Transcription
Welcome to the Create More Value podcast, sponsored by Fortuna Adviserss, the boutique shareholder value improvement advisory firm. Create More Value is a series of conversations with senior executives, board members, investors, and other experts that have overcome challenges to create exceptional value for their companies. There are many ways to drive value, so we cover a wide range of topics. I am the host, Greg Milano, founder and CEO of Fortuna Adviserss, and I hope you enjoy the conversation as much as I did. I would like to welcome Professor Aswath Damodaran. Thank you, Professor Damodaran, for joining me on our Fortuna Advisors podcast, Create More Value.
Thank you for having me. Aswath Damodaran is a distinguished professor of finance at New York University's Stern School of Business, where he's taught since 1986. I received my MBA from Stern right when it was named Stern, but was unable to schedule myself in Professor Damodaran's class. I later attended a three-hour seminar he did called "The Loose Ends in Valuation," which was outstanding and made me regret not ever having him as a teacher. He's renowned for his expertise in corporate finance, equity valuation, and investment management. He's become a significant figure in the field of finance education. Damodaran has authored over a dozen influential textbooks, including "Investment Valuation" and "The Damodaran on Valuation," which I happen to have a copy of right here, which are widely used in MBA programs globally. Throughout his career, he's been recognized for his outstanding teaching, receiving multiple awards, including the Stern School of Business's Excellence in Teaching Award and the NYU Distinguished Teaching Award. His courses in corporate finance and equity valuation are particularly popular among students, and he's known for his ability to simplify complex financial concepts. In addition to his teaching, Damodaran is an active researcher, publishing extensively in top finance journals and contributing to annual equity risk premium papers that are highly cited in both academia and industry. He runs a widely read blog that provides insights and analyses on valuation topics relevant to current market trends.
Moreover, his influence extends beyond academia, impacting practitioners on Wall Street and in corporate finance. Just the other day, I was working with a client, and they had done some international cost of capital work, and they cited your, you know, your work and your, your data that you published so nicely, uh, you know, liberally throughout. And I thought it was kind of interesting because I knew I was going to be speaking to you so soon after that. Uh, but your commitment to education and research has made, uh, made you a respected thought leader and a key figure in advancing the understanding of valuation and, and, and financial analysis, and I feel very fortunate to have you here today, uh, with me. So, turning to my first question. So, uh, we'll go back to, you know, sort of some, uh, questions about, you know, kind of how we got here. Uh, what inspired your initial interest in corporate finance and, and how has your perspective about the corporate finance field, uh, evolved over the years?
I'll be quite honest. I'm not that passionate about either valuation or corporate finance. My passion is teaching. I happen to teach corporate finance, and I happen to teach valuation. And I'll tell you what attracts me to those disciplines. To me, the, you know, since I teach both classes to the MBAs, the corporate finance to the first-year MBAs and valuation to the second year, I'm often asked the question, "What is the difference between your two classes?"
And my first reaction is, "There really isn't. It's the same material repackaged." But that's probably too facile an answer. To me, here's the difference between corporate finance and valuation. Corporate finance, you look at businesses from the inside out, from decision-makers, people who run the business. In valuation, you look at the same businesses from the outside in. And I'll be quite honest, it's my corporate finance class that's my passion. My valuation class is the class that comes out of corporate finance. What interests me in both those topics is the fact that they're not just about numbers. They're not just about stories. That connection of narrative and numbers that drives both corporate financial analysis and valuation. And thank God for that, because all it was numbers on a spreadsheet were one step away from ChatGPT replicating what we do. So, to me, what's interesting about both areas is you're looking at real businesses and saying, "What's the story about this business, and how does it play out in the numbers?"
Yeah, that's, that's great. I think that's that's a really good way of doing it. And I'm thinking about it, and I like the way you always weave the story in with the numbers. And, um, you know, having worked with many companies over the years, I find that to be lacking in some managements. Uh, they just rely on some spreadsheet, and, you know, if somebody had a 1% more revenue growth in their forecast, or 1% less revenue growth in their forecast, the numbers change, and nobody's really thinking through, you know, the sort of implications, um, and, and, and the story, and why it, why it makes sense.
I actually, one more point on this, which I think is relevant. I had a, a, a boss at one point in time who every time I did an analysis that showed a company, you know, was creating value, was earning returns meaningfully above its cost of capital, he would look at me and ask, "Why? Why do you think they are?" And, and I think that question, and not enough people ask that question. When I've watched videos of you talking about, you know, Uber and other companies over the years, you're always really emphasizing that story. So, I think that's a, a really good point.
