Corporate Finance Essentials will enable you to understand key financial issues related to companies, investors, and the interaction between them in the capital markets. By the end of this course you should be able to understand most of what you read in the financial press and use the essential financial vocabulary of companies and finance professionals.
2. Growth and return on growth
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En provenance du cours de IESE Business School
Corporate Finance Essentials
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Corporate Value Creation
In this session we will discuss EVA, a tool widely used to assess whether a company is creating or destroying value. We will also put this tool into practice by estimating the EVA of two companies.
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Javier EstradaProfessor of Financial Management
Department of Financial Management
[MUSIC]
Now, underlying issue number two.
Two managerial mistakes that we tend to see a lot in practice, and, and
believe it or not there's actually the both of
them have been very widely documented, particularly the first one.
Mistake number one, focusing in the short term, and
particularly in announcements that have to do with short-term earnings.
There's this quote/unquote,
obsession in the World's trade to actually meet the analysts expectations.
And we want to meet the analysts expectations because if we
disappoint them then they're going to be negative in our company and
a lot of people will be selling our stock, and
there's going to be downward pressure on the price of the stock.
So basically we, we have this focus, obsession some people would say,
with the earnings announcements and the short term earnings of the companies.
And as we'll see in a minute, that goes to the detriment of long term value creation.
Now, let me give you an example of this.
This is actually a well known study that is called as you can see there,
Value Destruction and Financial Reporting Decisions.
And let me read that little bit of the conclusions to you.
It says, the findings of our survey and
financial reporting practices are startling.
That participation in the earnings game is pervasive may not be surprising, but
that the majority of companies are willing to sacrifice long run economic value to
deliver short run earnings is shocking.
Yet, these actions are not even considered to be a problem for many CFOs.
So, we focus on the short term to the detriment of value creation in the long
term, and may people say, many CFOs say, well, that may not even be a problem.
That is a problem.
If you focus on creating value, that is actually a big problem.
Let me add one thing to this.
Says, what is the magnitude of the problem?
Well, we found that 78% of public companies would
sacrifice value to smooth earnings and
56% would knowingly defer valuable long-term projects to meet targets.
Now think about that.
Over half of the corporations actually tend to do things that
they know are bad for the long term, but in order to focus on the short term.
That is problematic, because if we want to focus on creating long term value for
shareholders at the same time taking into account the benefit of
all the stakeholders, we will not be able to do that if we focus on the short term.
And if we focus on the short term announcements of what earnings might be
next quarter or the quarter after that.
So Managerial Mistake number one, and
again we do tend to see a lot this in practice, and
it's been documented not only in this article but in many others too.
Is that this focus on the short term goes against the issue we're discussing in
this session, which is creating value, particularly in the long term.
Issue number two, and this one,
it's a little trickier, because growth always has a positive connotation.
We all want to grow, companies want to grow.
The faster the rate at which earnings grow, the better.
So here's the thing with growth.
Although it does have a positive connotation,
you can always grow a little faster if you invest a little bit more capital.
But as a manager what you need to see, and what your holders would like you to see,
is that the capital invested actually gets an appropriate return.
And we already know what we call an appropriate return,
a return that is higher than the cost of raising the funds to invest in,
in all the projects that the company does.
Now we're looking at it, at the company from way up above.
So we're not looking now at individual projects as
we've done in the session before.
Now we're looking at the whole package,
the whole thing that the corporation produces.
All the products, all the services, everything the corporation does, and
the return that it gets on the whole operations.
And now we need to compare the, the return of those projects,
the return of this company operating with the cost of raising the funds in order for
this company to operate.
And so, the, the second important thing and
the typical mistake is growing for the sake of growing.
Growth by itself is not enough.
What you need to earn is an appropriate return on the capital that you invest.
Now let me just give you a quick example here.
So this is a quote from a a little report on Mackenzie.
It, it's really on valuation, but at the beginning of that,
it actually touches upon the issue of growth and returns.
It says, it's common sense, growth requires investment and
if the investment doesn't yield an adequate return over the cost of capital,
it won't create shareholder value.
Executives who do not pay attention to both growth and
returns on capital, run the risk of not creating value for shareholders.
And that is exactly where we're going.
We're not trying to say that growth per se is bad.
Growth for the sake of growth is bad.
If you want to grow the company because you want to be bigger so
you have more power and so you actually have you know, more corporate jets and
more beautiful headquarters and what have you.
That may be good for the manager but it may not, may not necessarily be good for
the shareholders.
So, we don't want to grow just for the sake of growth.
Corporations should grow, but
they should be investing the capital at a rate that is consistent with beating
the cost of raising that capital in the in, in the first place.
