The Ultimate Ceo’s guide for Corporate Finance: Understanding the technical methods of company valuation, and then applying them to keep track of and improve company performance is the core expertise of the chief financial officer and the members of the finance organization. However, if the chief executive and other board members understand the nuances of valuation and grasp the technicalities behind the valuation methods and incorporate the principles of value creation, it becomes even more powerful tool. By doing so, according to top corporate law firms in India, they might take decisions that may look courageous on one hand, but be quite unpopular with various stakeholders in the wake of myths and misconceptions surrounding wealth creation strategies.
When the senior management in an organization has a strong understanding of the financial technicalities it is easier for them to resist the alluring appeal of financial engineering, highly stretched leverage, or the notion that the empirically established laws of economies do not hold good anymore. These can be potentially dangerous and harmful, and lead the senior leaders to take decisions that can prove to be counter-productive and destroy value and even slow down economies.
In this article here, we’ll try to understand how the four principles or the four cornerstones of value creation can aid the chief executive officer and other board members in taking some of the most important decisions that can increase the valuation of the company. The four principles are described below.
The core-of-value principle: This principle states that value creation is contingent upon the return on capital and growth, while at the same time, it highlights certain nuances of applying these concepts.
The conservation-of-value principle: According to this principle, it is immaterial how you utilize your finances- through financial engineering, share buybacks, mergers and acquisitions, etc., value can be created only by improving cash flows.
The expectations treadmill principle: It explains that the movement in the share price doesn’t only reflect the actual performance, but it is also reflective of the market’s expectation about the performance of a company with respect to growth and return on capital. Higher the expectations, more is the pressure to perform even better to maintain the market’s confidence.
The best-owner principle: This principle states that there is no inherent value in a business. Different owners see different values in the same business. The value of a business depends on how it is managed and what strategies are followed.
The four Principles and their Implications
Top corporate and m&a advisory firms in India maintain that the four principles mentioned above are critical to value creation in a company. Ignoring these principles can be catastrophic for a company. Take, for example, the events that preceded the financial crisis of 2008. Those who were involved in the securitized mortgage market for home loans thought that securitizing the loans would reduce the risk and ultimately make them more valuable. However, this theory was completely against the principle of value conservation. It didn’t result in any increased cash flows, which meant there was no value creation, and the initial risk was not mitigated. Securitization just meant that the risk had been passed on to someone else.
In hindsight, it may seem all too obvious, but many people miscalculated. It seems that no lessons have been learnt from that crisis, as similar misconceptions are being given precedence in board meetings where acquisitions, divestitures, projects, and executive compensation are evaluated. As we’ll find out, the four cornerstones of corporate finance are everlasting guiding principles for critical managerial decisions.
Mergers and Acquisitions
Acquisitions are an important growth tool for companies. If the acquired company falls into the hands of more efficient owners, then it typically adds substantial value for the investors. It has been empirically proven that acquisitions result in increased cash flows for the combined entity. However, major benefits accrue to the acquired company rather than the acquiring company. Research shows that just about 50% of the acquiring companies create value for themselves.
The conservation-of-value principle applies really well in acquisitions as they create value only when the combined cash flow is better than the sum of the individuals.
Divestitures are a good example of the best owner principle. Divestitures are often seen as an admission of failure. Top management is generally concerned about how the stock market would react to such decisions. However, market reaction is generally positive as it thinks that it is better to sell off unprofitable business than to carry excess baggage. Also, when the divested business goes into the hands of a new owner or management, it may perform better, which excellently illustrates the best owner principle.
Project Analysis and Downside Risk
Top executives are often involved in analysing project proposals and its financial attractiveness. There are sophisticated analytical tools that assist them in their decision. These tools may not always be correct; it sometimes gives a false sense of security. If your approach is primarily focussed on probability of success, it ignores the core-of-value principle and puts future cash flows in danger. A company should never embark on projects that have the potential of a negative spillover effect on the company. Taking into account the downside risk is very important in project analysis.
Most companies provide performance based compensation to their top executives. Some companies follow the short term total returns to shareholders (TRS). TRS, however, is dependent on the stock market movements, rather than the actual performance of the executives. The TRS system goes against the principle of expectation treadmill. For instance, if there is low initial expectation from a company, it is relatively easy for managers to beat the market expectations. However, this increases the expectation level, and the company would have to perform even better to meet those expectations.
Sticking to the four cornerstones of corporate finance may seem difficult at times, but it is essential for long term value creation. These four principles are vital guides for corporate finance.