Sometimes I don’t sleep well. In fact, many nights I don’t sleep well (but not because of my stock selection!). This has been a recurring problem that I have dealt with all my life, so I am used to it.
While I try to fall asleep at 2 in the morning, I usually find myself scrolling through the Internet / YouTube to find something that hopefully can put me to sleep.
My opportunity to channel these nocturnal events is almost always Professor Aswath Damodaran’s YouTube channel.
Now Professor Damodaran has nothing. I love his lectures, but they are still college lectures. Anyone who has been to college knows that they can sometimes be the cure for insomnia.
If you don’t know Professor Damodaran, you should. It is widely known as the “Dean of Valuation”, and teaches corporate finance and asset valuation classes at the Stern School of Business in New York City.
I don’t know how he can do this legally, but he usually posts all of his corporate finance lectures on YouTube for the masses. These lectures are great not only for my sleep problem, but also for great learning.
One sleepless night, I listened to one of his most recent lectures on value improvement. It was such a good lecture that (unfortunately for my body) it kept me awake all night.
As a value investor, I am looking for companies that not only offer me a lot from a value perspective, but can also create value for me over time. This is difficult for a company, so finding a business that can bring you great value and composite value is really a rough diamond.
In this two-part series on value creation, I will review Professor Damodaran’s four key points on how companies create value for shareholders, with some of my own dishes and examples.
I hope you don’t sleep.
1. Change in cash flows from existing assets
As a equity shareholder in a company, you are claiming a share in all cash flows after a company has paid its dues. Simply put, these cash flows are usually returned to investors in the form of:
In order for the shareholder to receive this cash flow, the business must be positive. How do they manage to make more money?
Increased after-tax gains on assets instead
Spoiler alert: Large listed companies often pay a lot of taxes to the government. Shocking statement, I know.
That said, companies tend to be very smart when it comes to taking advantage of all the tax breaks they can legally make to pay less taxes. In fact, one of Professor Damodaran’s more recent blog posts deals with this same subject.
With each new political administration new tax rates appear. The last thing I want to do is do politics here, so think about it this way: the less the company pays in taxes, the more money they will have to return to you as a shareholder. The business should take advantage of all possible tax loopholes.
Think of it the same way you do income taxes. You want to apply the highest deductions to get the largest refund possible.
It may seem basic, but proper corporate tax accounting is a key requirement. Or the address is sent to jail.
Reduction of reinvestment needs
As I mentioned earlier, a key way in which management returns cash to shareholders is by reinvesting the money you have left over. It is then assumed that this cash surplus will be used to make the business premises even more effective.
How is this done?
Reduce costs and make operations more efficient
Reducing costs is not fun, especially for businesses. Sometimes this leads to firing employees, which is obviously not good financially.
However, sometimes cost reduction is a necessary measure to save money or to complete the business. After all, business is not good for you as a shareholder if you can’t generate cash.
It is much more preferable to make growth investments in a more efficient business model. Putting funds into remodeling a new warehouse or upgrading it to new software is sure to create valuable time and resources for the business.
It is a much better option than firing employees.
Divestment or disposal of assets
If you suffer a significant loss of blood in one of your limbs, you will need to apply a tourniquet in order to stop bleeding. Sometimes this doesn’t work and the appendix is too far away. The next step is amputation.
Sorry for the horrible pictures, but this is a perfect metaphor. In business, sometimes the best thing to do is to break away from the forms with a poor investment or decision.
No one likes to admit when they are wrong, especially the managers of a listed company. They need to approach shareholders, admit the mistake, divest the business or asset, and move on. This can often cause them to lose their jobs.
But this is the worst case scenario. The best case is a referral.
Spinoff on eBay and PayPal
One of the most successful divestments in corporate history occurred recently with the derivation of eBay from PayPal. eBay created PayPal as its own proprietary payment software for the auction website. PayPal ended up being so effective that in 2015 eBay divorced PayPal.
Now, that may sound bad to eBay, and it was. Six years later, eBay is struggling to keep up with the rest of the e-commerce industry. They still operate big business, but not as dominant as before (not thanks to Jeff Bezos and Amazon).
However, this was a brilliant decision for eBay shareholders. At the time of the split, all eBay shareholders has received a new PayPal fee for every share of eBay shares he owned. Since then, the price of PayPal shares has been in the long run. PayPal is now worth much more than its parent company.
2. Increase the value of expected growth
This is definitely easier said than done. Being able to reinvest cash and grow at a faster rate than the previous year is something only the best executives can pull off.
So how do you successfully increase an annual profitability of a company? The best question is: how does management increase rate of your return on invested capital?
ROIC improvement in reinvestments
There are many ways in which executives can decide to reinvest cash to group the business. Here are some examples:
- Reinvest in more projects
- Create M&As that make sense
- Increase market share and expand it to new markets
Let’s explore how they add value.
Develop new products
Undoubtedly, the overall creation of a better consumer product will lend itself to higher yields. If you can create a newer or better product than your competitors, you have won the game.
Here’s an example of a product that has probably created the most shareholder value of all time: the iPhone.
When Steve Jobs first announced the iPhone in 2007, it was truly a revolutionary device. A phone that had a digital display with “apps”? It’s hard to believe that this was only 14 years ago …
The iPhone and all later generational models have been a colossal beast of a product. It has generated hundreds of billions of dollars in revenue for the company and has greatly rewarded shareholders. If I had repurchased shares of Apple when they first announced the iPhone, I would be sitting in an over 4,000% profit.
Generate M&A that makes sense
Mergers and acquisitions are hard to do well. Stellar management is needed to complete a successful merger. It is also often dangerous, as most companies pay too much to buy another.
One last recent success story should be Disney.
When Bob Iger became CEO of Disney, he took the company as a proof of acquisition. Under Iger’s leadership, Disney wrapped up incredible intellectual property, with some famous names like Lucasfilm, Marvel and Pixar.
Almost all of these additions to the Mouse House have not been at all amazing (with 21st Century still TBD). It’s no secret that Disney has been virtually the owner of the box office for the past decade and has now taken advantage of its IP to be streamed directly to your favorite device via Disney +.
These acquisitions made Disney one of the largest media companies on the planet and this has absolutely rewarded shareholders. If you had bought the shares of Disney when Bob Iger took over the company, you would have seen how his shares were appreciated 600%.
Creating shareholder value is not at all easy. Excellent managers are really needed to reduce costs, create excellent products and successfully complete a merger. You also need a smart investor to notice good management and make sure you don’t overpay for it.
There are still two more points that I will deal with more in the second part, so stay tuned!
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