How Finance Works: The HBR Guide to Thinking Smart About the Numbers
by Mihir A. Desai
This is an outstanding book which presents some complicated topics in a clear, well-organized manner with real-world examples. The author, a professor of finance and taxation at Harvard Business School and Harvard Law School, includes some sidebar commentary from two CFOs, an investment banker, and a hedge fund manager.
FINANCE PERSPECTIVE. Finance and accounting are related but different disciplines. Under accounting rules, “an up-front payment for a piece of equipment has to be capitalized, placed on the balance sheet, and then depreciated over time. Revenue similarly may need to be recognized over time. But this process of smoothing measures of performance is subjective, which allows managers to manipulate profits to their advantage.” In contrast, finance is forward-looking with an emphasis on cash flows.
“Many financial professionals consider the statement of cash flows a company’s most important financial statement… Typically, a statement of cash flows has three parts: operating, investing [i.e. capital expenditures], and financing [i.e. debt and equity] sections.”
(An excellent book which presents the accounting perspective is Financial Intelligence by Karen Berman and Joe Knight.)
FREE CASH FLOW. Free Cash Flow is “the purest measure of cash and forms the basis of valuation… In short, free cash flow isolates the cash that is truly free to be distributed or used however the company sees fit.” The author analyzes Netflix and Amazon between 2003 and 2017 to illustrate how profit and free cash flow can diverge.
Free Cash Flow = EBIAT + depreciation and amortization +/- changes in working capital – capital expenditures. EBIAT stands for earnings before interest after taxes.
[Excluding interest expense is counter-intuitive to me because interest is an obligation, not optional. I assume the rationale is that FCF measures funds available to either reinvest or return to capital providers, which includes lenders.]
VALUE CREATION: NPV > 0. “If managers care about value creation, then the most important financial decision rule they should follow is to undertake only positive NPV [net present value] projects… The deployment of assets—not financial engineering—is the source of all real value creation.”
“The net present value of any investment is the sum of all current and future cash flows discounted back to the present using an appropriate discount rate… Net Present Value0 = cash flow0 + (cash flow1)/(1+r) + (cash flow2)/(1+r)2 + (cash flow3)/(1+r)3 + (cash flow4)/(1+r)4 …” where r refers to the discount rate aka the cost of capital.
“If the ROE [return on equity] is the same as the cost of capital, nothing else matters—the company is not creating value. You could have stayed in bed. This comparison teaches us the sin qua non of value creation is beating the cost of capital.” Returning less than the cost of capital results in value destruction: “It’s not just that you could have stayed in bed, but you should have stayed in bed.”
COST OF CAPITAL. “The costs of debt and equity will be different; equity is a residual claim with a variable return, whereas debt has a fixed return that has priority for repayment.” Weighted Average Cost of Capital aka WACC = (D / (D+E))rd (1-t) + (E / (D+E))re. The cost of debt (rd) is the interest rate charged by the lender. The cost of equity (re) can be calculated using the Capital Asset Pricing Model: re = rrisk-free + beta x market risk premium.”
“It’s important to recall that these costs of equity are also the expected returns to the investors… As betas increase, expected returns increase. Note that zero beta assets have an expected return equal to the risk-free rate.”
“The appropriate cost of capital isn’t a function of who is investing but rather a function of what you’re investing in. Risk is embedded in the asset, not the investor.”
“If a company is at the optimal capital structure described above, it can’t simply take on more debt because it’s cheaper and think that’s smart. Equity holders will demand a higher return for that risk, and that will actually offset any benefit from using more debt.”
Chapter 1 includes a table which compares key financial data and ratios of 14 companies. “Carolina Light & Power has the highest leverage, and Intel has the lowest. Why? Varying levels of leverage reflect the amount of business risk because it is unwise to pile financial risk on top of business risk. Carolina Power & Light has stable demand, and its pricing is likely regulated, so its cash flows are steady. Accordingly, it can sustain higher amounts of leverage.”
VALUATION. “It’s critical to remember that valuation is an art, not a science… Valuation is subjective, prone to error, and leads to ambiguous answers [but] even if it’s flawed and problematic, valuation is critical to sound managerial decision making.”
“The two most important valuation methods are multiples and discounted cash flows…. The price-to-earnings (P/E) ratio is an example of a multiple. “EV/EBIDTA multiples helps us compare companies of varying capital structures… where EV is the sum of the market value of debt and equity, or the value of the business.” EBITDA stands for earnings before interest, taxes, depreciation, and amortization.