What do you think of some of the... Go ahead. Sorry. In fact, you know, saying on that point, I mean, that's the Buffett contribution to value investing. The talk of moats and competitive advantages has to be part of your number crunching. You earn 30% more than your cost of capital, and you can't tell me why? I don't trust your numbers. Something is off here. So, it's got to be based on something real, something that drives his storyline.
Yeah, that's a really great way to put it. What do you think are, are some of the misconceptions either in corporates or in, in investors where people kind of get it wrong, uh, in terms of valuation and decision-making?
I think the biggest mistake they make is they think that making money is easy, that beating your cost of capital is simple. And one of the things I do at the start of every year to kind of bring people back down to earth is I do a very simple calculation. I, you know, at the start of every year, I do what, what I call my version of Moneyball, which is I take every publicly traded company, I download all of their financial statements, something you couldn't have done 40 years ago.
And then I play Moneyball. I compute the return on capital, and we'll, at some point in time in this, this session, we'll probably talk about it, which is a flawed, noisy way of measuring return. And then the cost of capital for every company, including where it's incorporated, what business it's in. Then I compare the return on capital to the cost of capital. And here's a statistic from 2024. During 2024, 30% of companies globally earn more than their cost of capital. 30%. 70% either barely made their cost of capital or earn below their cost of capital. In fact, half of all companies earn less than the cost of capital.
That statistic is pretty much what it's been for the last decade. And I didn't do it in the '80s and the '90s, but my guess, if you went back to the last century, it was a little easier then to beat your cost of capital, to generate value.
The world has become a much more difficult place for most businesses to create value. And we can talk about why that might be. But the first thing I tell managers is, this is hard work. There is no metric or magic to this.
Which actually is bad news for consultants who come with these, you know, packages, "If you do this, you're going to earn more than your cost of capital." No, it's not going to happen. It's really hard work. And if you do it, even if it's 1% more than your cost of capital, you're already a winner.
That's great. Yeah, I, I, I think that's a really good point of view. You mentioned in the, your start of that response, um, that you think that the, the measure, the typical measures of return on capital are, are kind of flawed. Um, what are your views on the, the typical return on capital and cost of capital types of analyses that people do?
Cost of capital is not the problem. I mean, I can tell you what the cost of capital is for a typical company within a percent, no matter where you are in the world. So much. And that's the first thing, the first thing you'll notice when people do these calculations is 90% of that time is spent spent computing cost of capital, the number that's easy to estimate, and 10% on what am I actually making on my projects? Right? And then what do we do? We take the operating income, we net out taxes, we divide by book value of equity plus book value of debt minus cash. We do a little finessing. I remember Stern Stewart claiming that they did 64 adjustments. But the way I describe it is, you take a turkey and you dress it up, it's still a turkey. It's tough to to hide that scrawny net. Return on invested capital has a fundamental flaw. Both the numerator and the denominator are accounting numbers. You think, "So what?" Everything accountants do and have done historically affects your return on invested capital. I give you a very simple example of a company that looks like it's earning more than the cost of capital, but it's a horrifically bad company. So, you have a company that takes bad project after bad project. The projects are so bad that even they know it's bad. So, what do they do? Every two or three years, they write off the project. Completely rational, right? Project doesn't work, you write off the capital, what does it do? It takes it out of your investment capital base. And if it's five years later, and I don't realize you've been doing it, and I divide your operating income by invested capital, you can look like a hero when in fact,
you're a company that was actually destroying value. Zero. So, the fact that both the numerator and the denominator are accounting numbers means you're exposed not just to accounting actions, but to accounting inconsistencies.
And God, do we have a lot of accounting inconsistency out there in the 21st century.
Yeah. Yeah, actually, let me skip ahead because that brings me to, um, uh, a very related question. In our analytical framework, we pride ourselves on, you know, being able to better track value creation in modern business models. And a lot of it's because we take some of the investments that are expensed and we treat them as investments. How do you think companies and their investors should view such investments? And I'm talking about R&D, brand building, marketing, and lots of other things like that, employee training. Uh, how do you think people should think about those investments to try and improve their analysis?
