hi I'm Tim Kohler a partner in Kinsey's corporate finance practice in this video presentation I'm

going to show you what we have Mackenzie consider every executives essential guide to
corporate finance it's one thing for a chief financial officer and its staff to understand all the
technical issues of value creation and to apply those tools to make acquisitions or other
investment decisions it's much better though when the CEO and as many non financial
executives as possible understand exactly where value comes from how to create it and how
to avoid destroying it if they can master a few core principles with value creation in mind they
can all make better decisions with more confidence make tough decisions with more courage
knowing that creating value is the center of what they are doing last year some colleagues and
I decided to boil down those few core principles or cornerstones as we call them and to
explore them in a new book the finance world is also full of myths and misconceptions so we
sorted through those two in order to make it easier to spot common finance traps we settled
on four basic principles that executives can use to make better decisions and to avoid the
mistakes and damaging excesses we so often see in this presentation I will explain each of
these four principles demonstrate how each one works and illustrate how they show up in real
business situations because these principles build upon each other I recommend that you view
them in sequence starting with Cornerstone one the core valuation principle we enjoyed
creating this tour through our thinking about corporate finance and how you can use it to
make the best financial decisions I hope you enjoy it too and then it helps you create more
value for your company

how do companies create value that's the fundamental question behind all business decisions
do you create value by growing revenues by growing earnings what are the things that you
need to keep your eye on to know whether or not your company's creating value
fundamentally value is created by the cash flows that a company generates companies create
value by investing capital to generate feature cash flows those cash flows are determined by
how fast the company can grow gross revenues in particular and the return that the company
earns on the capital that is invests so it's the combination of growth and return on capital that
drives cash flow that ultimately drives the value of the company we call that the core valuation
principle so let's explore why it is that revenue growth and return on capital dr cash flow and
value you'll notice that i haven't mentioned earnings it's not that earnings are not important
but it's perfectly reasonable to see two different companies with similar earnings and similar
earnings growth generating different amounts of cash flow the reason for that is that they
generate different returns on capital returns on capital are what translates revenues revenue
growth and earnings and earnings growth into cash flows so ultimately what matters is
revenue growth and return on capital which is in turn drive earnings and cash flow and
therefore value let me illustrate how this simple chart actually mimics the value of real
companies the typical large company has a cost of capital of about 9% which discharges based
on the typical large company also has a return on capital of about thirteen percent and a
revenue growth rate of about four to five percent if we look at the intersection of thirteen
percent and four to five percent growth you'll see we end up with a company which is valued
at say 1500 to one 600 we've assumed that this company starts with earnings of a hundred
dollars so if we divide the hundred dollars into the value of the company we end up with an
implied price earnings ratio of 15 to 16 times not coincidentally the typical price earnings ratio
for a large company in the US or Europe is about 15 to 16 times in most periods when inflation
and this interest rates are at reasonable levels so this simple approach does a pretty good job
of mimicking the way the real world works now what I'd like to do is explore how changes in
the return on capital and growth affect the value of the company first let's explore return on
capital as I go from left to right for any level of growth I'm increasing the return on capital and
if you look across any line from left to right you will see that the value of the company
increases this means that improving return on capital if I can sustain the same level of growth
always creates value so higher return on capital is always better the same cannot be said for
gross however let's look at how growth affects the value of the company remember that the
cost of capital for this company is nine percent if I look to the right hand side of the chart
where the company earns a twenty-five percent return on capital as I grow faster that go from
top to bottom you see that the value of the company increases so more growth at a 25-
percent of eternal capital definitely increases the value of the company now let's look at the
left hand side however on the left hand side the company earns a seven percent return on
capital below the nine percent cost of capital what happens as this company grows faster as
you can see as I go from top to bottom from slower growth to higher growth the value actually
declines why does it decline it declines because as I grow faster I'm investing more capital at a
seven percent return when investors are demanding a nine percent return so as I grow faster
I'm effectively destroying more value and the value of that business will decline now look at
the second column the second column the company earns a nine percent return on capital
exactly equal to the cost of capital at a nine percent return on capital as I grow faster the value
doesn't change at all it stays constant why is that because growth neither creates nor
destroyed value I'm simply earning my cost of capital it's sort of like being on a treadmill you
can get a good workout you get sweaty but in the end when you're done with your workout
you're exactly where you started you might argue that we're too negative about the low return
on capital companies once the return on capital increase as the company grows faster in our
experience that's usually not the case true very small companies startup companies in
particular as they grow faster their margins typically do improve as they're able to generate
