Finance in training: The creation of value

Manuel Romera. Professor. IE Business School

30 May 2006

Too often, the world of business focuses on marketing and book profits in its search for shareholder value. The author argues that cash flow is much more important than either for boosting shareholder returns.

Often, participants in my programmes say it is obvious I enjoy what I do and I think they are right. In training, the level of intensity that is generated among participants is often very high, which helps stoke enthusiasm.

It is a continuous challenge to show your audience that behind the sophisticated appearance of some so-called specialists in the world of banking, finance and markets often lurks a host of personal complexes and a strong dose of ignorance. To mask their shortcomings, professors often hide behind absurd reasoning and complicated terminology that neither they nor their public understand, even though the speakers themselves are usually aware of their own weaknesses.

I always say that common sense is the least common of the senses and that, unfortunately, in the world of finance this notion must be multiplied by ten. The mantra of any financial department is the creation of value, but this concept is not always measured correctly, either in institutions or in training programmes.

Value creation should always be aimed at making the shareholder rich and the only way of achieving this is by quantifying the money he/she receives. Doing this requires measuring the return on equity and forecasting a company´s cash flow. The dividend paid out to shareholders should always be in line with the generation of cash flow. In fact, the best way of enhancing efficiency and boosting returns is by ensuring dividend payments are made to the shareholders; in other words, by focusing on the generation of cash flows. Consequently, linking the dividend policy to earnings, as most financial institutions or companies in Spain tend to do, is incomprehensible.

The metrics behind value creation are manifold and usually include technical analysis and price-earnings ratio or PER. There are also other metrics that have been popular for a long time, such as the Economic Value Added (EVA), the Cash Value Added (CVA) and the Shareholder Value Added (SVA). They have all been used as the rational basis for taking decisions on investments, but I think they are quite absurd and complex and are, therefore, the object of criticism in my classes.

Instead, the valuation of a company should be based on the money it generates-- known as free cash flow-- regardless of its finances. Value is created for the shareholder when the return on capital is higher than the cost of borrowed funds after tax, since the difference boosts profitability through equity cash flows or free cash flows for the shareholder. I am not aware of any other way of making shareholders rich than maximizing the money they earn. Can you think of any other way? Certainly no one can get rich off of a company’s PER or as a result of technical analysis or book profits.

That’s why it is important to understand that the return for shareholders includes discounting the equity cash flows at a minimum rate to calculate the net present value (NVP) and at the real rate to calculate their internal rate of return (ROR).

Accordingly, this means that the value of a company’s shares is nothing more than the equity cash flows discounted for the minimal cost of equity that shareholders require before making their investment.

This concept is much more Anglo-Saxon than continental European and, like everything else, it is open to criticism. However, the focus of attention should always be the same: when and how much cash (equity cash-flow) is generated by those shares that investors analyse? This leads to suppositions that are open to debate, including the theory that the rate of reinvestment of these equity cash flows is equal to the rate of revaluation of the cost of equity in a solvent model such as the Gordon Shapiro model or the Capital Asset Pricing Model (or CAPM).

This entire process is easily understood if we take for granted that a company shouldn’t just focus on sales, but rather on collecting the payments that guarantee profitability. After all, any financier knows that cash flow--and not book profits, as is often heard—is what is ultimately reinvested.

Looking at the experience of the great masters of investment, such as Warren Buffet and Peter Lynch, it’s easy to draw the conclusion that their greatest attribute was their ability to predict the cash flows of investments and their returns.

The world of business would be more serious, more efficient and better positioned to create value if all of us were able to focus more on pragmatic management techniques that seek to ascertain profitability and the financial viability of clients. This would enable us to complement those aspects of product marketing and commercialisation that almost always neglect the realities of cash flow.

Finally, financial training is a powerful tool if you are able to imbue your life with common sense and maintain a clear idea about the purpose of life, which is none other than the ability to earn money and the freedom to spend it to meet the needs of you and your loved ones. If you follow these principles, you are likely to be more in tune with the way you live and closer to finding happiness on earth. This, in my opinion, has a lot to do with spiritual happiness.


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