value creation - bfa.docx

Four Cornerstones of Value Creation Creating value is about exceeding expectations. In this module, we're going to talk about the four cornerstones of value creation based on some work from the consultancy, McKinsey and Company. These cornerstones represent the most important elements of value creat...

Four Cornerstones of Value Creation Creating value is about exceeding expectations. In this module, we're going to talk about the four cornerstones of value creation based on some work from the consultancy, McKinsey and Company. These cornerstones represent the most important elements of value creation. The first cornerstone of value creation is based on the concept known as Spread. Let's start with an example. If you could take a loan from a bank with an interest rate of 6% and invest that money and make 4% would you do it? I hope the answer is no. Because if you make 4% you won't be able to pay back the 6% and you wouldn't be able to create value. This is spread and it represents the difference between the rate of return that you make - the 4% in this case and the expectation of the cost of the money that you borrowed - in this case the 6%. As you can see in the simple example the only way to create value is to exceed that 6% borrowing cost. What makes this concept difficult is the language that we use. In the real world the 6% is known as a cost of capital or a hurdle rate. It's also called a weighted average cost of capital or a WACC. What it represents is the rate of return that is expected on an annual basis for the money that is borrowed and invested. It is similar to the interest rate on a loan from a bank. It is also a risk adjusted. If you take a higher risk investors charge you more. Only when we exceed this expectation of an annual rate of return can we create value. there are two additional important things to know about spread. First, approximately half of the spread of a company is based on the industry or the market that it is in. If a company is in a good industry it's relatively easy to make money. But if the company isn't a bad industry it can be very difficult to make money regardless of how well the company executes. Industry matters to spread. Warren Buffett a very famous investor has said as part of a secret to his success that he doesn't invest in companies. He invests in industries because they are more important then he picks the company that's going to win in that order. Because he says that if he falls in love with the company in a bad business there's nothing they can do. For the past 40 years this has made him one of the most successful investors ever. As an example of this think about the travel industry during the pandemic. When business travel effectively ended and passenger demand fell by over 60% no airline could make money in that environment no matter how well they were run. That's the point of the industry. The second concept that you need to know about spread is that growth does not create value. I'm going to say that again. Growth does not create value. Look at this example if you could borrow it 6% and you only make 4% what happens when you do more of that. You just dig yourself deeper into a hole. Now if you can borrow it 6% invest and make 14% I wouldn't want to do that all day long. Growth is the accelerant two value. And what matters is the growth return combination. There's good growth and there's bad growth. As leaders we have to separate and understand the difference. Cornerstone number two – it’s about cash flow not accounting. Accounting is a piece of paper. Income represents how much cash you're eventually going to generate, but it doesn't tell you how much cash you have today. In a way, it's like a pay stub. The pay stub doesn't tell you how much cash you actually have in your checking account on a given day. If we ever run out of cash bad things happen. So we're much more interested in the cash than the paper. Eventually they will be the same (meaning the pay stub will be the cash coming into our account) but timing matters. Timing also matters because of a concept known as time value of money. When we get the cash changes its value and that's why in finance we tend to focus on cash flow. Cash flow better represents value. Cornerstone number three is about expectations. Value is about the future not the past. A very important academic study was done at the University of Chicago. They looked at the cash generated by a number of different types of assets and investments over a long period of time. They then compared the cash generated with the price of these assets overtime. In this big data set what they found was that over the long run whatever cash these assets generated eventually became their price in the marketplace. This is a concept known as intrinsic value. What Chicago demonstrated is that overtime you were gonna be worth as a price whatever cash you have generated. This is also known as the law of 1 price. When we value a company we then say a company is worth today the sum of all of its future cashflows. To estimate those cash flows I have to guess today what those future cashflows are going to be. When those cash flows come in the market will adjust the price to the reality of what dessert. Warren Buffett has a great saying for this. He says that in the short run stock prices are like a voting machine and in the long run stock prices are like a weighing machine. But here's the challenge. Today as I guess the cash that a company will generate overtime the first ten years is probably the most important. So if we take any company how much cash are they gonna generate over the next 10 years today I'll guess and over time I'll see what they did. And the companies value will be based on what I think those cash flows are going to be over time based on my guesses today. But here's the row. If I could go in a time machine 10 years into the future what the company did in the last 10 years no longer matters to the value it's what they're going to do in the next 10 years. The challenge here is that I will never get to the actual cash flows in the future I will always be guessing what those cash flows are going to be. So I'm going to give you an always and finance. Price is always expectation. Companies will always be worth the expected cash flows not the actual cash flows because we never get to the future. This has important implications. If a company is doing poorly now but I expect them to do well later I might price them very high and I might be willing to give them cash. But if a company is doing well now but I expect them to do poorly in the future I might price them poorly now and I might not want to give them anymore cash. Investors make choices based on expectations. That has a very important role in value creation. Obviously we want these expectations to be as realistic as possible but anytime we deal with the future we deal with risk and uncertainty. Cornerstone number four is called sustainability of competitive advantage. We define competitive advantage as outperforming peers. Your company has competitive advantage they should be able to demonstrate that their lower cost allows them to make more money consistently or that their differentiation and uniqueness allows them to charge a price premium consistently relative to their peers. But the question of sustainability it's not whether a company has competitive advantage but rather for how long. And what we have found is that Darwin is constantly at work in the marketplace and that competitive advantage is transient. In 2000 General Electric was the most valuable company in the United states. 21 years later this company's value declined by 2% per year and it was broken up into three pieces. This is not an indictment against General Electric this is proving the point that it is very difficult to sustain a competitive advantage long term. So that the question investors are gonna now start to ask is now do you have advantage but for how long. And more importantly do you have a what's next. What the data suggests when we look at large datasets is that overtime there is regression to the mean and most companies tend to earn an average rate of return. In one study that looked at performance broken into quartiles after five years only 25% of the top quartile in returns remained in that quartile. The other 75% of the companies saw their performance fall. The traditional definition of competitive advantage espoused by Warren Buffett, it's called the Moat Theory. And what he says is, I want to have a knight in my castle ever expanding the lands (growth), and then I want to have a moat around that castle to keep out the bad guys (competitive advantage). So think of it this way. I can have a patent, I can have a brand, I can have an exclusive license. There's many different ways to have a moat. But here's the problem. What happens if nobody wants to invade your castle anymore? Then your moat doesn't matter. So increasingly it's known as the Wave Theory, and the idea of the Wave Theory is that your competitive advantage is like a wave, and that wave is going to crash. So it's no longer do you have advantage, it's for how long? Let me give you an example. If we go back to 2007, and you think about the smartphone market, odds are you had a Blackberry because Blackberry had 70% of global market share for smartphones, yet less than a decade later, they basically ceased to exist. If you told people in 2007 that the Blackberries would go away, they were called crackberries at the time, they would've thought you were nuts. Yet that's exactly what happened over time. So here's the point, the wave crashed. And what investors are increasingly searching for, what's the next wave? What is the market going to look like five to 10 years out, and where do I place my bets at that point in time? Wayne Gretzky said, "I never skated to where the puck is, I always went to where the puck was going". And that's the way we have to think about it as investors, and that's the way we have to think about it as leaders because that's going to be more important for the marketplace when we think about competitive advantage.