I think every investment that you're doing to create future growth is a capital expenditure. I don't care what accountants call it. And you've got to put it to the same test that you would as if you built a factory. Accounting as we know it was designed for the old-time manufacturing company. Return on invested capital works well as a measure for mature manufacturing companies as a portion of the entire market. We're now talking about 10% of all companies. For the rest of the companies, you're stretching the limits on what return on invested capital can do. Now, and even if accountants do the right thing, return on invested capital doesn't work for younger companies, for growth companies, because you have trouble actually scaling up on what you're actually doing today as a company.
So, I think when I look at companies, the first thing I ask is, "Where is this company in the life cycle?" Well, if it's a mature company, then I can get away computing a return on invested capital, finessing it, correcting it, and actually getting a sense of value creation. But if you're anywhere else in the life cycle, I can compute return on invested capital precisely, but it doesn't tell me much about whether you're creating value or not.
Yeah, I think that's a really good example. I mean, a high, a high multiple business that has a really bright future can live with a very low current return on capital and still be creating value. Uh, and as you say, a very mature company that maybe is on a glide path downward, trading at a low multiple, needs a very high return now to be creating value.
I mean, and in fact, you know, go back to capital budgeting 101.
You know, you look at a project, and you have all of the expected cash flows, you project them, you could be wrong, but you have expected cash flows.
We decide on whether to take projects either computing a net present value or an IRR.
The problem is IRR requires expectations of future cash flows. And with real companies, we don't have that. Return on invested capital is a cheat, right? It's a cheat. It's a cheat we use because we say we don't know what the projects look like. So, we're going to use return on invested capital. So, as long as people remember that when they use return on invested capital, they're not using the ultimate metric. They're using an approximation of the ultimate metric.
I think we'd be in much better shape because my concern with ROI, as that acronym has become this legend in consulting firms, is most consultants using ROI have absolutely no idea what they're playing with. No idea what its limitations are.
But the kinds of actions they take on its basis are staggering. I've seen businesses sell off divisions based on ROI. My reaction is, "What are you guys thinking?" ROI is a starting point for analysis. It cannot be an ending point. You need to think through what the rest of the business looks like. And if you can, you need to get as close as you can to that IRR idea that you started with, because that's essentially what your end game is.
Yeah, I agree. It's got to be the return over time, not, not the spot return. Um, that's a common error I see as well.
But it's ought to be cash. I mean, if you think about a good measure of return, return on invested capital fails every single test, right?
It uses earnings rather than cash flows.
Why? Because, you know, doing this for a company, you don't know what the cash flows from existing assets are.
It uses historical invested capital rather than an adjustment for whatever accounting write-offs and adjustments made rather than the actual amount invested in projects.
It doesn't factor in future cash flows and growth and the time value of money.
So, I use return on capital, but I recognize its limitations. And I think the more we recognize its limitations, the better in shape we're going to be, because we can then say, "This is the start of the analysis. My company looks like it's earning more than its cost of capital. But is it?" Because that's where the real analysis comes in.
Yeah. Yeah. If I go back to cost of capital, um, I agree with you that it's, uh, a lot easier to get your arms around the cost of capital than the proper return on capital. Um, but it does get complicated when you, um, are investing in other countries that are riskier and, and, uh, and so forth. And so, um, how do you think about the required return on investments that North American companies make in riskier countries like say, Argentina? And how do you factor in, like, things seem to be changing in Argentina right now? Um, you know, if you were to calculate a cost of capital using, you know, traditional metrics, it would seem pretty high, but some people would say, "But it's going to be heading down." So, do you factor that in, or do you wait for the indicators to actually change? You know, what is your thinking on how to, how to make that?
Right? I mean, the world is about the future, not about the past, right? Anytime you expect change to happen, those expectations have to be built in. It's not just the country risk that can change. You know, if you think tax rates can change, that's got to be brought in. Your cost of debt is going to change, that's got to be brought in. The cost of debt rate. I think part of the problem in analysis, there are two problems in the way I see companies approaching cost of capital. One is this legend or really a myth of a corporate hurdle rate, that's nonsense. There is no corporate hurdle rate. There are hurdle rates for investments. The problem with having a corporate hurdle rate is you think you have one discount rate, you can carry across businesses, which is nonsense.
So, there is no corporate hurdle rate. It's investment-specific and should reflect the risk of the investment. The second is people seem to think they have one shot at estimating the cost of capital, and then once they have it, they're stuck with it.
