As I run the risk of sounding presumptuous and a know-it-all, I hope you will come to see the value in this slightly longer than usual article.
What I have come to believe as of this writing on September 27, 2017, judging from strategy blog pieces and full-length strategy articles, is that many strategy professionals do not understand basic principles of finance and how they relate to strategy. By strategy professional, I mean anyone in firms or consultants who practice in the field of strategic management. In this piece, I want to provide finance principles written in a way that any strategy professional can understand. If my message rings true, please share widely. I do know something about finance. I finished all my coursework during my Ph.D. program thirty-four years ago in finance before switching to strategic management. While I have never been a CFO, I have interfaced with the CFO and his/her office in nearly all of my strategy engagements over thirty years of practice. This article should arm the strategy professional with the basic knowledge to have a substantive conversation with the CFO’s office in your firms or with your clients. The key takeaway from this article is that the strategy professional must test his/her firm’s strategy and changes to that strategy for creating financial value.
First of all a caveat: this article is written from the premise that a free enterprise capitalist system is worthy and justified. In my view, the foundation of such a system, even with its warts, is that investor money has the freedom to flow to its highest expected return adjusted for risk. All other economic systems curtail this freedom to some degree. This premise is crucial for how strategies and firms are valued in our economic system.
Here we go with the basic principles of finance and their relation to competitive strategy:
Principle #1: Cash Flow Is King
Net profit comes from the Income Statement and while it is a useful number, it is not the key number for strategists. Free cash flow is the number to focus on. Net profit from the income statement is simply revenue minus expenses. While accounting rules allow us to count revenue in say December of a year as the sales force books a sale of a product or service, we probably will not receive cash until the following year. Note most Internet-based firms get their cash up front before anything is shipped, which is good from a “cash is king” perspective. The booking of the sale or revenue before collecting cash is legal and stems from accrual accounting. Strategists need to adjust accrual accounting to be one of “cash on the barrelhead”. Work with the CFO’s office to do this. I cannot remember where I first read this but the following is a useful frame of reference: Say we start a year with $100 of cash in a cigar box. If at the end of the year we have $110 in the cigar box, we have done well. If we have $90 in the cigar box we have not done well. Think of all of the inflows and outflows of cash that happens in a business over the year. That $110 in the cigar box at the end of the year is worth celebrating.
Principle #2: Earnings More Than the Required Return is the Benchmark of Business Performance
I read in the Economist a few weeks ago that younger executives either never learned this or if they did they have forgotten it. The language of finance is similar to any foreign language you know: either use it or lose it. By Earnings I mean Free Cash Flow divided by the investments the firm has made. This number is Free Cash Flow Return on Investment and is the single best number for the strategy professional. Its acronym is FCFROI. Free cash flow is Revenue minus Expenses minus the New Investment required to drive newer rounds of revenue growth:
Revenue – Expenses – New Investment Required to Drive Newer Rounds of Revenue Growth
Notice this number combines income statement and balance sheet accounts. Performance numbers like return on sales, return on assets or earnings per share can provide some useful information. However, these are incomplete numbers, as they do not combine income statement and balance sheet accounts.
OK, now we are getting somewhere. If there is more left over after these subtractions, the business has probably done well. But the bar for performance gets even higher.
Now, what is the Required Return? It is the return expected by the investors in your firm given the amount of risk your firm is bearing. It is none other than the Weighted Average Cost of Capital or WACC. This is the cost or charge of the mix of debt and equity on the balance sheet. Most for-profit firms have a mix of debt and equity (as capital or investment) to fund new rounds of revenue growth and each has a cost to it. The cost of debt, or its interest rate, is almost always cheaper than the cost to entice equity shareholders to part with their money and invest in your firm.
Say a firm has 70% debt and its interest rate is 6%. It has 30% equity and its cost is 12%. Note determining the cost of equity is a little tricky so, work with your CFO’s office here. The weighted average cost of capital would be:
(.70 x .06) + (.30 x .12) = .042 + .036 = .08 rounded up
Here is the key point. The FCFROI needs to be greater than .08 for a firm’s stock price to go up if it is a publicly traded company or for the value of the firm to go up for private for-profit firms who do not offer shares of stock to the public. This is not ivory tower theory. It is fact. The works of Al Rappaport, Bart Madden and Koller, Goedhart and Wessels, who I have cited in other articles, have shown these relationships through rigorous data analysis.
So FCFROI – WACC = some positive number is the key point here
This number is called the “spread”. If it is positive, that is CFROI is greater than the WACC, the firm is a shareholder wealth creator. If the spread is negative this causes declining shareholder value or owner wealth (FCFROI – WACC = – ). Note the firm might even have positive accounting earnings on only the income statement while still having a negative spread, thus still destroying shareholder value or owner wealth. Bart Madden found over a thirty-year period Bethlehem Steel did not once earn FCFROI greater than its WACC and its stock price languished or declined over this period of time. But because they had positive Return on Revenue (income statement only number) and positive Return on Assets (balance sheet number only), they were fooled as to their real financial performance. Executives joined country clubs, flew around in company planes, and all the while destroying value for shareholders.
Principle #3: Your Firm’s Strategy Must Be Tested for Its Ability to Make FCROI Be Greater Than Your Firm’s WACC
Here is the punch line of this article for strategy professionals. If you do not test whether your current strategy or changes to your strategy are expected to make the FCFROI be greater than the WACC, you are not doing your job. I can send an example spreadsheet to anyone who asks on how to do this. The essence of this work is this:
- Do your firm’s annual strategic planning efforts and process.
- Do scenarios five years out that depict impacts of your strategy on the current or base business your firm enjoys. Forecast for each of the five years out expected revenue, expenses and new dollar investments that must be made.
- Do the same for the impacts of new initiatives to be launched from your strategy making efforts.
- The ending number from the five-year scenarios is the Free Cash Flow that is expected to be made by your strategy making efforts. Notice expected is the keyword. No one can guarantee this will actually happen, but we have to start with what we expect will happen.
- Through a technique called net present value, bring the five-year forecasts back to the present time and sum it to create one number. (Ask your CFO’s office how to do this if you do not know how). Subtract the amount of debt your firm currently has from this number. The result is the financial value for shareholders your firm’s strategy is expected to create. Now divide this by the number of common shares of stock currently outstanding or issued. This is the Implied Stock Price. Compare this number to the current actual stock price. If the Implied Stock Price is greater than the current stock price, your strategies are expected to earn more in Free Cash Flow than the WACC and you are golden. If the Implied Stock Price is less than the current stock price, your strategies are expected to destroy shareholder value. Go back to your spreadsheet and work other scenarios until you can confidently and prudently create shareholder value.
- Execute your strategy and initiatives to make what is expected in terms of creating shareholder value be actual shareholder value.
This article has presented the distilled essence of how strategy and finance relate and interact to create shareholder value or owner wealth. This is hard work to be sure. But it must be done. Now get to some serious work in making your firm a financial value creator.
Dr. William Bigler is the founder and CEO of Bill Bigler Associates. He is a former Associate Professor of Strategy and the former MBA Program Director at Louisiana State University at Shreveport. He was the President of the Board of the Association for Strategic Planning in 2012 and served on the Board of Advisors for Nitro Security Inc. from 2003-2005. He has worked in the strategy departments of PricewaterhouseCoopers, the Hay Group, Ernst & Young and the Thomas Group. He can be reached at firstname.lastname@example.org or www.billbigler.com.