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Bartley J. Madden
www.ValueCreationThinking.com
May 2016
The most up-to-date version of this PowerPoint will be posted at SSRN.
bartmadden@yahoo.com
2016 Bartley J. Madden Value Creation Thinking
www.ValueCreationThinking.com
Madden unites the fundamentals of financial valuation
with a unique emphasis on corporate purpose, culture,
and knowledge. He provides an important contribution
to our understanding of capitalism at a critical moment
and an illuminating roadmap for the future of business.
Dominic Barton, Global
Managing Director, McKinsey
& Co.
A free society is an engine of wealth creation Bart
Maddens Value Creation Thinking is driven by the
philosophy that an understanding of that [wealth creation]
process defines a path to the long term increase in
investor returns. Beware the crony capitalist firm
seeking profits from favors; the money is in creating value
for customers.
Vernon L. Smith, Chapman
University, Nobel Laureate in
Economics, 2002
CONTENTS
PART I
Introduction
Long-term value creation
The firms purpose
Managements core responsibilities
Life-cycle valuation framework
Eastman Kodak, 3M, Illumina, Amazon,
Whole Foods, JCPenney, Intuit, Walmart
Life-cycle valuation model
Existing assets and future investments
What really causes big long-term moves in stock
prices?
Life-cycles reviews
PART II Knowledge building and reconstructing your worldview
PART III A total system approach to valuation
2016 Bartley J. Madden Value Creation Thinking
INTRODUCTION
Long-term value creation begins with clarity about the purpose of the firm and managements core responsibilities.
Increasingly, the public has been losing trust in the capitalist system in which big corporations play the central role. The
decline in trust stems from our all too vivid memories about high-profile events such as: the unethical behavior that led to
Enron-type bankruptcies; big bank bailouts that removed penalties for high risk behavior; innovative financial products
that played a role in the 2007/2008 financial crisis and were designed to boost short-term profits for financial firms without
providing genuine value to customers; instances of executive compensation disconnected from firm performance; a neverending bull market for lobbyists who exert a heavy influence in the crafting of highly complex legislation, typically followed
by even more complex regulations, as well as many unintended consequences; and the list goes on.
For many, it is all too easy to lose sight of the primary benefit to society from business firms which is the value to
customers that use their products and services. While America is losing trust in capitalism, cronyism (think how business
is done in Italy and Greece) is on the rise. Cronyism removes a level competitive playing field and puts a premium, not on
efficiency and innovation, but on lobbying skill in Washington to seek special treatment. We should all want free-market
capitalism to triumph over crony capitalism. America needs a level competitive playing field in which value created is
shared in approximate proportion to the contribution made, thereby nurturing an opportunity rich society in which people
can rise as high as their skills and determination can take them.
We need an insightful understanding of how business firms create value over the long term and how that value is reflected
in stock prices. The thrust of this book, displaying long-term track records of value creation and dissipation, is to promote
the life-cycle valuation framework, which is used extensively worldwide by institutional portfolio managers, as the sensible
way to meet these needs. A way that enables us to better understand history as well as improve management practices.
The ideas in this book offer a path forward for managements and boards to deliver enhanced firm performance, driven by
employees who trust in, and share a purpose with, management. All of a firms stakeholders would benefit.
We will strive to fulfill the firms vision while instilling high ethical standards throughout the
firm. We will survive and prosper by delivering a level of efficiency and innovation that
earns customer loyalty and rewards long-term shareholders. We will strive for win-win
relationships that provide value for those who partner with us in serving our customers. We
will take care of future generations by designing our products and services, and using our
assets, consistent with environmental sustainability.
2016 Bartley J. Madden Value Creation Thinking
Competitive Fade
Mature
FADE
Economic
Returns
Failing
Business
Model
Long-term
Cost of
Capital
Reinvestment
Rates
Time
The rate at which a firms profitability fades over time depends primarily
on managements skill relative to competitors.
2016 Bartley J. Madden Value Creation Thinking
EASTMAN KODAK dominated the film and camera market for decades
but failed to adapt to changing technology (digital photography).
Rising CFROIs
6% Long-term
cost of capital
Long-term
underperformance vs. S&P 500
10
11
12
13
14
15
16
INTUIT sells financial software to consumers and is well known for its
purpose-driven culture that focuses on experimentation and fast learning.
