Sometimes I don’t sleep well. In fact, I don’t sleep well for many nights (but not because of my stock picks!). This is a recurring issue that I’ve dealt with all my life so I’m used to it.
When I try to fall asleep at 2am I usually scroll the internet / YouTube to find something that can hopefully rock me to sleep.
My channel for those late night binges is almost always Professor Aswath Damodaran’s YouTube channel.
This is not an easy thing for Professor Damodaran. I absolutely love his lectures, but they’re still college lectures. Anyone who has been to college knows that they can sometimes be the cure for insomnia.
If you don’t know anything about Professor Damodaran, then you really should. He is well known as the “Dean of Evaluation”, and teaches corporate finance and equity valuation at the Stern School of Business in New York.
I don’t know how he can do this legally, but he usually posts all of his corporate finance lectures to the masses on YouTube. These lectures are great not only for my sleep problem, but also great for learning.
One sleepless night I overheard one of his recent lectures Increase in value. It was such a good lecture that it kept me (unfortunately for my body) up all night.
As a value investor, I am looking for companies that not only offer me a lot in terms of value, but that can also create long-term value for me. This is difficult for a business to do so it really is a diamond in the rough to find a business that can offer you great value and great value.
In this two-part series on creating value, I’ll share Professor Damodaran’s four key points on creating business value for shareholders with some of my own insights and examples.
I hope I don’t put you in.
1. Change cash flows from existing assets
As a shareholder in a company, you claim a share of all cash flows after a company pays its dues. Put simply, these cash flows are usually returned to investors in the form of:
For you as a shareholder to actually receive this cash flow, the business must be cash flow positive. How do you make more money?
Increase in after-tax profit from existing assets
Spoiler alert: Large publicly traded companies tend to pay high taxes to the state. Shocking statement, I know.
That being said, businesses are usually well-versed in using every tax break they can legally to pay less tax. In fact, one is from Professor Damodaran latest blog posts discusses exactly this topic.
With every new political administration there are new tax rates. The last thing I want to do here is get political, so think about it this way: the less taxes the company pays, the more money it has to give back to you as a shareholder. It is up to the company to make the most of all tax loopholes.
Think of it just like filing your income tax. They want to apply the highest deductions so that you can get the largest refund possible.
This may sound trite, but a proper corporate tax balance is a fundamental requirement. Or the management is put in jail.
Reduction of the need for reinvestment
As I mentioned above, one important way management returns cash to shareholders is to reinvest the remaining money for you. The leftover money is then to be used to make the business even more money.
How is that done?
Reduce costs and make processes more efficient
Saving costs is no fun, especially for companies. This sometimes leads to the layoff of employees, which is of course not good economically.
However, sometimes cutting costs is a necessary measure to either save money or keep the business running to the full. After all, the business is of no use to you as a shareholder if it cannot generate any money.
Investments in growth in a more efficient business model are much more preferred. Spending money on remodeling a new warehouse or upgrading to new software is sure to save the company valuable time and resources.
It’s a much better option than laying off employees.
Sale or spin-off of assets
If you experience profuse blood loss in any of your limbs, you will need to put on a tourniquet to stop the bleeding. Sometimes that doesn’t work, and the appendage is just too far away. The next step is the amputation.
I apologize for the gruesome images, but this is a perfect metaphor. In business, sometimes it’s best to part with a bad investment or decision.
Nobody likes to admit when they’re wrong, especially not the manager of a publicly traded company. You need to reach out to the shareholders, admit the mistake, dispose of the business or asset, and move on. This can often result in them losing their jobs.
But that’s the worst case. The best case scenario is a spin-off.
eBay and PayPal spin-off
One of the most successful sales in the company’s history recently took place with eBay’s spin-off from PayPal. eBay developed PayPal as its own proprietary payment software for the auction website. PayPal became so successful that eBay split from PayPal in 2015.
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’re still running a great business, just not as dominant as they used to be (no thanks to Jeff Bezos and Amazon).
For eBay shareholders, however, it was a brilliant decision. At the time of the split, every eBay shareholder has received a new share from PayPal for every share of eBay stock they owned. Since then, PayPal’s share price has collapsed. PayPal is now worth far more than its parent company.
2. Increase in value through expected growth
This is definitely easier said than done. Being able to reinvest cash and grow at a faster rate than last year is something only the best leaders can create.
So how does a company successfully increase annual returns? The better question is how does management increase that rating your return on invested capital?
Improve the ROIC on reinvestments
There are many ways that executives can choose to reinvest cash to grow their business. Here are some examples:
- Reinvest in further projects
- Create meaningful mergers and acquisitions
- Increase market share and expand into new markets
Let’s examine how these add value.
Develop new products
Without a doubt, creating a better consumer product usually lends itself to higher returns. If you can make a newer or better product than your competitors, you have won the game.
Here’s an example of a product that has likely created the greatest shareholder value of all time: the iPhone.
When Steve Jobs first announced the iPhone in 2007, it was truly a revolutionary device. A phone with a digital screen with “apps”? It’s hard to believe that it was only 14 years ago …
The iPhone and all of its successors were one huge product. It has generated hundreds of billions of dollars in revenue for the company and has immensely rewarded shareholders. If you bought back Apple stock when they first announced the iPhone, you’d be sitting on an over 430% profit.
Generate meaningful mergers and acquisitions
Mergers and acquisitions are hard to get right. A successful merger requires excellent management. It’s also often dangerous as most companies overpay to buy another one.
One of the last success stories of recent times would have to be Disney.
When Bob Iger became CEO of Disney, he took the company on an acquisition tour. Under Iger’s leadership, Disney devoured incredible intellectual property with some big names like Lucasfilm, Marvel, and Pixar.
Almost all of these additions to the House of Mouse were just amazing (with the 21st century still open). It’s no secret that Disney has practically owned the box office for the past decade and has now used its IP to be streamed direct to your favorite device via Disney +.
These acquisitions made Disney one of the largest media companies in the world, and this has absolutely rewarded shareholders. If you had bought Disney’s stock when Bob Iger took over, you would have seen your stocks appreciate 210%.
Creating shareholder value is anything but easy. It really takes excellent managers to cut costs, develop great products and close a merger successfully. It also takes a smart investor to notice great management and be careful not to overpay for it.
There are two more points I’ll cover in more detail in Part 2, so stay tuned!