A better grasp of how value is created will help executives resist short-term pressure

Editor’s note: Why are managers so often short sighted at the expense of the long-term health and value of their companies? One reason is that compensation and incentive systems are too often geared to the short term. These incentives can skew our perspective of the bigger picture. Indeed, research suggests that most executives wouldn’t fund a viable new initiative if doing so reduced current earnings. Changing this won’t be easy, but building new incentive systems that focus executive attention on creating long-term stakeholder value is a critical priority for management innovation. One of the MIX’s Moonshots for Management addresses this need: Stretch management timeframes and perspectives.

This adaptation from Value: The Four Cornerstones of Corporate Finance, by McKinsey authors Richard Dobbs, Tim Koller, and Bill Huyett, argues that a better understanding of how shareholder value is created will help executives and their boards stay focused on longer-term goals.

It’s surprising how often senior executives and their boards make decisions that defy their own intuition about what creates lasting shareholder value. Perceived market pressure to deliver short-term profits, new financial engineering techniques, and misconceptions dressed as conventional wisdom all conspire against them, luring them into a limiting and potentially damaging dynamic.

To break free, we believe CEOs, their boards, investors, analysts and the media need to come to a common understanding of how value is created in order to properly assess—and in the case of companies, courageously pursue—value-creating opportunities.

Simply put, value is created by increasing a company’s cash flow through a combination of growth and returns on invested capital (ROIC). There is overwhelming evidence that companies that perform well on long-term cash flow, growth, and ROIC perform well in the stock market. And there is also plenty of evidence to show that failing to focus on cash flow can damage companies and even economies. Prior to the market’s collapse in 2008, for example, it was assumed that securitizing the high-risk loans taken out by homeowners who couldn’t afford them somehow made them less risky assets. But the cash flows from the loans remained the same, as did the high risks—which became all too evident when the housing market turned. The immutable rule is that it doesn’t matter how you slice the financial pie, be it through securitization, leverage, share repurchases or acquisitions, only improving cash flows will create value.

A sound understanding of the core principles of value creation will explain why, for example:

Growth isn’t always the key to value creation, despite the business world's obsession with it.

The idea that high growth is needed to achieve a high P/E multiple and better returns to shareholders is a myth. Of course, a company has to grow to thrive: slow-growth companies may generate fewer opportunities for employees, making it difficult to attract top talent, for example. But growth alone won’t lead to value creation unless it’s accompanied by adequate returns on capital. Our research showed that among 64 companies with low ROIC, those that grew at above-average rates but didn’t improve their ROIC earned 4 percent lower shareholder returns per year over 10 years than companies that grew below average but improved their ROIC.

In addition, high growth is more difficult to sustain than high ROIC. That’s partly because products have natural life cycles, which means sustaining high growth entails continuously finding new products, new geographic markets, or new customer segments—which is tough. Only in this way can companies hope to overcome the fact that world economic growth is typically less than four percent in real terms, and many companies compete for their share of this limited growth.

Companies therefore need patience to nurture new growth platforms over many years, and accept that investing in these platforms may impact short-term profits. Which brings us onto the next point.

Earnings are inevitably variable, so trying to smooth them is a fool’s game

Many executives still focus narrowly on earnings per share (EPS), going to great lengths to smooth out earnings or meet quarterly earnings target. But this is mostly wasted energy. Instead, senior executives should focus their attention on finding ways to grow revenues or improve returns on capital.

That’s not to say short-term earnings are irrelevant: they are an indication of cash flow generation. But research shows no meaningful link between earnings volatility and higher valuation multiples. Indeed, a degree of volatility is to be expected. How could a company with five different businesses in 10 different countries be expected to achieve 10 percent earnings growth every year for 10 years? Alas, nothing goes that smoothly. Moreover, companies that do attempt to smooth earnings aren’t likely to fool sophisticated investors, who dissect earnings information.

These investors will not be pleased to discover the lengths to which some companies are prepared to go to meet earnings expectations. One recent survey showed that fully 80 percent of CFOs were willing to reduce discretionary expenditure on marketing or product development to meet short-term earnings targets. In other words, they were willing to jeopardize long-term shareholder value. Far better to be transparent about why performance might not meet expectations, and make sure long-term value creation remains the goal.

Divesting high-performing businesses can create more value than retaining them.

Executives are often concerned that divestments make a company smaller and are an admission of failure. The real weakness, however, lies in retaining a business from which you can’t extract maximum value.

That’s because a business has no inherent value. Rather, its value potential depends upon who owns and operates it. A coal mining company that owns rail links nearby, for example, will likely enjoy lower transportation costs. Practical skills, insights, governance capabilities, or access to talent all have the potential to create more value for owners who possess these attributes than for those who don’t, depending on the nature of the business.

At different stages of a business’ life cycle, different owners will be able to create more value. A family business may serve the company well in its early days, but a venture capitalist might be the best owner to expand it, and a multinational when global distribution is required. For these reasons, companies need to continually look for companies for which they could be the best owner and examine opportunities for divesting businesses and putting their capital to better use.

In our experience, too few executives are able to articulate why they are the best owner of the businesses they own. Yet the research shows the stock markets consistently reacts positively to sales and spin offs.

The voices of certain investors should be heeded, and the rest ignored.

The role of investor communications isn’t to talk up share prices, but to ensure they are in line with the company’s intrinsic value. This will entail ignoring investors with a short-term orientation, and not becoming overly concerned with the media, whose need for a headline surpasses more thoughtful analysis. Instead, companies need to build relationships with those sell-side analysts who thoroughly understand the company’s strategies, strengths and weaknesses, and can better distinguish the shorter from the longer term.

These are what we call intrinsic investors. They typically have fewer companies in their portfolios in order to conduct deeper and more detailed research, and tend to hold stock for longer. They also happen to be the investors who generally have most influence on share price levels. Importantly, they seek transparency about results. They want management’s candid assessment of the company’s performance, and insightful guidance about targets and strategies. Their role in determining stock prices makes it worth management’s time to meet their needs. 

Many companies are reluctant to provide a detailed discussion of results, issues, and opportunities, arguing that it reduces their flexibility to manage reported profits or might reveal sensitive information to competitors. But open communication is the best way of achieving a closer match between the company’s market value and its own assessment of what that value should be. Even when strategic goals go wrong, intrinsic investors want to understand what management has learned. They understand that business entails taking risks, not all of which will pay off. They value forthrightness. And they will probably support a company though a course correction if they have developed faith in management’s judgment.

“I don’t want inside information. But I do want management to look me in the eye when they talk about performance. If they avoid an explanation or discussion, we will not invest, no matter how attractive the numbers look,” said one portfolio manager.

Companies bent on growing long-term value will not always be able to meet the demands of those clamoring for short-term profits. But executives rehearsed in the principles of value creation will be better able to question those demands, and resist seductive new economic theories that try to justify absurdly high and unsustainable share prices or skyrocketing profits. Those principles give corporate leaders a stable basis for making sound, courageous, and sometimes unpopular strategic and financial decisions about how best to create value. And they can encourage a more constructive, value-oriented dialogue among executives, boards, investors, analysts, and the media.