economies of scale and spread their costs over a large amount of volume but for most
companies a lower return on capital indicates a problem that needs to get fixed before the
company focuses again on growth for example maybe the cost structure is too high or the
products may not be distinctive enough to command premium prices from customers in our
experience companies in that situation need to focus on fixing those issues an increasing
return on capital before they turn to revenue growth we're a business stands in terms of
eternal capital and growth has important implications for its strategy particularly its choice of
whether to focus on return on capital or growth let me give you an example a high return on
capital consumer products company let's say will receive a ten percent increase in value for
one percent of additional growth whereas a more moderate return retailer might receive only
a five percent increase in value for one percent additional growth because of its lower return
on capital the inverse is also true the retailer will benefit much more from even modest
improvements of its margins or return on capital while the high return on capital consumer
products company will not receive much of a benefit from improving its margins or return on
capital of course the simple analysis assumes that it's equally difficult to increase revenue
growth as it is to improve return on capital which is often not the case it also makes the
assumption that when you improve growth or return on capital your return on capital or your
growth will remain constant which is clearly not the case that leads us to our second chart
which shows that different types of growth often will generate different amounts of value
because they generate different returns on capital recognizing that not all growth earns the
same return on capital this chart shows the value created for different types of growth now
this chart is an example from the consumer products industry different industries might have a
different rank order for different types of growth but it's a useful illustration to think about the
value of different types of growth the numbers in this chart are scaled to show the value
created for one dollar of additional revenues at the top of the chart we see the value created
from a company introducing a new product new products if they're successful typically
generate a very high amount of value per dollar of revenue generating the reason for this is
that often the additional cost for the company to sell that product are low it often has existing
manufacturing and distribution capabilities for example at the bottom of the chart we show
the value created from an acquisition the reason that the acquisitions tend to create smaller
amounts of value is that when you make an acquisition unlike a new product introduction you
have to invest an awful lot of capital upfront you have to pay for the business plus typically a
premium and so even though you may create a lot of value in an absolute sense there may not
be much left over in terms of return on capital after considering the price that you paid so
that's why we acquisitions tend to generate smaller amounts of value relative to the amount
of revenue that they generate in between you see some other sort of types of growth for
example expanding an existing market right if the consumer products company can get people
to wash their hands more often for example there's not a lot of costs associated with selling
more hand soap so the returns will generally tend to be high and the value creation will be
tend to be high if you look at the second of the bottom line competing for share in a stable
market you'll see that the value created from this type of growth spans both negative and
positive numbers in other words growing through competition in the stable market can
actually destroy value because often that growth comes in the form of price wars price wars
usually destroy value for everyone in an industry particularly concentrated industry now we've
seen how the core valuation principle works the value of a company is driven by the
combination of its revenue growth and its return on capital next we're going to turn to the
second corner stone which is the conservation of value conservation of value is the corollary to
the first principle conservation of value says that anything that doesn't increase the cash flows
of the company that are available to with investors doesn't create value

in my discussion of the first cornerstone the core valuation principle we saw that the value of a
company is determined by the combination of its growth and its return on capital the two
drivers of its cash flow will now turn to the second cornerstone the conservation of value
which is a corollary to the first cornerstone the conservation of value says that anything that
doesn't increase the cash flows of the company that are available for its investors doesn't
increase its value here's a way to think about the conservation of value principle think of a
pizza I can cut the pizza into either six pieces or eight pieces but regardless of how many pieces
like cut the pizza into the total size of the pie doesn't change it's the same for a company
company generates cash flows which are then distributed among different groups of investors
for example equity holders and debt holders it doesn't matter how those cash flows are
distributed in determining the total value of the company because the total value of the
company is determined by the cash flows that the company generates regardless of how it
distributes them to its different investors so unless I change the total cash flows coming into
the company I'm not going to affect value of that company I'm only going to affect the
distribution of value among the different groups of investors understanding the conservation
of value principle can help you differentiate from actions or decisions that merely redistribute
cash flows from those that actually increase the cash flows of the company and therefore
create value the conservation of value principle rests on the pioneering work of two Nobel
laureates Franco Modigliani and Merton Miller in the late 50s and early 60s they explored the
question of how the capital structure of a company affected its value and what they showed
was that it shouldn't affect the value of a company whether I had more or less debt relative to
equity in the capital structure because the total cash flows available all the investors hadn't