Big improvement in CFROIs
17
Outperformed
S&P 500, 13-fold,
1980 to 1990
1980-1990
18
PURPOSE
Vision
Survive and
Prosper
Win-Win Partnerships
Future Generations
2016 Bartley J. Madden Value Creation Thinking
CORE RESPONSIBILITIES
#3
Knowledge
Building
Culture
#2
Resource
Efficiency
#1
Valuation
Framework
19
Competitive Fade
3
%
FADE
Mature
1
Economic
Returns
Failing
Business
Model
Long-term
Cost of
Capital
Reinvestment
Rates
Time
2016 Bartley J. Madden Value Creation Thinking
20
Warranted
=
Value
t =1
Economic
Returns
Reinvestment
Rates
Fade
Todays
Asset Base
LIFE
21
100
100
Today
+ 1 year +2 year
PV Factor
0.9524
PV Today
0.9070
95.24 + 90.70
150
Today
-100
PV Today
TOTAL FIRM
VALUE TODAY
2016 Bartley J. Madden Value Creation Thinking
-95.24 + 136.05
% FUTURE
% FUTURE =
Stock market valuations are attuned to ROIs on new investments. All else equal, the more
capital reinvested in the future that achieves ROIs greater than the opportunity cost of
capital, the higher the firms market value. Consequently, the middle panel of the life-cycle
charts which displays real asset growth rates is especially important for high CFROI firms.
A firms management, board, and shareholders should understand what a current stock
price implies for the firms future investments in order to better judge the economic
soundness of managements planned capital expenditures. Business as usual is typically
not strategically sound for firms priced with significant negative values for future
investments.
A % Future scorecard, using current Credit Suisse HOLT data for 1,000 U.S. industrial
firms, is available at www.ValueCreationThinking.com
23
24
25
MARKET EXPECTATIONS
WALMART YEAR-END 1979
CFROI %
Actual CFROIs
20
15
Market
Expected
CFROI =
10.0%
10
5
0
70
75
80
85
90
20
10
0
70
75
2016 Bartley J. Madden Value Creation Thinking
80
85
90
Source: Credit Suisse HOLT Global Database
Market
Expected
Asset
Growth =
7.0%
26
LIFE-CYCLE REVIEWS
Boards of directors need to coordinate with management and
implement a common valuation language that is best suited to:
(1) analyze the impact on the firms value of major, board-level
decisions, especially those that deal with strategy and
resource allocation, and
(2) communicate to shareholders why they should be confident
that major decisions are likely to create long-term value.
A strong case can be made that the proposed Life-Cycle Review,
highlighted on the next two slides, is the preferred means to meet
this need.
27
28
29
PART II
KNOWLEDGE BUILDING AND
RECONSTRUCTING YOUR WORLDVIEW
The knowledge-building process can be analyzed in the
form of a knowledge-building loop. Adoption of the
recommended four core beliefs will upgrade ones
worldview, thereby leading to substantial gains in
knowledge-building capability.
The next two slides illustrate the knowledge-building loop
and the contrast between a dysfunctional culture and
a high-performance culture.
30
PERCEPTIONS
WORLDVIEW
ACTIONS AND
CONSEQUENCES
PURPOSES
FEEDBACK
KNOWLEDGE
BASE
31
Managements
Worldview
My work provides a
paycheck, nothing more.
Vision
High-Performance
Culture
My work helps me live a
purposeful life.
Commitment
to employees
Innovation and
efficiency
Experimentation and
systematic problem solving
is how we make progress.
Ethical behavior
Do whatever it takes to
make accounting targets.
Never rat out a coworker.
2016 Bartley J. Madden Value Creation Thinking
I trust management.
32
ABBREVIATED DESCRIPTION
OF THE FOUR CORE BELIEFS
1. Past experiences shape assumptions.
2. Language is perceptions silent partner.
3. Improve performance by identifying and fixing a systems
key constraints.
4. Behavior is control of perception.
The next seven slides highlight an application of
the four core beliefs.
2016 Bartley J. Madden Value Creation Thinking
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34
35
36
37
38
39
KIVAS SOLUTION
40
41
PART III
A TOTAL SYSTEM APPROACH TO VALUATION
A valuation model is a mechanism to generate an expected long-term net cash receipt (NCR) stream for
the firm and then translate this into a present value. Why not simply specify each years NCR over the
long term? This would result in users of the model then having no benchmarks to gauge the plausibility
of the specified NCRs, especially those in the distant future. The valuation model should facilitate a
learning process, and not just be a logically sound application of discounted cash flow mathematics.
With a learning process in mind, there is a compelling rationale to use the three life-cycle variables to
generate the models NCR stream. Users can then study life-cycle track records (the past) and make
judgments about likely future track records. The same language is used to understand and
communicate about the past and the future. With such a common language in place, users can much
more easily explain and discuss with others why they are using a particular set of optimistic/most
likely/pessimistic forecasts. Different opinions can be debated in a useful way. Experience suggests
that the more experience users gain with analyses of historical life-cycle track records, the better their
forecasting skill will be with future life cycles. In summary, the life-cycle valuation model and global
database are designed to enable users to better understand firms past performance, pinpoint key
valuation issues, decode market expectations, and help judge the plausibility of forecasts.