Costs of capital are your specific. I have never done a valuation where my cost of capital stays the same over time. You value a young growth company, and you make it into this mature company over the next 10 years. How in God's name can your cost of capital that you started with stay the same in year 10? So, if you open the door to the fact that cost of capital is your specific, then you allow yourself to do things like, "Hey, I'm investing in Argentina. I think the risk in Argentina is going to decrease," and I'm going to bring that into my analysis as a decreasing country risk premium. It allows you to do that on every single input because it's not just country risk that's shifting. Your beta might be shifting, your tax rates might be shifting, your debt ratios might be shifting, your cost of debt might be shifting. I try to steer away from macro views when I do cost of capital. What I mean by that is I try not to adjust my risk-free rate over time, no matter how strongly I feel interest rates can go up or down, because then you bring an interest rate view into your capital budgeting, which might be at odds with what your investors, whose money you're investing, might think about the future. I try to be macro neutral, but I try to bring in whatever changes are consistent with what I'm doing with my cash flows.
So, um, one of the questions that we, uh, get asked a lot, and I'd be really curious of your answer on this, what aspects of risk do you factor in the cost of capital, and what aspects of risk do you factor into your forecast, you know, the cash flow forecast, and, and, you know, or, or a, a set of cash flow forecasts, because sometimes you'll do a high, medium, low, or even get more sophisticated. But what, what kinds of things do you factor into the cash flows, and what kinds of things do you factor into the cost of capital?
Greg, I'm going to put this question back to you. When you say risk factored into your cash flows, what exactly are we talking about?
Okay, let's say that there are risks associated with counterparty risk. There are risks associated with, um, quality problems in a factory. There are risks associated with technology.
Let me back up. So, so you're bringing to expectations things that might happen, that your supplier might go bankrupt, and that's what you're supposed to do with cash flows. That's not adjusting for risk. That's an expected cash flow.
So, when people talk about risk-adjusting cash flows, I'm afraid they have no idea what they're talking about. That's basic expected cash flow. Risk-adjusting the cash flow is much messier. I tell people, um, to watch the Howie Mandel show, "Let's Make a Deal."
Now, in that show, if you've never seen it, you have two suitcases. One has nothing, and one has a million dollars. And this is the way the show works. Howie Mandel offers a contestant a fixed amount of money to walk away from the gamble.
Now, if you think in pure risk-neutral terms, the expected value is $500,000. We watch the show, people walk away with $350,000, $400,000 guaranteed. They say, "Okay, I'm walking away." That's a certainty equivalent cash flow. In finance, we, but that's basically a simple way of thinking about saying, if I replace your expected cash flow with a guaranteed amount, how much would that money be?
If you truly want to risk-adjust cash flows, you'll have to pay, "Let's Make a Deal" with every single expected cash flow. I have never in my lifetime seen an analysis that adjusts cash flows for risk and actually means what it says. Usually, when people talk about adjusting cash flows for risk, they say, "Oh, could I bring in the scenario that my my company might be nationalized 10% of the time?" Of course, you should.
That's what you're always supposed to do. That's not risk-adjusting your cash flows. It is basically coming up with an expected cash flow. So, I think when people talk about risk-adjusting cash flows, they need to stop and ask, "What exactly am I talking about?" Because most of the time, they're not risk-adjusting the cash flows. They're just saying, "Should my expected cash flows be more realistic?" And the answer is, absolutely.
Yeah, that's really good because I think, and that's, I think one of the biggest problems that I see, because I think people do a forecast of what they'd like to see happen, and they don't factor in, you know, any probability of things going wrong.
Exactly. Yeah. And that's, I think, a problem with your expectation. You have an expectation problem. In fact, one of the things I think I don't think companies do enough is when they do capital budgeting, they make all these great forecasts, they come up with a positive, and I mean, no company ever takes a project saying it's a negative net present value project. I'm going to take it anyway. They find a way to make the, then it gets filed away, and nobody ever looks
at those projections.
My question is, why not?
Why aren't you looking at the actual cash flows? Because if your expectations are being set in a non-biased way, here's what I should expect to see. You took a hundred projects over the last 20 years. In roughly 50 of the projects, the actual cash flow should have come in above expectations. In 50, they should have come in below expectations. But if, in your case, 98% of the time you're coming in below expectations, you have a problem with the way you're setting estimates, and you need to learn. I think, you know, it's, it's, the key to overcoming behavioral issues and bias is to be honest with yourself. And companies, I'm afraid, don't want to be. And, you know, the biggest project most companies take is an acquisition.
