Tim Koller, a long-time McKinsey consultant, is the author of the go-to books on valuation
Value creation is the primary responsibility of any public company, and Tim Koller, who leads McKinsey & Company’s research activities in valuation and capital markets, is the author of two of the most highly regarded books on the subject: Valuation: measuring and managing the value of companies – the standard textbook in nearly every business school – and, more recently, Value: the four cornerstones of corporate finance.
‘We typically think the priority investors are what we call intrinsic investors’ – Tim Koller
Let’s start with an overview of the four cornerstones that primarily drive valuation. What are they?
To put this in context, we found that a lot of clients tend to over-complicate things, so we thought we’d focus on what executives really need to know. The first cornerstone is that the value creation of a company ultimately is driven by the combination of growth and return on capital it achieves, and the resulting cash flows. Companies with a starting point of a low return on capital typically would benefit more from improving their return on capital. Firms with a starting point of a higher return on capital typically benefit more from growing faster.
The second cornerstone is conservation of value. This means anything that doesn’t increase the cash flows of a business, any kind of transaction or financial structure or accounting change, any kind of action that doesn’t increase cash flows through the return on capital and growth, probably is not going to create value.
The third cornerstone is the expectations treadmill. As a listed company, you’re concerned about the return to shareholders, but there are times the return to shareholders in the stock market may be disconnected from the true value creation of the company for long periods of time. You can earn a high return from investing in a company that isn’t that great if its performance improves and beats expectations.
You could also earn a low return by buying the best company out there with high expectations already built into the share price – it’s really important for management teams and boards to understand this and to understand what is driving their share price performance. And a lot of companies don’t make that connection explicitly. They don’t ask: why did our share price do what it did relative to peers? What does that mean for us?
The fourth cornerstone is what we call the better-owner principle, which is simply the idea that the value of a business really depends upon who owns or manages it, what that person’s strategy is and how well he/she executes against that strategy. Therefore, from a management perspective, I should own only assets that I am a better owner of, where I can extract more cash flows either because of my links to other businesses or because of certain management skills.
How would you translate those concepts for IR professionals looking to add value?
The question is: what can IROs do to add value beyond the day-to-day operations of the department? I think the value-add is really figuring out who the priority investors are in your company – either investors that own the company right now or investors that perhaps should own it but don’t.
We typically think the priority investors are what we call intrinsic investors. They generally have relatively concentrated portfolios because they do a lot of research before they make a decision. They tend to have lower turnover and when they make an investment, they are willing to take a sizable position. It’s really more about figuring out who the 10 or 20 most important investors are – not just by size but also by how smart and influential they are – and finding out why they do or do not own you.
The IRO should also act as a gatekeeper to ensure the CEO’s and CFO’s time is wisely spent with the right investors, because they have a limited amount of time and you want them to spend it mostly where they learn from the investors and engage in a meaningful dialogue on how the current business strategy will lead to higher returns or increased growth.
Another key responsibility for IROs is to make sure the CEO, CFO and other top managers know what those investors think about the company and what they want to hear. You should know the issues on intrinsic investors’ minds and make sure you’re addressing them. And finally you need to serve as a filter for top management, minimizing all the noise that comes from the outside world. There are lots of investors with different priorities and they are not all of similar value to a company.
The investment community has drastically changed in the last few decades and the amount of ‘fast’ money has grown dramatically. Is it still practical to focus on the long-only money?
With all the clients we’ve looked at, there’s plenty of money out there that is smart and sophisticated. While you need to answer the questions of the people who are more trading-oriented, you should spend the bulk of your time and energy on the intrinsic investors – and that makes it a tough job. I think there are plenty of investors out there to focus on but it takes a little bit of extra work. If you’re just answering the phone, it’s going to be short-term investors, so you have to be more proactive and identify and target those investors that focus on value creation.
Several large companies have stopped providing any financial guidance, but they tend to be companies with long histories and successful track records where credibility is so well established they are held to a different standard. Your position is that companies should avoid the traditional financial guidance, such as EPS, but can smaller companies follow this path?
I think that’s the right direction to take. A metric such as EPS can be very misleading, and it’s more useful, for instance, to provide metrics that are more operational and with a reasonably wide range – for example, the range of revenue growth and what’s driving it. In certain industries, you even go back a little further than that: oil companies can’t predict oil prices but some of the better companies in the oil industry focus on the things they can control, the things they can influence. They can give guidance as to how much oil they’re going to produce, for example; that’s under their control. But trying to put together an EPS forecast for an oil company is kind of ridiculous because who knows what oil prices are going to be? And that’s going to be the single largest driver in a short period of time.
I think you need to tailor it a little bit to the industry. In the pharmaceutical industry, rather than EPS, companies spend a lot of time talking about individual drugs and where they are in the pipeline and what’s coming into the market, what’s coming off patent. I think you can do more to help investors understand the business and where it’s growing.
If you were putting together an investor presentation, what would be the top message points you’d want to get across?
I would want to demonstrate to investors that I know what’s driving the growth and returns in my industry, and that I have a strategy for achieving the right balance of growth and returns on capital in the future. I would supplement that with an understanding of why the numbers are what they are, what’s driving them, and either why they’re maintainable or how I can make them better. That’s what I think it all boils down to.
Fred Bratman is senior vice president of investor relations at United Rentals.