Value: A book review by Bob Morris

Value: The Four Cornerstones of Corporate Finance
Tim Koller, Richard Dobbs, and Bill Huyett
John Wiley & Sons (2011)

How executives can make much better decisions – “even as markets, economies, and industries change around them”

All organizations need a solid foundation on which their executives can base their most important decisions about strategy, mergers and acquisitions, budgets, financial policy, and performance measurement – “even as markets, economies, and industries change around them”

This book was co-authored by three McKinsey & Company partners — Tim Koller, Richard Dobbs, and Bill Huyett — who bring decades of experience and a diversity of perspectives to their rigorous consideration of what they characterize as “the immutable principles of value creation. ” These principles are in the best interests not only of shareholders but of everyone else directly and indirectly involved in the given enterprise. This is a key point because, more so today than ever before, value addition or reduction can occur at any level and in any area of an organization’s operations.

The focus in the book is on the four cornerstones of finance, best revealed within the narrative, in context. (They are introduced and discussed briefly on Pages 4 and 5, then delineated thoroughly through Part One, Chapters 1-5.). These are among the passages that I found most valuable:

o  Desegregating cash flow into revenue growth and ROIC (Pages 17-21)
o  The best-owner life cycle (55-57)
o  Summary of key points re five stock market eras, 1960-2009 (76-83)
o  Why accounting treatment won’t change underlying value (114-116)
o  Trends in return on capital (133-138)
o  The logic for systematic divestitures (158-162)
o  Why companies should retain at least some risks (189-195)

Most readers (I among them) agree with Koller, Dobbs, and Huyett that the most difficult part of creating value and, specifically, applying and then sustaining the four cornerstones “is getting the right balance between delivering near-term profits and return on capital, and, continuing to invest for long-term value creation. [Not just in fixed assets, but investments that are expensed right away, such as new product development, new geographic markets, and people.] Configuring the management approaches of the company to reflect this balance is the chief executive’s responsibility.”

Tim Koller, Richard Dobbs, and Bill Huyett provide a wealth of information, insights, and counsel that will serve as “a catalyst and guide for improving how executives plan strategy, make decisions, solve problems, and meanwhile create the next generation of leaders. Ultimately, we hope that the collective impact of more companies embracing these [four] principles creates a more stable and productive economy.”

Finding the courage to shrink

Here is an excerpt from another excellent article featured online by The McKinsey Quarterly, published by McKinsey & Company. Bill Huyett and Tim Koller acknowledge that spinning off businesses can have real advantages in creating value—if  executives understand how. To read the complete article, check out other resources, sign up for email alerts, and obtain subscription information, please click here.

Source: Corporate Finance Practice

*     *     *

It takes courage to break up a company. CEOs and boards of directors often fear that investors will view asset divestitures as admissions of failed strategy—that having certain businesses under the same corporate umbrella never made sense. Many worry that shedding assets will cost a company the benefits of scale, cut into the advantages of analyst coverage, or even damage employee morale. Spin-offs in particular draw scrutiny because they shrink the size of the parent company but, unlike sales, don’t generate cash to reinvest.

We don’t believe these arguments hold up. What’s more, they may lead executives to pass up value-creating opportunities. A fundamental principle of corporate finance holds that a business creates the most value for shareholders and the economy as a whole when it is owned by the best—or, at least, a better—owner. [Note: See Richard Dobbs, Bill Huyett, and Tim Koller, “Are you still the best owner of your assets?” mckinseyquarterly.com, November 2009.] So it makes sense that companies should continually reallocate their resources as circumstances change. Moreover, the benefits of being part of a large company come at a cost; in fact, many spun-off companies can make substantial cuts in overhead costs once they are independent. Investors typically don’t care about a company being too small once it reaches a threshold of about $500 million in market capitalization. [Note: See Robert S. McNish and Michael W. Palys, “Does scale matter to capital markets?” mckinseyquarterly.com, August 2005.]  And in our experience, executives and employees of spun-off companies often feel liberated and quite happy to be on their own.

So it’s a good sign that there’s been something of a revival in spin-off activity this year. According to Bloomberg, as of August 25, 174 companies had announced spin-offs of all sizes—quickly approaching the previous global record of 230, in 2006. Among the notable deals: Kraft Foods’s spin-off of its North American grocery unit and ConocoPhillips’s spin-offs of its downstream businesses.

