>30 Years of McKinsey's Book on Valuation

Lessons on market bubbles, sifting through the noise on real value creation versus gimmicks, and much more

Earlier this year, McKinsey recorded a conversation with the co-author of our favorite book on value creation. Tim Koller reflected on why they decided to write a book on understanding and creating value, and how the framework’s evolved over time. Last year, we listed the first principles in a separate blog post.

McKinsey's First Principles of Valuation

We then later compiled our own “Return on Capital” guide, shared exclusively with our annual premium members.

The Puts and Takes on Value Creation

Quite a Piece

Initially, the book’s first edition had about 150 pages. Today? 800+, mainly because of incorporating new items such as sustainability, AI, digital, and the ever-evolving accounting rules. It’s quite a piece of work but to get a firm understanding of value creation and how to measure it, you’ll only need a couple of chapters. Understanding the basics very well is what matters most.

What I typically recommend to people is you read the first four or five chapters sequentially to get a sense of the key ideas in the book. And then the rest of the book, you can pick and choose what you want to look at, right? So academics look at certain chapters, you know, practitioners often look at other chapters.

So after you get through the first couple of chapters, you can go wherever you want to go. Each chapter is pretty self-sufficient and not that much dependent upon the other chapters. So it’s not as intimidating as it sounds or looks. - Tim Koller

The Essence of Value Creation

One of the most important takeaways is that the core principles of value creation have remained unchanged.

The core ideas in the book are the same as they were 35 years ago when it first came out. We still value companies based on discounted cash flows. And the drivers of discounted cash flows, and this is what’s most important, are return on capital and growth. Those ideas are timeless, foundational, whatever you want to call them. And they predate the book by a long time. I think we just did a good job of articulating that.

The above quote is well-timed in an era that’s dominated by a new technological revolution (AI) and some strange practices of circular vendor financing. During the dotcom (not suggesting we’re living in a similar world), people accused Tim of having an outdated view on valuation.

During the dot-com bubble, I was accused of being like a Newtonian physicist in an age of quantum physics, because I would say, well, how is this eventually going to translate into cash flows? And that was the response to me, just don’t get it. You know what I mean? It’s a new world out there. But I bided my time. And eventually, we were proven correct that companies that don’t generate cash flows, that don’t earn a decent margin and return on capital don’t create value. And a lot of some of those companies, they either went bankrupt, or some of those companies just, you know, they didn’t create the kind of value that they were anticipating. - Tim Koller

And the real crux is: value creation is a process of the company’s execution on value-creating growth and doing the right thing. It’s about fundamentals, and for as many shareholders as possible to profit, expectations on growth in intrinsic value have to be realistic. Share prices going up and down is not about fundamentals. A melt-up and subsequent melt-down are effectively a zero-sum game, or worse, depending on the timing and shifting around of capital from one asset to another.

There was one large company, I spoke to the CFO, like a year or two after the dot-com bust. He said that that overvaluation that occurred was actually one of the worst things that could happen to the company. Because eventually, he knew the share price was going to come down. It came down. People’s stock options were underwater. So everybody was unhappy. The board was unhappy, because they didn’t know what was going on and stuff like that. So it’s not good when these things occur, when these bubbles occur. I have learned a lot about bubbles over the last 35 years. I’ve seen a number of bubbles. They usually are concentrated in an industry or a couple of companies. But they’re driven by market dynamics. And they always go away.

We’re Not in Control of the Company and Other Shareholders

For us as outsiders, the main difficulty in investing in public companies compared to managing private companies is that we’re not in control of the situation. Companies do report their earnings from time to time but there’s a time lag. As mentioned above, all shareholders have different expectations, profiles, and time horizons. It’s also a challenge for us writing a newsletter.

We’re sharing our own subjective perspective on companies and long-term return expectations, and we’re very confident about our portfolio’s prospects but we don’t know whether our readers will be equally patient ;-) We’ve been bluntly transparent about the non-linearity of stock returns, irrespective of the near- to mid-term fundamental performance.