changed any unless the cash flows coming into the company changed as a result of the change
in the capital structure it shouldn't affect the value of the company here's an example of how
this works let's suppose we have a company that has an enterprise value of one thousand
dollars and it doesn't have any debt to begin with so its equity value is also one thousand
dollars now what would happen if that company were to borrow two hundred dollars and you
have 200-dollars to repurchase shares from the equity holders once the company has
borrowed the two hundred dollars and paid it out to the shareholders the total enterprise
value hasn't changed any because the cash flows coming in into the company in terms of
revenues costs Cal expenditures haven't changed at all the total of the debt plus the equity
must still be one thousand dollars the only way the value of the company can change is if by
changing the capital structure it changes the cash flows coming into the company one way that
can happen this is a tax deductibility of interest expense in most countries interest payments
are tax deductible so it reduces the overall taxes of the company and increases the cash flows
so by taking on debt I can reduce the tax burden of the company increasing the total cash
flows and the enterprise value and I have more value than to distribute between both the debt
holders and the equity holders but it's not the change in capital structure itself that affects the
value of the company it's the fact that changing the capital structure changes the taxes at the
company pays and that's what changes the value of the company so increasing the debt of the
company can increase the company's cash flows two ways one through the lower tax burden
that the company has to pay and secondly to the improved monitoring of the company by the
creditors which makes it less likely that the managers of the company will makes privileged
investments with the cash flow that the company generates that might lead you to think that
companies should take on lots and lots of debt in order to increase their value now there's a
negative effects from debt as well the negative effect of debt is that by taking on debt the
flexibility of the company and the attractiveness of that company as a business partner as a
customer or supplier is less attractive so the benefits of debt the reduction in taxes and the
reduction in frivolous investments have to be weighed against the cost of debt namely the
reduced flexibility of the company and the fact that becomes a less attractive partner as a
customer supplier or even as an employer for potential employees the conservation of value
principle is so useful for executives because it provides us a way to think about whether an
action creates value or not and that can be applied to questions of accounting policy
acquisitions dividend policy capital structure a whole range of issues can be looked at through
the lens of the conservation of value principle for example the only way to create value from
an acquisition is when you put the two companies together the combined cash flows of the
two companies operating together are greater than they what they would have been
separately it's not a matter of things like EPS accretion dilution or other factors like that it's
really about to the cash flows of the combined into the increase when you put those two
companies together you can also apply this to things like accounting policy for example one of
the most controversial accounting issues over the last ten years was the treatment of
executive stock options for years executive stock options were not treated as an expense in a
company's income statement despite the fact that there was clear value being distributed to
those managers the United States Financial Accounting Standards Board recognized this flaw
as options became more important and proposed a rule change that would require companies
to record options as an expense when they were issued many executives and venture
capitalists were opposed to this rule because they assumed that the stock market we'll be
confused by the accounting change they assumed that the expensing of stock options which
would reduce reported accounting income would lead to lower stock market values because
the market would not differentiate between the economic change and the accounting change
now we know that simply changing the accounting rules is not going to change the cash flows
of the company or the way that the value is going to be distributed and in fact that's exactly
what happened when the new accounting rules came into play reported corporate profits did
go down and for some companies went down quite a bit companies that relied on stock
options quite a bit but there was no evidence that the values of companies changed as a result
of thing so in other words the stock market was smart enough to realize that the accounting
change didn't change cash flows or the distribution of value so equity values didn't change or
consider financial engineering which is the use of complex financial instruments instead of
simple debt and equity is there any benefit from using complex financial instruments instead
of simple debt and equity in most cases the use of complex financial instruments like
convertible debt or off-balance sheet debt or sale and leaseback Arrangements doesn't affect
the total amount of cash flows coming into the company so therefore if they neither create
nor destroy value they simply change the way we distribute that value across different sets of
investors so once again by looking through the lens of does the transaction increase the total
cash flows available to the company we can see whether or not it affects the value of the
company but there are examples where complex financial structures do create value take the
example of hotel companies hotel companies often create separate legal entities to own the
hotels versus those that operate the hotels and the reason for that is that they can structure
the ownership companies in a tax-advantaged way according to the tax laws in us in a couple
of other countries so by creating a more complex structure the total tax is paid by the entity
are lower than what it otherwise would be and that leads to the value creation but once again
this points out that in order to understand the value creation from complex financial
transactions we need to understand the effect on total cash flows and if the transaction
