In most of these educational articles I discuss strategy, psychology, technical research and virtual portfolio management. In this article I decided to digress slightly to discuss more the fundamentals that affect business decisions. Why is it that some companies become great innovators while others fails to realize their potential? This has been the subject of great papers in the past by esteemed figures such as Stephen Kaufman and Clayton Christensen.
Before understanding how discounted cash flow analysis can affect business decisions, let’s understand the term itself. Discounted Cash Flow describes a method of valuing a company or financial asset using the time value of money. All future cash flows are estimated and discounted to give them a present value. The discount rate used is generally the cost of capital. Discounting a future stream of cash flows into a "present value" assumes that a rational investor would be indifferent to having a dollar today or to receiving some years from now a dollar plus the interest or return that could be earning by investing tthat dollar for those years.
A problem with discounting can arise when managers make an assumption that the present health of a company will continue into the future – indefinitely! When managers consider investments, they often do so in isolation. In practice, this can be dangerous as competitors disrupt the market place with new products or apply margin pressure or take market share. Essentially, managers and business owners must recognize that the market place is continuously changing and must not make business decisions in isolation.
Business owners often have a very hard time forecasting streams of cash from an investment in innovation, yet they have an even harder to time predicting how financial performance may deteriorate in the absence of investment in innovation.
Innovation may be stifled not only from flawed analysis of financial models, but also from assumptions of how Wall Street will react to certain actions. For example, business owners who believe equity markets will punish them for a write-off of obsolete assets may delay adopting new technology.
Another hindrance may be an excessive focus on earnings per share figures. When managers shift their focus onto earnings per share as the primary driver of share price and hence of shareholder value creation, innovation can suffer. Indeed Pete Petersen of Blackstone commented in a recent interview how private equity companies like his own were able to outperform over decades because they were not targeting quarterly performance. Instead, his team focused on performing over 5 year timeframes. In some respects, Google has shown a disdain for short-term performance targets too by failing to give quarterly guidance. Instead, they focus on building value. Indeed, our sources tell us they were inquiring recently at little-known start-up with big prospects, Luxim. It is this type of focus on finding companies that can create industry paradigm shifts that enhance the value of companies driven by vision rather than by quarterly metrics.
Great companies tend to have visionaries who don’t fall victim to focussing on short-time horizons, flawed financial analysis or investor concerns. Apple is a perfect example of how a leading visionary can transform a company by understanding what it is people want and delivering it to them in an easy-to-use manner. Steve Jobs didn’t just guide Apple through its latest transformation, he led Pixar to a successful acquisition by Walt Disney beforehand. He also founded NeXt, which was bought out by Apple and brought Jobs back to Apple a second time.
To discover the views of a CEO and what his/her focus is, simply review quarterly and annual reports as well as letters to shareholders. The tone and philosophy of the CEO is quickly evident. If you want a benchmark against which to compare every other CEO, these letters by Buffett are the best place to start!