Our HEICO report made it clear:

Despite continued growth in earnings, cash flows, and healthy ROIICs (i.e., doing everything right), the (HEICO) buy-and-hold investor had to endure an 11-year streak of not earning any positive nominal return (1998-2009). 11 years is about 2,750 trading days - it’s an eternity for 99% of all investors. Over the next five years, the stock coolly returned 500% or a 43% CAGR excluding dividends. It’s a great reminder of how clueless one can be on the next year’s (and years’) return - everyone wants to earn a decent return and understands that the trajectory won’t be linear, and yet, in real life, owning stock feels a lot different with an unsatisfiable desire for instant gratification.

HEICO

For example, a miss on a given quarter’s earnings might be viewed as positive (investing for future growth as those expenses aren’t being capitalized on the balance sheet), negative (oh, something’s happened on the demand side), or neutral (a shift in deliveries/project timing coming next quarter, thereby neutralizing the recent quarter’s shortfall on earnings).

75 percent of CFOs are willing to sacrifice long-term profits to meet short-term guidance. They issue an outlook, and then they want to achieve that in the following quarters to keep the market, so to speak, satisfied.

If you’re invested in companies where the executives have pure accounting and “one-off” adjustments high in their minds, then watch out. Driving EPS by buying back stock, raising debt, and not focusing on ROIC and revenue growth (preferably by selling more stuff/increasing your share of wallet with existing customers, rather than raising prices too much) - it’s not going to be sustainable (generally speaking).

Growth’s gotta make sense.

There was this thing where the idea was that all you had to do was get as big as possible, as fast as possible, and you would eventually win and make a ton of money and win your markets. And people in the early 2000s applied that to the power generation market. So there were so the utilities were spinning out their power generation units into separate listed companies that had very high valuations.

And these power generation units were going around buying up power plants all over the world. So you’d have a company with power plants scattered around the US that had no connection to each other, you know, power plant in India, power plant in South America, etc. Because they were told that they had to get bigger in order to, and then they would just create a ton of value if they could get really big, really fast.Most of those companies actually went bankrupt. I remember talking to one of the strategy people at one of those companies, and they said, well, you know, the bankers were telling us that’s what we had to do to get the market value up. So we just did it. But the economics never really made any sense. - Tim Koller

Which Type of Investor Are You?

This is one of the key aspects of investing - knowing who you want to be. Are you focused on the core principles of value creation? Then, you’d better be looking for companies that are led by executives who share that same view.

I hope that readers and others come away with an understanding that the stock market or investors, I should say, is much more sophisticated than often people realize it. The stock market is not monolithic. Different investors have different approaches. There are long-term investors that focus really on the fundamentals that use these techniques. And therefore, the company should also think about value creation in terms not of trying to manipulate short-term EPS, but in terms of trying to create fundamentally long-term revenue growth at an attractive return on capital. And I think that that’s, you know, more and more we see that. And I’m pretty excited about that.

And, executives don’t have to be too transparent on what’s next. We like silent executors. No words but action.

Breaking Down Growth

In the interview, Tim Koller also referred to the growth component of value creation.

We also have to talk about what growth means, right? Because you can’t just take the top line revenue growth of a company because now you have acquisitions, divestitures, currency effects. So you got to take it all apart.

This is quite central to our analysis process. When we’re writing our in-depth reports and earnings recaps, we don’t intend to make bold predictions but simply try to understand what it takes to grow, how much capital it requires, whether the growth is competitively value-creating and long-lasting, what the competitive response to such growth could be (can they capture growth as well).

Understanding growth, cyclicality, and what could go wrong to sustain growth is what defines strong investment cases. Executives should also challenge their own assumptions - a pre-mortem analysis as it were. Extrapolating past numbers, looking at a stock’s average valuation, et cetera shouldn’t be called analysis. We’re buying the future; not the past.

Opportunity Costs

The stock market is all about opportunity costs. Why should an investor buy company X’s stock over company Y’s? It’s because company X can grow intrinsic value at a more attractive clip and generates good growth with surplus cash (dividends and buybacks).

Outside AI, there are pockets in today’s market where low- to mid-teens percent growth at very reasonable multiples, low leverage, is still present. It will simply take time for the intrinsic investors to re-discover those hidden gems. Such cycles of relative underperformance are exactly why Tim Koller looked like a “fool” during the dotcom. In the end, he proved to be a genius.