Several years back, I stumbled at an airport in Far East Asia on the book “Valuation: Measuring and Managing the Value of Companies “by Tim Koller, Marc Goedhart, David Wessels and McKinsey and Co. Now in its 8th Edition, it is a classic invaluable book in understanding valuation, value-creation and finance, a recommended text in top business schools around the world. Tim Koller, the Lead author, was recently interviewed by the Investor Podcast in an episode titled “First Principles of Valuation”.
Below are 10 Lessons spiced with my reflections in few places from the interview.
1. Value is created when your business delivers a return on capital greater than the cost of capital. Applies across all geographies and businesses including digital and tech.
2. “What matters for any investment is the cash flows that you generate and the way to generate cashflows is to earn a return on invested capital higher than the cost of capital”- Tim Koller
3. Valuation of a business is a function three things- a) return on capital greater than cost of capital, b) how much capital is invested and c) revenue growth. In any business you run, these three levers are critical to driving genuine enduring valuation and creating value.
No matter the function you start from, you will be a well-rounded solid business leader when you understand finance and understand the operational implications (active customer numbers, acquisition cost, product usage per customer/frequency, product margins) of these three levers. It implies that if you are growing with a return on capital lower than your cost of capital, without a scale trajectory (path) and positive unit economics that will deliver a return on capital greater than your cost of capital, you are ultimately destroying value irrespective of your current valuation. This is particularly relevant to startups that have found product-market fit. – reflections
Partner well with your finance function to create value while finance must also understand the business, strategy and operations to provide genuine value-creating support rather than mechanical book-keeping. – reflections
4. You cannot please all investors. Focus on the investors that matter which are long term sophisticated, intrinsic investors not short term sell side analysts who tend to be disproportionately louder in stock market investor presentations. It is the long term sophisticated intrinsic investors that ultimately determine value of the company.
5. The use of technology and AI itself does not create enduring value if the efficiency gains of #AI and tech diffuse rapidly in your industry across competitors. What really matters in business value creation is whether companies use technology and AI to create “enduring competitive advantage” in critical markets that others cannot copy, not industry generic efficiency gains. The is particularly relevant to financial services, telecommunications, media and entertainment, mobility and fmcg industries.
6. Focus more on the operating performance where real enduring long-term value is created, not financial and accounting gimmicks.
Disaggregate your Return on Capital (ROC) to business or operating unit levels to ensure visibility of where value is being created.
Recognize that not all businesses produce cash flows that gives immediate return on invested capital. Management has a duty to educate the board and investors on the nature of its businesses and their gestations to profitability/ maturity in valuation of the company.
It is important that CEOs and CFOs be granular about their companies and operating unit performances. The strategic issues, economics, growth, gestation and maturity of each business are different. When Boards, CEOs and CFOs apply a one size fits all to value-creation across their businesses, they are likely to destroy value. This is particularly relevant to banking and financial services, telecommunication and media.
7. The direction (trajectory) of Return on Capital is as important as the absolute numbers on the return on capital. It foretells a future that should be baked into the valuation /value of the company.
8. When it comes to a company’s portfolio of risk investments or businesses, three main factors are essential for ensuring business value creation:
a) Don’t be a dabbler. Will you be willing to invest sufficiently and long term in the business to win? You are only a dabbler if you don’t.
b). Will you be able to attract the critical talents needed to get the business to win?
c) Do you have the competitive advantage to win for the investment to generate return on capital greater than cost of capital? If you don’t have these three, you are likely to destroy value.
9. Executive compensation tend to create short term incentives that makes executives sacrifice long term-value creation. This is reinforced by Boards who cannot discern immediate ROC issues that are operational and investment horizon/ maturity issues as they impact on ROC.
Boards and CEOs must be conscious of these challenges and balance executive compensation appropriately.
10. Enterprises Value (EV) over Net Operating Profit after Tax (NOPAT) is a better measure of valuation multiples than price-earnings ratio or EV/EBITDA because it equalizes for companies with different asset intensity or outsourcing strategy and different tax jurisdictions.
Where a company is obviously not yet profitable like in many startup digital businesses, EV/ EBITDA would be good measure of the valuation multiples that private investors are putting on the company based on their faith, founder and management story, their relative projections of scale, growth , market opportunities and the potentials of managers to build enduring moats around those advantages. It presupposes that startups as they mature, building businesses with positive unit economics should strive to translate their positive unit economics to positive and growing EBITDA margins even when not yet profitable at PAT or NOPAT. – reflections
Olu Akanmu is Academic Director of Lagos Business School Tech-Leap Initiative.
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