1.

Why Value Value?

Value is the defining dimension of measurement in a market economy.

People invest in the expectation that when they sell, the value of each
investment will have grown by a sufficient amount above its cost to
compensate them for the risk they took.
Alternative measures are neither as long-term nor as broad.
Competition among value-focused companies also helps to ensure that
capital, human capital, and natural resources are used efficiently across the
economy, leading to higher living standards for everyone.
The guiding principle of value creation is that companies create value by
investing capital they raise from investors to generate future cash flows at
rates of return exceeding the cost of capital
The faster companies can increase their revenues and deploy 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.
Anything that doesnt increase cash flows doesnt create value.
Creating value means balancing near-term financial performance against
what it takes to develop a healthy company that can create value for
decades aheada demanding challenge.

CONSEQUENCES OF FORGETTING TO VALUE VALUE

Market Bubbles: Internet Bubble

Financial Crises:
Flaws:
Securitizing risky home loans made the loans more valuable because it
reduced the risk of the assets.
Using excessive leverage to make an investment in itself creates value.
Financing illiquid assets with short-term debt.

If investors and lenders value their investments and loans according to the
guiding principle of value creation and its corollary, prices for both kinds of
assets will reflect the real risks underlying the transactions.
Stock markets generally continue to reflect companies intrinsic value during
financial crises.
Equity markets rarely predict inflection points in the economy

BENEFITS OF FOCUSING ON LONG-TERM VALUE

Most companies anywhere in the world, pursuing the creation of long-term

shareholder value does not cause other stakeholders to suffer
Value-creating companies also create more jobs
There is a strong positive correlation between long-term shareholder returns
and investments in research and development evidence of a commitment to
creating value in the longer term
Companies that create value also tend to show a greater commitment to
meeting their social responsibilities

CHALLENGES OF FOCUSING ON LONG-TERM VALUE

Focusing in long term value is a tough job for executives. They cant be
expected to take it on unless they are sure it wins them more investor
support and a stronger share price.
Companies that fail to create value over the long term do less well in the
stock market.
There is no empirical evidence linking an increased EPS with the value
created by a transaction, their focus on short-term EPS, major companies
not infrequently pass up value-creating opportunities.
Short-term efforts to massage earnings that undercut productive
investment make achieving long-term growth even more difficult,
spawning a vicious circle.
Applying the principles of value creation sometimes means going against
the crowd. lunches. It means relying on data, thoughtful analysis, and a
deep understanding of the competitive dynamics of your industry

3.

The Expectations Treadmill

If managers focus on improving Total Return of Shareholders (TRS) to win

performance bonuses, then their interests and the interests of their
shareholders should be aligned. But TRS measured over periods shorter
than 10 years may not reflect the actual performance of a company and
its management
The reason is that a companys progress toward performance leadership
in any market will attract investors expecting more of the same, pushing
up the share price.(expectations treadmill)
If TRS is analyzed in the traditional way, it doesnt show the extent to
which improvements in operating performance contributed to the
measure as a whole
TRS may rise or fall across the board for all companies because of
external factors beyond managers control, such as changing interest
rates
TRS can work as a performance measure, but only in comparison with
the TRS performance of a companys peers in its sector.

WHY SHAREHOLDER EXPECTATIONS BECOME A TREADMILL

All the investors collectively will earn, on a time-weighted average, the

same return as the company. But individual groups of investors will earn
very different returns, because they pay different prices for the shares,
based on their expectations of future performance.
The analogy of a treadmill, the speed of which represents the
expectations built into a companys share price the speed of the
treadmill quickens as performance improves.
It describes the difficulty of continuing to outperform the stock market
Even for the extraordinary manager, it can be extremely difficult to keep
beating high expectations.
The expectations treadmill pushes Companies into taking enormous risks
to justify its share price.
Smart investors often prefer weaker-performing companies, because they
have more upside potential, as the expectations expressed in their lower
share prices are easier to beat.

REAL-WORLD EFFECTS OF THE EXPECTATIONS TREADMILL

The expectations treadmill explains the mismatch between TRS and the
underlying value created by the two companies.
For TRS to give deeper insight into a companys
True performance, we need a more granular approach to this measure

DECOMPOSING TRS

When managers, boards of directors, and investors understand the

sources of changes in TRS, they are better able to evaluate
management.
Decomposing TRS can help with setting future targets.
The decomposition we recommend gives managers a clearer
understanding of the elements of TRS they can change, those that
are beyond their control, and the speed at which their particular
expectations treadmill is running
A first approach

A Manager might assume that all forms of earnings growth create an

equal amount of value.
This approach suggests the dividend yield can be increased without
affecting future earnings, as if dividends themselves create value. But
dividends are merely a residual.
The traditional expression of TRS fails to account for the impact of
financial leverage
Second approach break up the TRS equation into four parts:
o The value generated from revenue growth net of the capital
required to grow
o What TRS would have been without any of the growth
measured
o Changes in shareholders expectations about the companys
performance, measured by the change in its P/E or other
earnings multiple
o The impact of financial leverage on TRS

This enhanced approach shows that not much of the 14.4 percent TRS
reflects the creation of new value.

