The Drivers of Value - McKinsey’s insights (the full overview)

1️⃣ Value of a Company is a Function of Two Metrics

If you have two fast-growing companies, let's say they're growing at the same rate, but one of them has a higher return on capital, it won’t have to invest as much in order to achieve that revenue growth and that profit growth. As a result, it'll generate more cash flows and it should be worth a lot more.

That is why, for example, some slow-growing companies like consumer packaged goods companies have fairly high valuations, not because they're growing fast but because they have high returns on capital

2️⃣ The Market Will Figure It All Out

Over the long run, you’d expect markets to reflect a company’s intrinsic shareholder value creation, while short-term moves are predicated on noise and/or a company’s quarterly optimization toolkit.

Choices of accounting methods, in the end, all flesh out in terms of eventually translating into cash flows. Don’t focus on the short-term share price, although for the most part, we find that the real short-term share price does reflect the economics of the company.

3️⃣ Meeting Short-Term Consensus vs. Striving for Maximum Long-Term Value Creation

There are a lot of companies out there that will do whatever they can to meet the consensus. And when we asked investors about this, they said, “We don’t want companies taking artificial actions at the end of a period just to hit their numbers if it’s going to be a negative in the longer term. We don’t want companies cutting prices at the end of the quarter to sell something additional.

4️⃣ Business Unit Analysis

The other thing that’s important when it comes to return on capital is not to look at it just, especially for a larger company, not to just look at it at the enterprise level. That really doesn’t tell you anything. It’s also very important to dive down into the units.

5️⃣ Using EBITDA: In-House Production versus Outsourcing

Different companies have different asset profiles. For instance, if one company outsources its manufacturing while another does it in-house, the in-house manufacturer will have more depreciation on its books. If you ignore depreciation, you miss those differences in asset intensity. Yet they’re really using the same amount of equipment and factories; it’s just under someone else’s name. Similarly, we consider taxes because companies operating in different countries can have very different tax rates. That’s why we prefer enterprise value over NOPAT.

For us as outsiders, the main difficulty in investing in public companies compared to managing private companies is that we’re not in control of the situation. Companies do report their earnings from time to time but there’s a time lag. All shareholders have different expectations, profiles, and time horizons. It’s also a challenge for us writing a newsletter. We’re sharing our own subjective perspective on companies and long-term return expectations, and we’re very confident about our portfolio’s prospects but we don’t know whether our readers will be equally patient ;-) We’ve been bluntly transparent about the non-linearity of stock returns, irrespective of the near- to mid-term fundamental performance.

For example, a miss on a given quarter’s earnings might be viewed as positive (investing for future growth as those expenses aren’t being capitalized on the balance sheet), negative (oh, something’s happened on the demand side), or neutral (a shift in deliveries/project timing coming next quarter, thereby neutralizing the recent quarter’s shortfall on earnings).

Over time, value’s driven by the key factors identified by McKinsey’s book on valuation:

The core ideas in the book are the same as they were 35 years ago when it first came out. We still value companies based on discounted cash flows. And the drivers of discounted cash flows, and this is what’s most important, are return on capital and growth. Those ideas are timeless, foundational, whatever you want to call them. And they predate the book by a long time. I think we just did a good job of articulating that.