increases those cash flows it may very well create value if it doesn't increase the cash flows it's
not likely to create value and more often than not will destroy value because it introduces
complexity and legal and other costs in order to create these structures as a rule executives
should exercise caution when faced with transactions where it's not clear how that transaction
will lead to an overall increase in the cash flows of the entire company always ask what's the
source of value creation how are the total cash flows going to increase as a result of this
transaction so we've seen how value is created and destroyed to the first two cornerstones
next we turn to how value is reflected in the stock market
now that we've explored how companies destroy value through the first two cornerstones let's
turn to how value and the stock market interact many executives spend tremendous time
watching their share price and sometimes they make strategic decisions based on what they
see happening to their share price so it's critically important that executives have the proper
interpretation of movements in their share price otherwise it could lead them to value
destroying strategic decisions we call this third cornerstone the expectations treadmill let me
explain why the value of a company is a function not just of its actual performance but of the
expectations of investors about future performance so the only way that a company's share
price can increase faster than the market is if they are continually able to increase the
expectations of investors about their future performance the problem is is that once I've
improved my performance and met the investors expectations in order to increase their
expectations again I have to improve performance and bring it to another higher level so I'm in
continuous cycle where the only way that I can outpace the market is by continually beating
expectations but those expectations if I continue to beat them will keep going up eventually
the expectations will become so high that i can no longer beat those expectations that's why
it's not unusual for companies with great performance in terms of return on capital and
growth to have just normal share price performance because they can no longer beat the
expectations that are built into this share price I'd like to illustrate this with an example
comparing two companies Target and Walmart two of the largest us-based retailers from 1995
to 2005 target shareholders earn an annual return of twenty four percent per year that
includes both dividends and share price appreciation Walmart's returns on the other hand for
shareholders were fifteen percent per the target shareholders earn nine percent per year
more than walmart shareholders but what does that tell us about whether target created
more value or Walmart it actually doesn't tell us very much and we can see that when we
disaggregate those return to shareholders into their components the top three components
are the actual underlying performance of the company's growth cash flow generation less
investments that they required for growth down below we look at the change in industrial
expectations as measured by the multiples and then finally we also look at the impact of
financial leverage so let's explore each of these when we look at the return to shareholders the
trf from performance from actual performance you see that Walmart actually outperforms
target ten percent per year to eight percent per year right and you can see also if we dig
deeper we can see why that's the case Walmart grew revenues thirteen percent a year while
target only grew nine percent a year on the other hand target improved its margins during this
period where Walmart's were flat that doesn't mean that Walmart's margins were not good
and in fact this represented more of a catching up of target to Walmart's level of margins and
then finally we have to subtract off in terms of performance investments required in order to
achieve that growth so in terms of actual delivered performance Walmart outperforms target
ten percent per year to eight percent per year target shareholders benefited more from
improvement in the expectations of performance as an important driver of their return and
let's explore how that work we see we have two elements here that explore the effective
expectations the first element called the total return to shareholders assuming no growth
what this does is it reflects the way the companies were valued at the beginning of the time
frame back in nineteen ninety five back in nineteen ninety-five target had a price earnings ratio
of a 11 while Walmart's price earnings ratio was 15 so the starting point in terms of delivering
return to shareholders target was already advantaged because the expectations as reflected in
the lower price earnings ratio were much lower so they didn't have to deliver as much in order
to meet the low expectations that were built in to walmart price and that favored target by 2%
the next element reflects the change in earnings multiple or the change in expectations the
first part measured the at the beginning level of expectation the change in multiple measures
the change in expectations you can see here that targets multiple increased substantially
leading to five percent per year of additional return to shareholders from the increase in the
multiple effectively catching up with Walmart Walmart multiple was essentially flat leading to
no improvement in the shareholder returns so these two elements combined represent a total
seven percent advantage for target shareholders because target had a lower valuation at the
beginning of the time frame and the expectations which started out lower gradually increased
to catch up with walmart's expectations so an entire seven percent of the difference between
the two returns is driven by the expectations of target catching up to the expectations for
Walmart the final element I'd like to discuss is the impact of financial leverage when a
company has lots of debt small changes in performance in the overall performance of the
company are magnified by the effect of debt to greater changes for the shareholders and
that's what happened here at the beginning of the timeframe target had much more debt than
Walmart and as a result of that the improvements that target made both in terms of the
underlying performance and the expectations were magnified to the shareholders because of