So, remember that the, the second point here is two common managerial mistakes,
one is focusing too much on the short term, the other is growing for
the sake of growing.
And what they have in common is that both of them go against what we're trying to
discuss in this session, which is trying to create value for
shareholders in the long term.
And again, remember point number one, we're tying to create value for
shareholders, but
we will not be able to do that without taking into account the interest of all
the other stakeholders that have something to say in the process of value creation.
Third and final point of this sort of underlying issues that we
mentioned before.
And, and, the we, here we need to make a distinction between two things that
are similar, but they're actually very different.
One thing is, what we really want to do.
And, and what we really want to do is invest the capital that were raised
in good projects, and, you know, what we call the good project we already know.
It's basically a project that has a positive net present value.
So, this session is not about going back and evaluating different projects.
This session is not about deciding whether we should invest in it or,
or invest in that.
We know the rules that we need to use in order to decide should we invest or not.
Should we invest in a, or should we invest in b?
So this is not about what we want to do, we want to invest in good projects.
The, aim of the discussion of this session,
the ultimate goal that we're trying to discuss is, how do we actually get there?
How do we get executives to actually deliver the value that
shareholders expect?
And the reason that we need to pose this question,
is because of that principal agent problem that we talked about before.
Principals, shareholders would like managers, agents, to do
with their capital, something that is very clear to get the highest possible return.
Now, that may be great for the shareholders, but
the question is, is that the best thing for managers?
If the goals of these two are not the same, then what managers end up doing may
be good for them and not necessarily good for the shareholders.
So, as we said before, this whole issue of corporate value
creation is very much linked to the principle agent problem.
How do we give the agent, the managers, the right incentives to
do exactly what the principles, the shareholders want them to do?
And that implies that we basically need two things.
First, we need to be able to obtain periodic feedback.
And the reason we want to obtain periodic feedback is, is very clear.
Remember that when we run an NPV calculation, we say, you know,
we're considering investing in this project, we've tried to foresee.
That's the key word,
we try to foresee, to forecast what the cash flows are going to be.
We run our net present value, if it's positive, then we go ahead and
invest in this project.
But remember, we decide to go into this project on the basis of
what I expect to happen in the future on the basis of an expectation.
Then I need to evaluate, because what I expected, I may be very optimistic, and I
may have put a lot of capital in a project in which the expectations are great, but
then it turns out actually to be a flop.
And, and, you know, I'm,
I'm sure you can think of many companies that have gone through blunders like that.
You know, we invest a lot in this project and then we realize nobody wanted to
buy this product, or nobody wanted to buy this service.
So, we need to evaluate over and over and over again, how are we doing.
Are the expectations that we have, are they being met or not.
Maybe we're doing better, maybe we're doing worse, but
we need to be able to evaluate how the corporation is doing over time.
Remember the NPV is like taking a picture.
At one moment in time you make a decision based on what you know you have to
put in today in terms of capital, and what you expect to get in the future.
And on the basis of that you say I go ahead or
I don't go ahead for this project.
Well, our problem now is a little different.
Our problem now is actually monitoring whether over time the corporation is
creating value or, or not.
So, point number one, we need to be able to obtain periodic feedback,
annual, quarterly feedback on how the corporation is doing.
Issue number two is, how we actually create the appropriating incentives.
How we actually motivate the managers to do
exactly what shareholders would like them to do.
And that goes to the heart of what you might've heard about us, at VBM.
VBM stands for Value-based management, and there's many ways of defining this.
And if you asked ten
different people they will probably give you ten different definitions.
But Value-ba man, based management at the end of the day, is two things.
Number one is trying to find a variable that you can use to
determine whether a corporation is creating or destroying value.
And, and I'm saying trying to find a variable because, you know,
there are many different consulting companies offering you different things.
Offering ways of saying, you know,
this is the way you should measure whether you're creating or destroying value.
And then there's a competitor and say no, no, we actually have a better way.
So there's not just one way.
There's more than one way to measure whether a company's creating value or not.
But value based management, first step is basically to find a variable that
we think it possibly measures whether we're creating or destroying value.
And step two or part two of VBM is basically linking that variable, whatever
it is, in our case, we're going to use EVA, or economic value add added.
Linking that variable to the compensation of executives.
In other words, if we find a variable that appropriately captures whether
we're creating or destroying value, we want to set up a compensation system.
So that the more of this variable the executives create,
then the higher their compensation is going to be.
In other words,
the more value they create, the higher their compensation is going to be.
So VBM, Value-based management is all about that.
Is how do I measure whether I'm create, creating or destroying value, and
how do I compensate executives so that they actually have the incentives to
create more and more and more and more value over time.
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