The trick to executing a spin-off strategy—and to overcoming predictable objections to it—is to understand where the value is created. Markets typically respond favorably to spin-offs, but savvy managers understand that such deals create value not from some mechanical market reaction but from the sharpened strategic vision that comes with restructuring or the tax advantages relative to a sale.

Spin-offs: A brief history

Company breakups through spin-offs date back at least a hundred years. Many of the earliest and best-known ones were mandated by courts to split up monopolies, including the 1911 breakup of Standard Oil into 34 separate companies, as well as the 1984 breakup of AT&T into 8 companies.

After the AT&T breakup, spin-offs became a more common way for companies to change their strategic direction. American Express, for example, spun off Lehman Brothers in 1994, ending its strategy of becoming a financial supermarket. In 1993, as the historical links between chemical and pharmaceutical businesses became less relevant, the British chemical company Imperial Chemical Industries [Note: ICI was subsequently acquired in 2008 by Dutch chemicals conglomerate AkzoNobel.]  (ICI) spun off its pharmaceutical business as Zeneca. [Note: Zeneca later merged with Astra in 1999 to form AstraZeneca.]  Recent spin-offs have reflected similar shifts. In 2008, when the integration of the production and delivery of media content didn’t lead to the anticipated benefits, Time Warner announced that it would spin off its cable television business.

Some of the major conglomerates built in the 1960s and ’70s used spin-offs to break themselves up. ITT, one of the best-known conglomerates of that era, used a double spin-off in 1995 to split itself into three companies, ITT Sheraton (now part of Starwood Hotels and Resorts), Hartford Financial Services, and the remaining industrial businesses, which kept the ITT name. In January 2011, ITT announced that it was further splitting up into three companies: ITT Corporation (industrial process and flow control), Zylem (water and waste water), and ITT Exelis (defense). In an even more extreme example, the company that was Dun & Bradstreet in 1995 has spun out businesses four times (1996, 1998, 1999, and 2000) and now exists as seven different companies.
Understanding the benefits

One common misperception about spin-offs is that they are quick fixes for low valuations. Managers see the typically favorable response that markets have to a spin-off announcement as confirmation that a spin-off itself mechanically illuminates value that investors previously overlooked. But that belief is misleading.
Such assumptions rest errantly on a “sum of the parts” calculation. For each of a company’s businesses, analysts add up an assumed earnings multiple based on the multiples of industry peers. If they find that the sum of the parts is greater than the market value of the company as currently traded, they assume the market hasn’t valued the business properly.

*     *     *

To read the complete article, check out other resources, sign up for email alerts, and obtain subscription information, please click here.

Bill Huyett is a partner in McKinsey’s Boston office, and Tim Koller is a partner in the New York office.

The authors wish to acknowledge the contributions of Katherine Boas and Mauricio Jaramillo.

Creating value: An interactive tutorial provided by McKinsey & Company

Here is the latest report that McKinsey & Company’s Quarterly makes available online. To see the video and sign up for a free subscription with limited access to McKinsey resources, please click here.

In this video presentation, McKinsey partner Tim Koller explores the four guiding principles of corporate finance that all executives can use to home in on value creation when they make strategic decisions.

*     *     *

If investors and managers should have learned anything from the turbulence both in markets and in the real economy in recent years, it’s that there is no substitute for real value creation. Financial engineering, excessive leverage, the idea during inflated boom times that somehow the old rules of economics no longer apply—these are the misconceptions upon which the value of companies are eroded and entire economies become inefficient. Conversely, real value creation builds stronger companies, economies, and societies.

Executives—and not just those in the corporate-finance function—can make smarter and more courageous strategic decisions if they arm themselves with the tools to understand which actions will create and destroy value within their organizations. In this interactive video, Tim Koller, a partner in McKinsey’s New York office, explains the four principles—or “cornerstones”—of corporate finance that can help executives figure out the value-creating answers to some of the most pressing corporate-finance questions. Koller, a co-author with Richard Dobbs and Bill Huyett of the recently published book Value: The Four Cornerstones of Corporate Finance (Wiley, November 2010) describes each principle, explains how it works, and draws on real company case studies to illustrate the strategic choices that executives make to create real value.

NOVEMBER 2010 • Tim Koller
Source: Corporate Finance Practice