Valuation: measuring and managing the value of companies7th edition. 2020. McKinsey & Company, Tim Koller, Marc Goedhart and David Wessels. Wiley.
What is “value”? This is a pressing question for investors: Turning investment theory into a successful value-driven equity strategy has proven difficult over the past decade.
Tim Koller, Marc GoedhartAnd David Wessels outline the fundamentals of valuation and provide a step-by-step guide to measuring a company’s value. This seventh edition of Assessment (the first was published in 1990) also addresses three factors challenging many value strategies today: the growing proportion of investment in intangible assets, the network effects enjoyed by dominant technology companies, and the integration of an environmental, social and governance (ESG) lens in assessing value.
The fundamental principles of business valuation are general economic rules that apply to all market conditions. The guiding principle is simple: “Companies that grow and earn a return on capital greater than their cost of capital create value.”
The authors argue that too many investors are using the wrong yardstick by focusing on earnings per share. In practice, “expected cash flows, discounted at the cost of capital, generate value,” explain the authors. Moreover, “the stock market is not easily fooled when companies take action to increase reported book profits without increasing cash flow.” This is because rising accrued expenses usually indicate that the company will post lower profits in the future.
The book, originally written as a manual for McKinsey & Company consultants, offers a practical guide to valuation. The core of the book is a series of step-by-step methods for calculating value using the firm’s discounted cash flow (DCF) and discounted economic profit approaches. The authors state that “a good analyst will focus on the key drivers of value: return on invested capital, revenue growth, and free cash flow.” Analysts should be prepared to dig into the footnotes to “reorganize each financial statement into three categories: operating items, non-operating items, and funding sources.” Where to find this ideal analyst? Detailed work to the scale described requires time and judgment. The authors cite the example of Maverick Capital as practitioners: they hold just five positions per investment professional, many of whom have covered the same industry for more than a decade.
I have to be clear: it’s not me. My decade as an equity fund manager ended 20 years ago. Instead, I bring the perspective of a multi-asset investor to the practical lessons this book offers, of which there are many.
First, for companies that find a strategy to achieve an attractive return on invested capital (ROIC), there is a good chance that this market-beating return will be sustained. In a study of US companies between 1963 and 2017, the top quintile of companies ranked by ROIC did see diminishing returns to the mean, but they remained about 5% above the mean 15 years later.
According to the authors, these “high ROIC companies should focus on growth, while low ROIC companies should focus on improving returns”. Growth is rarely a solution for underperforming businesses. “In mature companies, a low return on investment indicates a flawed business model or an unattractive industry structure.”
ROICs across industries are generally stable, so industry rankings don’t change much over time.
Over the past 35 years, higher stock market valuations have been driven by steadily increasing margins and return on capital. For asset allocators, higher valuations of US companies relative to other countries reflect higher ROIC.
Companies with the highest returns combine a number of competitive advantages. The authors identify five sources of premium prices: innovative products; quality (real or perceived); brand; customer lockout, such as replacement razor blades; and rational price discipline (avoiding commoditized products). And they identify four sources of competitive cost advantage: innovative business methods (eg IKEA stores); unique resources (in the mining sector, gold from North America is closer to the surface than that from South Africa and therefore cheaper to extract); economies of scale; and the network economy.
The second lesson is that sustaining above-average growth is far less common than sustaining superior returns. The authors note that “the high growth rates degraded very quickly. Companies growing more than 20% in real terms have typically grown only 8% in five years and 5% in ten years. Yet some sectors have always been among the fastest growing, including life sciences and technology. Others, like chemicals, came of age long before the 1990s.
Third, analysts valuing fast-growing internet and technology stocks should, according to the authors, “start with the future, . . . think in terms of scenarios and compare the economics of business models with those of your peers. This requires an estimate of what the future economics of the company and its industry might become. DCF remains the essential tool, providing value in each of the many possible scenarios. The largest increases in value have been seen in winner-take-all industries. The authors state, “In network-effect industries, competition is held at bay by the market leader’s low and declining unit costs.” Investors will need to take a 10- or 15-year view to properly value a fast-growing company, which often means looking past growing losses in the early stages.
Digital applications can provide clear performance benefits for any business. McKinsey & Company has identified at least 33 opportunities, from digital marketing to robotic process automation.
Fourth, the best owner of a business changes frequently during its life cycle. The authors explain: “A company . . . is likely to start out owned by its founders and could end its days in the portfolio of a company specializing in extracting cash from companies in declining sectors. The chapter on enterprise portfolio strategy provides a good framework for understanding the rationale for mergers, acquisitions and divestitures.
Yet, fifth, “one-third or more of acquiring companies destroy value for their shareholders, as they pass all of the profits from the acquisition to the shareholders of the acquiring companies,” the authors state. Buyers typically pay around 30% more than the advertised price before the announcement. Yet acquisitions can create value, and this book offers six archetypes for successful deals.
Divestitures, on the other hand, generally add value, a sixth lesson. The authors note that “the stock market always reacts positively to divestitures, both sales and spin-offs. Research has also shown that spin-offs tend to increase profit margins by a third within three years of closing deals.
Finally, a corporate strategy that addresses ESG issues can boost cash flow in five ways:
- Facilitate revenue growth
- Cost reduction
- Minimize regulatory and legal interventions
- Increase employee productivity
- Optimization of investments and capital expenditure
For example, one study found that gold miners with social engagement activities avoided planning or operational delays. A do-nothing approach is also not gratuitous. Better performance on ESG issues reduces downside risk. For example, it can help avoid blocked assets. A strong ESG proposition can create more sustainable opportunities, increasing the value of DCF.
However, ESG reporting is not presented in the chapter on communication to investors. I urge authors to address this issue in their next edition. Asset owners need to understand the impacts of their investments.
In conclusion, neither the Internet nor the growing attention paid to ESG issues has made the rules of economics, competition and value creation obsolete. As the authors state, “the faster companies can grow their revenues and deploy more capital at attractive rates of return, the more value they create.”
This well-written book gives CEOs, business leaders, and CFOs insight into the strategies they can use to create value and provides investors with tools to measure their success.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, and the opinions expressed do not necessarily reflect the views of the CFA Institute or the author’s employer.
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