Creating or Destroying Corporate Value

Two managerial mistakes that we tend to see a lot in practice, and believe it or not there’s actually the both of them have been very widely documented, particularly the first one.

Mistake number one is focusing in the short term, and particularly in announcements that have to do with short-term earnings. There is this quote/unquote obsession in the World’s trade to actually meet the analyst’s expectations. And we want to meet the analyst’s expectations because if we disappoint them then they are going to be negative in our company and many people will be selling our stock, and there is going to be downward pressure on the price of the stock. So we, we have this focus, obsession some people would say, with the earnings announcements and the short-term earnings of the companies. And as we will see in a minute, that goes to the detriment of long-term value creation.

Now, let me give you an example of this. This is actually a well-known study that is called Value Destruction and Financial Reporting Decisions. It says the findings of our survey and financial reporting practices are startling that participation in the earnings game is pervasive may not be surprising, but that the majority of companies are willing to sacrifice long-run economic value to deliver short-run earnings is shocking. Yet, these actions are not even considered a problem for many CFOs. Therefore, we focus on the short term to the detriment of value creation in the long term, and may people say, many CFOs say, well, that may not even be a problem. That is a problem if you focus on creating value, that is actually a big problem.

Let me add one thing to this. Says, what is the magnitude of the problem? We found that 78% of public companies would sacrifice value to smooth earnings and 56% would knowingly defer valuable long-term projects to meet targets. Now think about that. Over half of the corporations actually tend to do things that they know are bad for the long term but in order to focus on the short term. That is problematic because if we want to focus on creating long-term value for shareholders at the same time taking into account the benefit of all the stakeholders, we will not be able to do that if we focus on the short term. And if we focus on the short term announcements of what earnings might be next quarter or the quarter after that. Therefore, Managerial Mistake number one, again we do tend to see a lot this in practice is that this focus on the short term that goes against the issue we are discussing, which is creating value, particularly in the long term.

Issue number two, and this one, it is a little trickier, because growth always has a positive connotation. We all want to grow, companies want to grow. The faster the rate at which earnings grow, the better. Therefore, here is the thing with growth. Although it does have a positive connotation, you can always grow a little faster if you invest a little bit more capital. But as a manager, what you need to see, and what your holders would like you to see, is that the capital invested actually gets an appropriate return and we already know what we call an appropriate return, a return that is higher than the cost of raising the funds to invest in all the projects that the company does.

Now we are looking at the company from way up above. Therefore, we are not looking now at individual projects. Now we are looking at the whole package, the whole thing that the corporation produces. All the products, all the services, everything the corporation does, and the return that it gets on the whole operations. Now we need to compare the return of those projects, the return of this company operating with the cost of raising the funds in order for this company to operate. Therefore, the second important thing and the typical mistake is growing for the sake of growing. Growth by itself is not enough. What you need to earn is an appropriate return on the capital that you invest.

Now let me just give you a quick example here. Therefore, this is a quote from a little report on Mackenzie. It is really on valuation, but at the beginning of that, it actually touches upon the issue of growth and returns. It says it is common sense, growth requires investment and if the investment does not yield an adequate return over the cost of capital, it will not create shareholder value. Executives, who do not pay attention to both growth and returns on capital, run the risk of not creating value for shareholders. That is exactly where we are going. We are not trying to say that growth is bad. Growth for the sake of growth is bad. If you want to grow the company because you want to be bigger so you have more power and so you actually have you know, more corporate jets and more beautiful headquarters. That may be good for the manager but it may not, may not necessarily be good for the shareholders. Therefore, we do not want to grow just for the sake of growth. Corporations should grow, but they should be investing the capital at a rate that is consistent with beating the cost of raising that capital in the in, in the first place.

So, remember that the second point here is two common managerial mistakes:

  • one is focusing too much on the short term,
  • and the other is growing for the sake of growing.

What these two common managerial mistakes have in common is that both of them go against value creation for shareholders in the long-term. And again, remember point number one, we’re trying to create value for shareholders, but we will not be able to do that without taking into account the interest of all the other stakeholders that have something to say in the process of value creation. Third and final point of this sort of underlying issues that we mentioned before and here we need to make a distinction between two things that are similar, but they are actually very different. One thing is what we really want to do is invest the capital that was raised in good projects i.e. A project which has a positive net present value.

The aim of this discussion this session is, how do we actually get there?

How do we get executives to actually deliver the value that shareholders expect?

The reason that we need to pose this question, is that principal-agent problem. Principals, shareholders would like managers, agents, to do with their capital, is to get the highest possible return on it. Now, that may be great for the shareholders, but the question is what is which is the best thing for managers? If the goals of these two are not the same, then what managers’ end up doing may be good for them and not necessarily good for the shareholders. Therefore, as we said before, this whole issue of corporate value creation is very much linked to the principal agent problem.

AdminCorporate FinanceCreating or Destroying Corporate Value Two managerial mistakes that we tend to see a lot in practice, and believe it or not there's actually the both of them have been very widely documented, particularly the first one. Mistake number one is focusing in the short term, and particularly in announcements that have to do...Investment analysis basics