Four Cornerstones Of Corporate Finance You Should Not Ignore

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This article has been adapted from Value: The Four Cornerstones of Corporate Finance by Tim Koller, Richard Dobbs, and Bill Huyett. Most executives have figured out how to create value for shareholders. Through experience, observation, and intuition, they’ve developed a wealth of personal wisdom that, with some luck, typically takes them in the right direction.

But let’s face it:  that wisdom doesn’t always prevail. Indeed, the run-up to the financial crisis of 2008 is but one example of how easily finance myths, fads, and misconceptions overwhelm wisdom, even in the most sophisticated organisations.

Executives don’t have it easy. It’s tough to hold steady when shareholders expect absurdly high returns during periods of relative alignment between companies’ share prices and underlying economic value. It’s even tougher to stick with fundamentals as peers’ profits skyrocket in seemingly irrational ways, as they did in 2008, or when share prices reach unprecedented and unsustainable levels, as they did during the Internet-bubble era.

During such periods, seductive new economic theories emerge. These theories catch the attention of journalists, traders, boards, investors, and executives—even though they’re blatantly at odds with the tenets of finance that have held true for more than 100 years.

These episodes of wishful thinking have only reinforced the immutable principles of value creation. These four principles, which we call the cornerstones of corporate finance, start with the axiom that companies exist to meet customer needs in a way that translates into reliable returns to investors.

Together, the cornerstones form a foundation upon which executives can ground decisions about strategy, M&A, budgets, financial policy, technology, and performance measurement—even as markets, economies, and industries change around them. 

Stated simply, the cornerstones are:

The Core of Value: A business’s value is driven by its growth and return on capital, and resulting cash flows.

The Conservation of Value: Value is created when companies generate higher cash flows, not by simply rearranging investors’ claims on cash flows.

The Expectations Treadmill: Movements in company share prices reflect changes in the stock market’s expectations, not just underlying performance.

The Best Owner: The value of a business is not an absolute but, rather, depends on who is managing it and the strategy pursued.

For executives with functional, business, or corporate responsibilities, ignoring the cornerstones can lead to decisions that erode value or lead to outright corporate disaster. Let’s take two examples.

First, leverage: As the market heated up in 2007 and 2008, many savvy financial services executives thought leverage could be used to create (as opposed to merely redistribute) value. That misconception clashes with the cornerstones. Leverage is a quick way to manufacture accounting profits, but it doesn’t add real value to the economy because it merely rearranges claims on cash flow and increases risk.

Second, volatility: Some say companies are better valued when they deliver steady, predictable earnings growth. That, too, is an assumption that doesn’t emerge from the cornerstones. The truth is that the most sophisticated investors—the ones who should matter most to executives—expect some earnings volatility, if only as recognition of changing sector and economic dynamics beyond any one company’s control. Related is a belief that EPS guidance, and the significant executive time consumed by managing guidance, is valued by investors even though empirical evidence clearly states otherwise.

Compounding the misconceptions are apparent disconnects in how financial performance reflects economic theory and empirical data. These disconnects can cloud top-management judgments about business strategies and investment cases. Basic economics suggest, for example, that above-cost-of-capital returns will be competed away. Data show, though, that some companies earn consistently superior returns using business models that vaccinate themselves against competitors and new entrants.

In our practice we see uneven development of finance capabilities among general managers and functional leaders. All too often, these emerging leaders have picked up their finance knowledge without a grounding in the cornerstones, leading to such overly simplistic refrains as “we need to grow earnings faster than revenue.” Or the ungrounded might overemphasize earnings per share at the expense of capital productivity or growth.

When we combine the misconceptions, contradictions between finance and economics, and the uneven development of finance skills, we understand the roots of decisions that diverge from the perennial principles. The voices of the media don’t always shed light, the views expounded by investors about what constitutes value and what doesn’t are splintered, and traders cause further confusion by unnaturally bidding up or down stock prices of individual companies and even entire sectors.

Internalizing the four cornerstones of finance, understanding how they relate to the real economy and the public stock markets (or private-owner expectations), and having the courage to apply them across the enterprise have significant upside and little downside. At least, the four cornerstones can prevent executives from making strategic, financial, and business decisions that undermine value creation. At best, the cornerstones can encourage a more constructive, value-oriented dialogue among executives, boards, investors, bankers, and the press—resulting in courageous and even unpopular decisions that build lasting corporate value.

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Copyright (c) 2011 by McKinsey & Company.  This article has been adapted with permission of the publisher John Wiley & Sons, Inc from Value: The Four Cornerstones of Corporate Finance by Tim Koller, Richard Dobbs, and Bill Huyett.

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