The life-cycle valuation model using CFROIs for economic returns was developed at Callard, Madden &
Associates in the 1970s and Credit Suisse HOLT continues this research program today. This
commercial research program is based on ten critical ideas, many of which differ from mainstream
finance in important ways. The following slides explain these ten ideas.
42
43
CAPITAL OWNERS
Capital
Expenditures
Gross
Cash
Flow
Outflows
for New
Investments
Interest
Payments
Increase Net
Working Capital
Cash
Inflow
New
Capital
Outflow
Debt
Repayments
Dividends
NCR
Gross
Cash - Outflows
Flow
Share
Repurchases
Firm's
NCR
Cash
Cash
Inflow Outflow
New
Debt
Stock
Sale
NCR
Capital
Owners
NCR
44
#5 SYSTEMS THINKING
From a logical perspective, there is a compelling rationale to apply
systems thinking to a valuation model. With the life-cycle model shown
on the next slide, the forecast of future NCRs is highly sensitive to the
procedures used to assign fade rates for economic returns and
reinvestment rates. Consequently, the assignment of the investors
discount rate should be contingent on how fade rates are forecasted. In
other words, the valuation model is a package deala total system in
which the handling of one component affects other components in the
system. Both the early work at Callard Madden & Associates and Credit
Suisse HOLTs current global database use investors discount rates that
are based on a market-implied process which is in tune with the fade
forecasting routines used.
45
Reinvestment Rates
Fade
Warranted
=
Value
Todays
Asset Base
LIFE
t =1
Tangible Assets
Intangible Assets
46
#6 FORWARD-LOOKING INVESTORS
DISCOUNT RATE
How might you assign a discount rate in order to estimate the warranted value of
a new municipal bond offering that has not yet been issued? The expected
NCRs are already known in terms of interest and principal payments over the life
of the bond. With an assigned discount rate, you can calculate a warranted
value, which is the expected market price for the bond when it starts trading.
A reasonable approach is to first analyze a large universe of traded municipal
bonds and observe the yield-to-maturity and the credit quality of the sponsoring
entities. Based on the current market prices for these bonds, you could then plot
yield-to-maturity (i.e., the market-implied discount rate) versus credit quality.
Then run a regression equation with yield-to-maturity as the dependent variable
and credit quality as the independent variable. The resulting regression line
provides an estimated discount rate for a specified level of credit quality. You
would see a higher discount rate for lower quality and vice versa. The same
logic applies to estimating investor discount rates for individual firms. Such a
process requires that each firm in a sample universe of firms have forecasted
NCR streams based on standardized fade forecast routines.
2016 Bartley J. Madden Value Creation Thinking
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48
49
50
51
Accounting fixes
Conceptual
model fixes
Global database
covering a large
universe of companies
Test proposed
improvement
Implement
improvement
52
FUTURE RESEARCH
Connecting firms financial performance to stock market valuations is a very complex task.
One neglected area in mainstream finance is the construction of simulation models (Excel
spreadsheets) that tie known time series of life-cycle variables to detailed accounting
statements through time. For example, this could be a fruitful path to a better
understanding of the costs and benefits of intangible assetsa wickedly difficult problem
for sure.
The early Callard Madden & Associates work began with a model corporation that
connected business economics to accounting data. It constructed the firm as a portfolio of
ongoing projects with known characteristics for project ROIs and a specified capital
structure. With an inputted environment of time series data for inflation/deflation, nominal
interest rates, and real project ROIs and real investment rates, the as-reported accounting
statements were produced each period. The CFROI metric was developed to use the asreported financial statements to mirror the known, steady-state project ROIs. The next two
slides show: (1) 3M CFROI calculation for 2014 and (2) a simulated earnings/common
equity (book value) using the model corporation with actual U.S. data for inflation/deflation
rates and nominal interest rates covering approximately 100 years. The real project ROIs
were maintained at 6 percent for every year. The gyrating path of the calculated
earnings/common equity over time should give pause to mathematical model builders who
ignore real world complexities like the impact of inflation and deflation on historical-cost
accounting statements.
2016 Bartley J. Madden Value Creation Thinking
53
Inflation Adjusted
Gross Cash Flow
$8,711
$8,791
CFROI = 15.2%
Release of
NonDepreciating
Assets
$48,350
Inflation Adjusted
Gross Operating
Assets
Book Assets
+ Accumulated Depreciation
+ Inflation Adjustment to Gross Plant
+ LIFO Inventory Reserve
+ Capitalized Operating Leases
+ Capitalized R&D
- Equity Method Investments
- Pension Assets
- Goodwill
- Non-Debt Monetary Liabilities & Def. Taxes
54
IMPACT OF INFLATION/DEFLATION ON
REPORTED EARNINGS/COMMON EQUITY
Simulated Earnings/Common Equity
using actual U.S. inflation rates
20
15
10
CFROIs = 6%
6% Project ROIs
0
1870 1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990
Years
2016 Bartley J. Madden Value Creation Thinking
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