their high leverage and that led to an additional three percentage points of improvement in
value per year for the shareholders so we look at the total difference in shareholder returns
we see that basically all of the outperformance by target was due to bringing up the
expectations from a very low level to a level similar to walmart and to the fact that they had
greater financial leverage at the beginning of the timeframe now by the end of the timeframe
target had similar financial leverage to walmart now if I were to look forward and say well
what can happen now going forward what's the likely differences in return to shareholders
going forward now we're starting out with a point where the two companies have similar
financial leverage and similar expectations as embodied in similar price-earnings ratios so
without further changes in those variables which are unlikely the only way that target can beat
Walmart going forward is by increasing their real performance not just by improving
expectations so the expectations treadmill has important implications for measuring the
performance of a company and for executive compensation take executive compensation over
periods of three or even five years most of the movements in the company's share price are
going to be driven by changes in expectations and the resulting multiple rather than the
underlying performance of the company so by compensating executives based on trf we're
typically compensating them more for changes in expectations rather than delivered
performance and that may work against high-performing managers who are in a starting point
with high expectations and work too much in the favor of managers who are simply beating
low expectations it's not that TRS is a bad measure where we should use it but we need to
understand what are the components are returned to shareholders as we talked about in the
case of Walmart versus target how much of that TRS is coming from underlying performance
how much is that TRS is coming from changes in expectations it also has important patience
for looking forward if for example I've had a high return to shareholders over the last three
years because my expectations at the beginning of the period were low and now there have
been brought up to the period of to the average of my peers it's unlikely that I can expect my
expectations to continue to outpace the peers so my TRS is likely to be more in line with my
peers or more in line with my actual performance rather than outperforming on the other
hand it may also help me understand why very strong companies are very strong managers
who had a tremendous amount of real performance in terms of revenue growth and returns
on capital didn't outperform their peers in terms of return to shareholders because they
already had high expectations built into the share price so it's important to disaggregate return
to shareholders into the key components of true underlying performance and the effect of
expectations and changes and expectations on those returns to shareholders the expectations
treadmill also has important implications for investors it shows investors that there's a
difference between a good investment and a good company a good investment maybe to
invest in a company which has very low performance and low expectations as long as that
performance improves even a little bit and the expectations improve a little bit the share price
will likely outperform other companies on the other hand a good company with good growth
and good returns on capital maybe allow the investment if all the other investors already
expected to perform well and those high expectations are built into its share price in other
words it won't be able to outperform expectations the share price is not likely to outperform
the market now we've seen how companies creating a destroyed value and the interaction
between that value and prices in the stock market in the next and final cornerstone we'll
explore how different owners can lead to different values for same business
we've explored how businesses create value and how that value is reflected in the stock
market now we're going to explore how value varies depending upon who owns a particular
business this is important because one of the levers that companies have to create value is the
decision when to own a business should they dispose of businesses that they're currently
owned or should they acquire businesses that they don't know we call this the best owner
principle because value is maximized when a business is owned by the owner who is uniquely
positioned to extract the most value from it let me illustrate with an example in 2001 General
Mills purchased the Pillsbury division of Diageo for ten point four billion dollars shortly
thereafter General Mills increased the cash flows and operating profits of the Pillsbury
business by four hundred million dollars per year increasing pills raise value by seventy percent
how did they do that a couple of things one they were able to use Pillsbury's refrigerated
trucks to distribute a new line of refrigerated products that General Mills was introducing the
General Mills didn't have to go out and sort of build the whole fleet of trucks secondly General
Mills was able to introduce some Pillsbury products into the US school market where General
Mills already had a strong presence and distribution system and finally as with many
acquisitions of overlapping businesses general mills and pillsbury used similar distribution and
manufacturing processes and they were able to consolidate some of those activities total
effect was to increase the value by seventy percent diageo couldn't have done these same
things with Pillsbury because diageo's core business was manufacturing and distributing
alcoholic beverages with very few overlaps with Pillsbury's businesses this example also shows
that there is no intrinsic value for a business such as Pillsbury's it depends on who the owner of
the businesses let's look at how this works the first column represents the value of Pillsbury to
General Mills including all of the benefits that we just talked about the value to diageo by
definition much less because diageo can extract those same benefits from owning the business
the transaction price of ten point four billion dollars is presumably somewhere between the
value of Pillsbury to general mills and the value to diageo so both parties benefit from the
transaction is they're able to split the value increase that comes from general mills better
