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The CEO’s Guide to Corporate Finance

Four principles can help you make great financial decisions - even when the CFO’s not in the room.

by Richard Dobbs, Bill Huyett, and Tim Koller, McKinsey

The problem

Only improving cash flows will create value.

Strategic decisions can be complicated by competing, often spurious notions of what creates value. Even executives with solid instincts can be seduced by the allure of financial engineering, high leverage, or the idea that well-established rules of economics no longer apply.

Why it matters 

Such misconceptions can undermine strategic decision-making and slow down economies.

What you should do about it

Test decisions such as whether to undertake acquisitions, make divestitures, invest in projects, or increase executive compensation against four enduring principles of corporate finance. Doing so will often require managers to adopt new practices, such as justifying mergers on the basis of their impact on cash flows rather than on earnings per share, holding regular business exit reviews, focusing on enterprise-wide risks that may lurk within individual projects, and indexing executive compensation to the growth and market performance of peer companies.

It’s one thing for a CFO to understand the technical methods of valuation—and for members of the finance organization to apply them to help line managers monitor and improve company performance. But it’s still more powerful when CEOs, board members, and other nonfinancial executives internalize the principles of value creation. Doing so allows them to make independent, courageous, and even unpopular business decisions in the face of myths and misconceptions about what creates value.

When an organization’s senior leaders have a strong financial compass, it’s easier for them to resist the siren songs of financial engineering, excessive leverage, and the idea (common during boom times) that somehow the established rules of economics no longer apply. Misconceptions like these—which can lead companies to make value-destroying decisions and slow down entire economies—take hold with surprising and disturbing ease.

What we hope to do in this article is show how four principles, or cornerstones, can help senior executives and board members make some of their most important decisions. The four cornerstones are disarmingly simple:

1. The core-of-value principle establishes that value creation is a function of returns on capital and growth, while highlighting some important subtleties associated with applying these concepts.
2. The conservation-of-value principle says that it doesn’t matter how you slice the financial pie with financial engineering, share repurchases, or acquisitions; only improving cash flows will create value. 
3. The expectations treadmill principle explains how movements in a company’s share price reflect changes in the stock market’s expectations about performance, not just the company’s actual performance (in terms of growth and returns on invested capital). The higher those expectations, the better that company must perform just to keep up.
4. The best-owner principle states that no business has an inherent value in and of itself; it has a different value to different owners or potential owners—a value based on how they manage it and what strategy they pursue. 

Ignoring these cornerstones can lead to poor decisions that erode the value of companies. Consider what happened during the run-up to the financial crisis that began in 2007. Participants in the securitized-mortgage market all assumed that securitizing risky home loans made them more valuable because it reduced the risk of the assets. But this notion violates the conservation-of-value rule. Securitization did not increase the aggregated cash flows of the home loans, so no value was created,and the initial risks remained. Securitizing the assets simply enabled the risks to be passed on to other owners: some investors, somewhere, had to be holding them.

Obvious as this seems in hindsight, a great many smart people missed it at the time. And the same thing happens every day in executive suites and board rooms as managers and company directors evaluate acquisitions, divestitures, projects, and executive compensation. As we’ll see, the four cornerstones of finance provide a perennially stable frame of reference for managerial decisions like these.

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