“The discounted cash flow method is the gold standard of valuation… Present value0 = cash flow1/(1+r) + cash flow2/(1+r)2 + cash flow3/(1+r)3 + cash flow4/(1+r)4 … + terminal value… The preferred way to think about terminal value is to deploy a perpetuity formula—a neat trick that effectively calculates today’s value for a stable set of cash flows… Growing Perpetuity Formula = Cash flow1 / (Discount rate – growth rate).”
“Through the valuation, you have determined the value of the business, not its equity. The value of the business is often called enterprise value… You have valued the cash flows to the capital providers—both debt and equity—that the enterprise generates.”
“The important lesson here is that to get to the value of a company’s equity from the enterprise value, you need to think about how much debt and cash there is.”
When evaluating an investment opportunity, “the appropriate way to arrive at the correct expected value is to consider the alternative scenarios such as a worst-case scenario, a best-case scenario, and a base case and attach probabilities to them… It forces you to really think through the nature of the business and its potential outcomes. For example, if there’s a 10 percent chance that the value is $120 (best case), a 70 percent chance the value is $100 (base case), and a 20 percent chance of a $10 value (worst-case or fraud scenario), what is the expected value? … The expected value must be calculated by probability-weighting scenarios. The expected value formula is fairly simple: Expected value = 10% PV (best case) + 70% PV (base case) + 20% PV (worst case). So in this case, the expected value is $84.”
“Unless you pay less than the expected value, your purchase is not actually creating any value in expectation. And if you pay up to the best-case scenario… you have transferred value to the seller and created no value in the best case.”
CAPITAL ALLOCATION. “Once a company is generating free cash flows, what should management do with that cash? Should managers invest that cash in new projects? Should they acquire companies? Or should they distribute the cash to their shareholders?”
“The notion that M&A is safer than organic investment is far from well-grounded, and the data on the failure rates of mergers directly contradicts their supposed safety…. Although the rationale of synergies can be tantalizing when assessing a merger, realizing those synergies is no trivial task.”
The book includes examples of both value-adding and value-destroying acquisitions. “Some analysts estimate that [Jaguar Land Rover] now comprises 90% of Tata Motor’s total valuation. In hindsight, Tata’s decision not to integrate JLR worked out extremely well.”
On the other hand, only one year after the 2011 acquisition, “HP wrote down the value of Autonomy by $8.8 billion (in other words, it reduced the goodwill asset on its balance sheet and recorded the loss as a onetime expense)… By August 2012, HP’s market capitalization had fallen 43% from the time of the acquisition announcement.”
[On a tangential note, I don’t understand is why companies bother with such write-downs. Goodwill is basically a fudge factor—the difference between acquisition price and book value of the acquired company. Since it is not really a meaningful number on the balance sheet, what’s the point in writing it down?]
“Conglomerates appear to destroy value rather than create it. Conglomerates often trade at a discount, which means that their combined value is less than if the business were traded separately.”
“The raw mechanics of buybacks and dividends are all value-neutral… Value creation comes from the asset side of the balance sheet, not from financing…Managers can only create value by investing in positive NPV projects.”
“Capital allocation is the most important financial problem facing a CFO and CEO. The question of when to distribute or reinvest cash, whether to grow organically or inorganically, and whether to distribute via repurchases or dividends can occasion tremendous value creation or destruction.”
WORKING CAPITAL. “A powerful way to frame the financing consequences of working capital is to frame working capital temporally rather than monetarily. This framing is called the cash conversion cycle… If companies pay before getting paid, they must finance the shortfalls in their cash conversion cycles. None of this shows up in the measure of net profit or EBITDA, so just buying and selling hammers creates a financing need.”
“Amazon actually manages its inventory, receivables, and payables in such a way that it ends up with what’s called a negative working capital cycle, or negative cash conversion cycle… Amazon—and Apple, for that matter—have working capital cycles that allow them to grow rapidly without seeking external financing… In effect, suppliers are financing Amazon’s and Apple’s growth.” Laurence Debroux, CFO of Heineken notes, “If you insist on squeezing every last bit from every supplier in an effort to improve your working capital, then you’re going to end up killing those suppliers. This is not the ecosystem you really want to live in.”
Desai, Mihir A. How Finance Works: The HBR Guide to Thinking Smart About the Numbers. Harvard Business Review Press, 2019. Buy from Amazon.com
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