
Managerial Decisions That Add Value
Differences abound between how a firm in Singapore views the concept of value versus a firm in the United Kingdom. As a matter of fact, corporate holders across continental Europe take a much broader view of governance structures, corporate social responsibility, and the natural environment than both their Asian and North American counterparts.
Despite that fact, maximizing shareholder value remains paramount everywhere on Earth. Managers who keep to the code make better decisions.
Decision #1: How Much Cash-Flow Risk To Acquire
All-or-nothing project scenarios take center stage in the business world. Successful projects are rewarded with cash flow while failed projects lead to nothing. According to popular financial theory, managers should use expected cash flow calculations to get a cash flow risk figure. But that places the focus on a single scenario. On top of that, most don't make good use of the expected-value approach.
Managers should instead run as many scenarios as they can to reduce loss magnitudes even before embarking on a project. Can the upside compensate for the downside? What is the percent chance of gain or loss?
Decision #2: Mitigate the Expectations Treadmill
No good deed goes unpunished; the saying rings true for high-value companies. Businesses that do well are expected to do better and better as time moves forward. This is known as the 'expectations treadmill'. Continuously beating expectations is hard, bar none. A company cannot forever satisfy total shareholder returns regardless of previous outperformance. Unfortunately, there are no strict ways of attenuating expectancy. We do know this much: taking risky bets isn't the answer.
Decision #3: To Acquire or Not to Acquire
Acquisitions add value, but not all acquisitions add value equally. Empirical evidence confirms how 33%+ of purchases end up devouring overall value, particularly for the buyer because the selling party reaps most of the benefit from the transaction.
Data tells no lies, and value is neither created nor destroyed during or after M&A activity because of the target size, target P/E ratio, EPS dilution, and business synergy. The path to value must be specific; otherwise, the business is just spinning its wheels.
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