Value: The Four Cornerstones of Corporate Finance
Shows arithmetically that payout choice alone does not create value.
Summary
Koller, Dobbs and Huyett, all of McKinsey, wrote this as a short statement of the principles underlying the firm's longer valuation textbook, aimed at executives and directors rather than at analysts.
The four cornerstones are stated as propositions. The core of value is that a company creates value by investing capital at returns above its cost of capital, and that growth and return on invested capital together determine how much. Growth without an adequate return destroys value, which means growth is not universally desirable. The conservation of value holds that value is created by changing cash flows, not by rearranging claims on them, so financial engineering, accounting changes and share repurchases that do not alter operating cash flow do not create value regardless of their effect on reported earnings per share. The expectations treadmill holds that shareholder returns depend on performance relative to expectations already in the price, which means that an excellent company with an excellent price cannot deliver excess returns, and that managers pursuing share price appreciation are chasing something outside their control. The best owner principle holds that a business has no single intrinsic value, since its worth depends on who owns it and what they can do with it, which is the basis for divestiture as well as acquisition.
The authors apply these to specific decisions: whether to pursue growth, how to assess acquisitions, whether repurchases create value, how to communicate with investors, and how to structure a portfolio of businesses.
The principles are mainstream corporate finance stated clearly rather than original contributions. The book's value is that it states them in a form that a non-specialist executive can apply, and that it identifies the specific errors that follow from ignoring each. The treatment is oriented to large public companies and the empirical support is McKinsey's own research, which is not independently verifiable.
Key takeaways 7
- Value is created only by investing capital at a return above its cost, so growth at inadequate returns destroys value.
- Rearranging claims on cash flows through financial engineering does not create value regardless of the effect on reported earnings per share.
- Shareholder returns depend on performance relative to expectations already in the price, not on absolute performance.
- A company already priced for excellence cannot deliver excess returns by continuing to be excellent.
- A business has no single intrinsic value, because its worth depends on what its owner can do with it.
- The best owner principle justifies divesting good businesses to owners who can do more with them than you can.
- Managers who target share price appreciation are pursuing an outcome that depends on expectations they do not control.
Who should read it
Executives and directors who need the principles of value creation stated in a form they can apply to growth, acquisition and payout decisions.
About Tim Koller
Partner at McKinsey & Company and lead author of the firm's valuation textbook.
Valuation: Measuring and Managing the Value of Companies sets out discounted cash flow practice end to end - forecasting, return on invested capital and growth as the two drivers of value, cost of capital, and the treatment of non-operating items - and is the text most corporate finance training runs on. Value: The Four Cornerstones condenses the same framework into the few principles that hold when accounting rules and buyback fashions change.
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