One can point to countless examples. In many industries, investors look at gross margin as a proxy for a business’s resistance to commoditization (in, for example, technology) or its brand power (apparel). Investors in financial services put a premium on return on tangible equity. Biotech investors value forward-growth expectations—almost without regard to current profitability. In other sectors, investors put a premium on dividends, which they view as signals of a company’s confidence in future earnings and its managers’ willingness to put their money where their mouth is.
The drivers of valuation provide a rich and refined tool for common managerial tradeoffs, such as driving growth at the expense of margins or reinvesting free cash flow instead of paying down debt. Indeed, the success of companies such as Church & Dwight and VF has been achieved, in part, on a strong understanding of the way that business fundamentals and valuation multiples interact to inform strategic decisions. (See Improving the Odds: Strategies for Superior Value Creation, the 2012 BCG Value Creators Report, September 2012.)
9. The shape and asymmetry of investment opportunities are far more important than the precision of the calculations behind them. Too often, senior management wastes time and energy trying to get the data inputs for their models precisely right. The leading example of this phenomenon is the fruitless fretting over a company’s weighted average cost of capital. (Charlie Munger, the vice chairman of Berkshire Hathaway, once said, “I’ve never heard an intelligent discussion about the cost of capital.” He’s right.) What managers should be evaluating is how a proposed investment compares with the next-best use of capital. If the difference in the cost of capital assumptions (within reasonable bounds) reduces the attractiveness of an investment, it has likely already failed the test.
Even more important, excessive focus on technical precision takes time and effort away from the more meaningful determinants of investment decisions, such as the reliability and asymmetry of the forecast and whether there are any accounting principles at play that decouple reported earnings from cash flow. Management time and attention are much better spent on pressure-testing key assumptions, contrasting different approaches for evaluation (such as cash versus accounting metrics), and considering the different competitive scenarios in which the investment could unfold. (See Risky Business: Value Creation in a Volatile Economy, the 2011 BCG Value Creators Report, September 2011.)
10. Treating your investors like customers pays dividends over time. Relatively few companies put anywhere near the level of time, effort, and intensity into learning why investors own their stock that they put into figuring out why customers buy their products. This is a mistake.
Some customers are more valuable than others, so it makes no sense to try to serve every customer equally. Similarly, there are investors that a company wants and those that it would just as soon not have. Each investor has its own investment process, capital allocation preferences, KPIs, and buy-sell triggers. Investors differ in their willingness to support a company’s mid-to-long-term strategy—especially when results are likely to take time to materialize. The smart play for management teams is to identify the “right” investors and go after them, just as they would pursue high-value customers.
Doing so takes more than the typical approach to investor relations. Value-oriented leadership teams seek to engage in a genuine dialogue with sophisticated investors about the ways value will be created. They use such opportunities to benefit from the experience of portfolio managers and analysts, whose insights can help challenge conventional wisdom within the company.
Company executives also need to appreciate that the support of patient and long-term-oriented investors comes at a price—in the form sometimes of inconvenient transparency. During both good and not-so-good times, investors want a candid assessment of key market forces, the company’s strategies to win, and the upsides for sticking around, as well as the roadmap for getting to the payoff and how they can track progress. And when mistakes are made, investors want to know what lessons have been learned. They increasingly also want reassurance that a solid governance system—one that includes a proven board of directors and executive compensation that emphasizes the right metrics—is in place. (See Winning Moves in the Age of Shareholder Activism, BCG Focus, August 2015.)
All this takes time and sophistication on the part of management, but the effort is worthwhile. Over and over, we see that well-aligned investors are critical to ensuring the success of well-designed strategies.
The shape of the playing field has changed many times since the early 17th century and, indeed, over the 20 years of our Value Creators series, which have seen the dot-com bubble expand and burst, the surges in the middle years of the first and second decades of this century, and the great financial crisis. One of the biggest changes has been to the nature of business itself.
Value management grew up in an economy that was dominated by capital-intensive companies, for which value creation was largely about squeezing out incremental returns on physical capital (accounted for on balance sheets). Recent decades have seen the rapid rise of “discovery” businesses—including IT, pharma, professional services, and medical technology—for which value creation is much more about driving top-line growth and generating returns from investments that flow through the income statement. (See “Value Patterns: The Concept,” BCG Perspectives, May 2012.)
This proliferation of new business models is, in many cases, interpreted as making value management less relevant when, of course, the opposite is true. The 2019 Value Creators report will examine some of the new challenges we expect managers to face as advancing technology causes the economy—and the managerial principles that govern value creation within it—to evolve. But the use of TSR as a North Star that guides value-creating agendas and the application of the hard-won, timeless principles of value creation are more important than ever. The game may be changing once again, but the rules—and the ways of winning—remain the same.