Several years ago, I came across the book “Valuation: Measuring and Managing the Value of Companies” by Tim Koller, Mark Goedhart, David Wessels, and McKinsey & Company at an airport in Far East Asia. Now in its 8th edition, it is a classic invaluable book in understanding valuation, value-creation and finance, a recommended text in top business schools around the world. Lead author Tim Koller was recently interviewed by the Investor Podcast in an episode titled “First Principles of Valuation.”
Below are 10 lessons containing my thoughts on some of the points from the interview.
1. Value is created when your business returns on capital greater than its cost of capital. Applies to all geographies and businesses, including digital and technology.
2. “What matters for any investment is the cash flow you generate and the way to generate cash flow is to earn returns on invested capital greater than the cost of capital” – Tim Koller
3. Valuation of a business depends on three things- a) return on capital over cost of capital, b) how much capital has been invested and c) revenue growth. In any business you run, these three levers are critical to driving real sustainable valuation and creating value.
No matter what function you start with, when you understand finance and the operational implications of these three levers (active customer count, acquisition cost, product usage per customer/frequency, product margin) you will be an all-around solid business leader. This implies that if you are growing with a return on capital less than your cost of capital, without a scale trajectory (path) and positive unit economics that will deliver a return on capital greater than your cost of capital, you are ultimately destroying value regardless of your current valuation. This is especially relevant for startups that have found product-market fit. -reflection
Partner well with your finance function to create value, while finance must also understand the business, strategy and operations to provide real value-creation support rather than mechanical bookkeeping. -reflection
4. You can't please all investors. Focus on the investors who matter who are the long-term sophisticated, insider investors and not the short-term sell side analysts who speak disproportionately loudly in stock market investor presentations. It is long-term sophisticated internal investors who ultimately determine the value of the company.
5. If the efficiency gains of #AI and technology spread rapidly among competitors in your industry, the use of technology and AI does not in itself create sustainable value. What really matters in business value creation is whether companies use technology and AI to create “sustainable competitive advantages” in important markets that others cannot copy, not industry general efficiency gains. This is particularly relevant to the financial services, telecommunications, media and entertainment, mobility and FMCG industries.
6. Focus more on operational performance where real sustainable long-term value is created, not on financial and accounting gimmicks.
Disaggregate your Return on Capital (ROC) down to the business or operating unit levels to ensure visibility of where value is being created.
Recognize that not all businesses generate cash flows that yield an immediate return on invested capital. Management has a duty to educate the board and investors about the nature of its businesses and the profitability/maturity in valuation of the company.
It is important that CEOs and CFOs are clear about the performance of their companies and operating units. The strategic issues, economics, growth, gestation and maturity of every business are different. When boards, CEOs and CFOs apply a one-size-fits-all approach to value-creation in their businesses, they are likely to destroy value. This is particularly relevant for banking and financial services, telecommunications and media.
7. The direction (trajectory) of returns on capital is as important as the absolute number of returns on capital. It predicts a future that should be factored into the company's valuation/value.
8. When it comes to a company's risk investments or portfolio of businesses, three main factors are essential to ensure business value creation:
a) Don't be stingy. Would you be willing to make a substantial and long-term investment in the business to win? If you don't you are just a sycophant.
B). Will you be able to attract the key talent needed to make the business win?
c) Do you have the competitive advantage to win the investment to generate returns on capital greater than the cost of capital? If you don't have all three, your value is likely to be destroyed.
9. Executive compensation creates short-term incentives that force executives to sacrifice long-term value creation. This is reinforced by boards that may not understand operational immediate ROC issues and investment horizon/maturity issues as they impact ROC.
Boards and CEOs must be mindful of these challenges and balance executive compensation appropriately.
10. Enterprise value (EV) on net operating profit after tax (NOPAT) is a better measure of valuation multiples than price-earnings ratio or EV/EBITDA as it equalizes for companies with different asset intensity or outsourcing strategy and different tax jurisdictions.
Where a company is clearly not profitable yet like many startup digital businesses, EV/EBITDA would be a good measure of the valuation multiple that private investors are placing on the company based on their confidence, the founder and management story, their relative estimate of scale, growth, market opportunity, and the ability of managers to build a sustainable moat around those gains. It is believed that as startups mature, building businesses with positive unit economics, they should strive to convert their positive unit economics into positive and growing EBITDA margins, even if not yet profitable on PAT or NOPAT. -reflection
Olu Akanmu is the Academic Director of the Lagos Business School Tech-Leap Initiative.
