McKinsey & Co’s Investment Valuation Model
I’ve been reading through The Four Cornerstones of Corporate Finance published by McKinsey & Co. and wanted to share some of the pricinples and facts i came across:
1- Financial engineering, excessive leverage, the idea during inflated boom times that somehow the old rules of economics no longer apply- these are misconceptions upon which the value of companies are destroyed and entire economies falter.
2- The first and guiding cornerstone is that companies create value by investing capital from investors to generate future cash flows at rates of return exceeding the cost of that capital.
3- The faster companies can grow their revenues and deploy more capital at attractive rates of return, the more value they create. In short, combination of growth and return on invested capital (ROIC) drives value and value creation.
4- For businesses with high returns on capital, improvements in growth create the most value. But for business with low returns on capital, improvements in ROIC provide the most value.
5- The second cornerstone of finance is corollary of the first: Value is created for shareholders when companies generate higher cash flows, not by rearranging investor’s claim on those cash flows. They call this in the book “conservation of value”, or anything that doesn’t increase cash flows via improving revenues or returns on capital doesn’t create value.
6- So if a company will change debt for equity or issues debt to repurchase shares, for instance, it changes the ownership of claims to its cash flows. However, this doesn’t change the total available cash flows or added value (unless tax savings from debt increase the company’s cash flow). Similarly, changing accounting techniques may create the illusion of higher performance without actually changing the cash flows, so it wont change the value of a company.
7- The third cornerstone is that a company’s performance in the stock marker is driven by changes in the stock market’s expectations, not just the company’s actual performance (growth, ROIC, and resulting cash flow). They call this in the book the expectations treadmill because the higher the stock market’s expectations for a company’s share price become, the better a company has to perform just to keep up. The large American retailer Home Depot, for instance lost half the value of its shares from 1999 through 2009, despite growing revenues by 11 percent per year during the period at an attractive ROIC. The decline in value can mostly be explained by Home Depot’s unsustainably high value in 1999 at $132 billion, the justification of which would have required revenue growth of 26 percent per year for 15 years, which would hard to do.
8- As the old adage says, good companies aren’t necessarily good investments.
9- The fourth and final cornerstone of corporate finance according to McKinsey & Co. is that the value of a business depends on who is managing it and what strategy they pursue. Otherwise called the best owner, this cornerstone says that different owners will generate different cash flows for a given business based on their unique abilities to add value.
I hope this was helpful.