This example shows the impact of debt financing on the TRS

decomposition.
Greater leverage doesnt necessarily create value, because greater
leverage equals greater risk, and greater risk can amplify weaker as well
as stronger performance.
UNDERSTANDING EXPECTATIONS

A Company whose TRS has consistently outperformed the market will

reach a point where it will no longer be able to satisfy expectations
reflected in its share price
Managers need to realize and communicate to their boards and to
investors that a small decline in TRS is better for shareholders in the long
run at this juncture than a desperate attempt to maintain TRS through illadvised acquisitions or new ventures.

MANAGERIAL IMPLICATIONS

Instead of focusing primarily on a companys TRS over a given period,

effective compensation systems should focus on growth, ROIC, and TRS
performance relative to peers
If executives and boards understand what expectations are built into
their own and their peers share prices, then they can better anticipate
how their actions might affect their own share prices when the market
finds out about them
Executives also need to give up the bad habit of incessantly monitoring
their stock prices. TRS is largely meaningless over short periods
Once your share price rises, its hard to keep it rising faster than the
market average. The expectations treadmill is virtually impossible to
escape, and we dont know any easy way to manage expectations down.

4.

Return on Invested Capital

The value of a business depends on its return on invested capital (ROIC)

and growth
In a business with increasing returns to scale, the first competitor to grow
big can generate very high ROICs will usually create the bulk of value in
the market.

Rates of return on invested capital depend on competitive advantage,

itself a product of industry structure and competitive behavior

DRIVERS OF RETURN ON INVESTED CAPITAL

The structure of an industry influences the conduct of the

competitors, which in turn drives the performance of the companies
in the industry
According to Porter, the intensity of competition in an industry is
determined by five forces: threat of new entry, pressure from
substitute products, bargaining power of buyers, bargaining power of
suppliers, and the degree of rivalry among existing competitors.

COMPETITIVE ADVANTAGE

Price premiums offer any business the greatest scope for achieving
an attractive ROIC, but they are usually more difficult to achieve than
cost efficiencies.

Price Premium Advantages:

To sell its products at a price premium, a company must find a way to
differentiate its products from those of competitors.
Sources:
o Innovative products
o Quality
o Brand
o Customer lock-in
o Rational price discipline
Cost and Capital Efficiency Advantages

Cost efficiency is the ability to sell products and services at a lower cost
than the competition. Capital efficiency is selling more products per
dollar of invested capital than competitors
Sources
o Innovative business method
o Unique resources
o Economies of scale: what matters is having the right scale in the
right market.
o Scalable product/process: The cost of supplying or serving
additional customers is very low.

SUSTAINABILITY OF RETURN ON INVESTED CAPITAL

The longer a company can sustain a high ROIC, the more value the
company will create

Length of Product Life Cycle:

The longer the life cycle of a companys businesses and products, the
better its chances of sustaining its ROIC.
Persistence of Competitive Advantage:
If the company cannot prevent competition from duplicating its business,
high ROIC will be short-lived, and the companys value will diminish.
Potential for Product Renewal:
When companies have found a strategy that creates competitive
advantages, they are often able to sustain and renew these advantages
over many years.
EMPIRICAL ANALYSIS OF RETURNS ON INVESTED CAPITAL

ROICs differ by industry but not by company size. Industries that rely on
sustainable competitive advantages such as patents and brands tend to
have high median ROICs, whereas companies in basic industries, such as
paper, airlines, and utilities, tend to earn low ROICs
Some industries earn higher median returns than others

ROIC by Industry and Company Size:

Both industry and company are important in explaining individual

companies ROICs
Industries where companies build identifiable sustainable advantages,
such as patent-protected innovations and brands, tend to generate
higher returns.

The size of a companys revenues shows no clear relation to ROIC,

suggesting that scale in terms of absolute size is rarely a source of
competitive advantage

Sustaining ROIC:

The best-performing companies cannot maintain outstanding

performance over the long term, their ROIC does not revert all the way
back to the aggregate median

If a company finds a formula or strategy that earns an attractive ROIC,

there is a good chance it can sustain that attractive return over time and
through changing economic, industry, and company conditions
especially in the case of industries that enjoy relatively long product life
cycles
If a company earns a low ROIC, that is likely to persist as well.