ownership of Pillsbury we find that it's particularly important for investors to identify the
sources of better ownership this helps them think through whether in fact they are the best
owner of a particular business or whether someone else might be and they are better off
divesting that business let's now explore the different sources of best ownership the most
straightforward source of best ownership is unique links between a business and other parts of
the company consider a coal mining company that has an established mind with fully
developed infrastructure railroad lines power plants etc now suppose that a coal mining
opportunity opens up on an adjacent piece of property the company that already has that
infrastructure leading to that area is likely to be able to operate the new mine at a much lower
cost than any other competitor so it has a natural best owner advantage over any other
operators that's one example unique linkages a second source of best ownership is distinctive
skills that a company can bring to a business now these can occur anywhere in the business
system from product development to marketing to manufacturing but of course those skills
have to apply to a part of the business which is critical to that business's success being a great
manufacturer for example isn't going to be important to a let's say a consumer products
company where the most important skills our product development and marketing Procter &
Gamble is a good example of the company with distinctive skills it has distinctive skills in the
development and marketing of consumer branded products Procter & Gamble currently has 23
products with more than 1 billion dollars in sales and another 20 products with more than half
a billion dollars in the sales some of these products have been around for 50 years some have
been purchased recently and some have been developed from scratch in the last 10 years in all
those cases though Procter & Gamble does an extraordinary job of building those brands and
keeping them at the top of their market a third source of better ownership is better
governance private equity firms are an example of better governance the best private equity
firms don't just buy companies and hope to sell them at a higher price and use a lot of debt the
best private equity firms don't create value through financial leverage they create value
through improving the underlying performance of the businesses that they own they don't
have time though to run the businesses on a day-to-day basis so what they do is they rely on
better governance and what that means they work with managers to instill a stronger
performance culture they help managers overcome or abandon any sacred cows that exist in
the business and they'll often work with managers to help change the time horizon of the
managers so the managers can focus on value creation let's say over a five-year period instead
of a one-year period so it's like better governance that ultimately leads to value creation from
private equity firms a fourth source of better ownership is better insight or foresight what this
means is that a company can see into the future better than others because of some existing
businesses or other sort of advantages that it has for example the software company quicken
notice that many small business owners were using their consumer finance software to run
their small businesses the reason was that existing small business software with too complex
for many of them that insight helped quicken to develop a accounting software for small
businesses that was much easier to use than the other products on the market and they were
able to quickly gain a substantial share of the market as a result of that insight the fifth and
final source of best ownership is distinctive access to talent customers or suppliers we typically
find these in emerging markets only because in emerging markets it's not unusual that the
pool of managerial talent may be very limited and larger better known companies may have a
better chance at attracting the best managers and also in some of these markets to be
successful you have to navigate significant government bureaucracies and only the larger
better known companies have the resources and contacts to be able to do this successfully
that's also why you often don't find distinctive access to talent or customers or suppliers as a
source of advantage for companies in developed markets the best owner of the business will
also change over time when the company is new the founders who have the original idea are
typically the best owner but as the business grows the founders may need to bring in
professional managers and venture capitalists to provide the capital and manage the skills to
bring it to the next level of size as the company further develops it may need new distribution
capabilities that it can't build on its own and it might be worth more in the hands of a large
company that has significant distribution and manufacturing capabilities unfortunately in our
experience too few executives understand truly whether or not they are the best owner of
each of the businesses that they're responsible for
1 WhyValueValue?
Many companies make decisions that compromise value in the name of creating value. But with courage and
independence, executives can apply the four cornerstones of finance to make sound decisions that lead to lasting
value creation.

2 The Core of Value Return on capital and growth are the twin drivers of value creation, but they rarely matter
equally. Sometimes raising returns matters more, whereas other times accelerating growth matters more.

3 The Conservation of Value You can create the illusion of value or you can create real value. Sometimes
acquisitions and financial engineering schemes create value, and sometimes they dont. No matter how you slice the
financial pie, only improving cash flow creates value.

4 The Expectations Treadmill No company can perpetually outperform the stock markets expectations. When
a company outperforms, expectations rise, forcing it to do better just to keep up. The treadmill explains why the
share prices of high performing companies sometimes falter, and vice versa.

5 The Best Owner No company has an objective, inherent value. A target business is worth one amount to one
owner and other amounts to other potential ownersdepending on their relative abilities to generate cash flow from
the business.