Companies, investors, and governments must relearn the guiding principles of value creation if they are to defend against future economic crises.
APRIL 2010 • Timothy M. Koller Source: Corporate Finance Practice
In response to the economic crisis that began in 2007, several serious thinkers have argued that our ideas about market economies mustchange fundamentally if we are to avoid similar crises in the future. Questioning previously accepted financial theory, they promote a new model, with more explicit regulation governing what companies and investors do, as well as new economic theories. My view, however, is that neither regulation nor new theories will prevent future bubbles or crises. This is because past ones have occurred largelywhen companies, investors, and governments have forgotten how investments create value, how to measure value properly, or both. The result has been a misunderstanding about which investments are creating real value—a misunderstanding that persists until value-destroying investments have triggered a crisis. Accordingly, I believe that relearning how to create and measure value in the tried-and-truefashion is an essential step toward creating more secure economies and defending ourselves against future crises. The guiding principle of value creation is that companies create value by using capital they raise from investors to generate future cash flows at rates of return exceeding the cost of capital (the rate investors require as payment). The faster companies can increase their revenues anddeploy more capital at attractive rates of return, the more value they create. The combination of growth and return on invested capital (ROIC) relative to its cost is what drives value. Companies can sustain strong growth and high returns on invested capital only if they have a well-defined competitive advantage. This is how competitive advantage, the core concept of business strategy, links to theguiding principle of value creation. The corollary of this guiding principle, known as the conservation of value, says anything that doesn’t increase cash flows doesn’t create value.1 For example, when a company substitutes debt for equity or issues debt to repurchase shares, it changes the ownership of claims to its cash flows. However, it doesn’t change the total available cash flows,2 so inthis case value is
conserved, not created. Similarly, changing accounting techniques will change the appearance of cash flows without actually affecting cash flows, so it will have no effect on the value of a company. These principles have stood the test of time. Economist Alfred Marshall spoke about the return on capital relative to the cost of capital in 1890.3 When managers, boards ofdirectors, and investors have forgotten these simple truths, the consequences have been disastrous. The rise and fall of business conglomerates in the 1970s, hostile takeovers in the United States during the 1980s, the collapse of Japan’s bubble economy in the 1990s, the Southeast Asian crisis in 1998, the dot-com bubble in the early 2000s, and the economic crisis starting in 2007 can all, to someextent, be traced to a misunderstanding or misapplication of these principles. Using them to create value requires an understanding of both the economics of value creation (for instance, how competitive advantage enables some companies to earn higher ROIC than others) and the process of measuring value (for example, how to calculate ROIC from a company’s accounting statements). With this knowledge,companies can make wiser strategic and operating decisions, such as what businesses to own and how to make trade-offs between growth and returns on invested capital—and investors can more confidently calculate the risks and returns of their investments. Market bubbles During the dot-com bubble, managers and investors lost sight of what drove ROIC; indeed, many forgot the importance of this ratio...