And there, I can almost guarantee you, 99% of the time, the expected cash flows are higher than the actual cash flows. We know bias is part of the, it, it's embedded into that process. And here's tangible evidence of how much so.
Yeah, I mean, I'm laughing because back in the '90s, I worked with Vulcan Materials, and the chairman and CEO at the time was a guy named Herb Kelleher. And I was talking to Herb when I first met him, and he said, he said, "I keep approving 20, 25, 30% return on investments, and as a company, we keep earning 10%." And it was, you know, this is what you're saying. I'm glad you brought that up because, you know, I wrote a piece on alternative investing about six months ago, and a big part of alternative investing is hedge funds and venture capital investment. And the legend is that they earn much, much higher returns than the rest of us. And, you know, what is the legend based on? Right? The target rates they post on their side. We acquire 50% invest in startups. You know, the actual returns of PE and VC funds are very, very similar to what public equity investors get, 12%, 14%. Many a slip between the cup and the lip, right? So, where is this gap between the 50% you're putting out there and the 14% you're earning? It's, I think the difference between what you show your clients as a target IRR and what you can actually deliver. And I think you can extrapolate from that into much of what companies see in their forecast, and then looking at what they actually can deliver.
That's interesting. I'd like to see that. I haven't, I didn't notice that. Um, so you're, in addition to all your great, you know, sort of, uh, thoughtful insights that you've shared with the world since you, since you began, uh, on this journey, you've been very highly renowned, um, for your teaching ability. Uh, and you mentioned before that's really how you view yourself as a teacher first. Our clients are constantly worried about educating, especially non-financial managers. If you're trying to take a more, you know, sort of value-based discipline into a company to get people throughout the company making better decisions, you can't just train the finance people. You have to have the non-financial people at least understand the basics of what's going on. Uh, how do you approach the challenge of teaching complex financial concepts to diverse audiences? How do you, how do you get through to them? How, how do you, how do you make it real?
I think the first thing I tell them is, no company has ever become great through its finance department. The finance department is support. You can compute cost of capital, you can do the return on invested capital, but the real value creation is on the ground, in the factories, if you're a manufacturing company, in the R&D, if you're a technology company, in the marketing, if you're a brand name company.
So, the first thing is taking your finance group through a training program and teaching them how to compute cost of capital, return on invested capital, is not going to create value. That's like treating a mechanic, you know, to teaching a mechanic how to read all the dials, and the car itself is 30 years old and falling apart. It's not going to fix the car. So, I think the, you're right. The first part is this has got to be company-wide, and it's not going to come from the number crunching. The number crunching can keep you on task, can keep, can create discipline, but real value creation requires imagination, requires being creative. And I hate to add this to the mix because it's going to undercut everything we teach in business, it's got to come from luck. So, if you're a superstitious person and you pray before you take every project, keep doing it, because 80% of success in business and investing has nothing to do with whether you did things right. It's you got being in the right place at the right time.
Which also should also make us all much more humble about success. I think one of the reasons companies get into trouble is they, they end up, you know, missing Wall Street's old adage of, "Don't mistake dumb luck for skill." Companies get lucky with a project, they think they're skillful, then they throw tens of billions of dollars into the same business and say, "Why isn't it working?" Because you got lucky that first time around. You weren't skillful.
So, I think companies need training, but the mechanics are pretty simple. I tell people, look, you give me 10 bright people. I don't care whether they're marketing people, finance people, production people. I can teach them enough finance.
But the real work of value creation is out there. You've got to give them, and unfortunately, many companies, finance becomes this, this structure to keep creative people from being creative. And I can understand, you know, you, because some creative people just go off the tracks. But I, I'd much rather take your 100 most creative people and teach them enough finance to be disciplined than take your 100 finance people and try to teach them to be creative, because that's almost an impossible task, cuz they've spent a lifetime kind of putting their imagination into shackles and not letting it out.
So, I think we need to first bring down the level of fear about finance. And this is finance. We can add, subtract, multiply, or divide. You can do finance at the core. Finance is simple. I tell people, 12 hours, I can teach you all the finance. Everything else is icing on the cake. Right? So, you don't understand beta is not a big deal. You can be a perfectly good business person and practice finance without understanding the cap. Modern portfolio theory is a load of common sense and a basic structure of thinking about businesses.
So, I think that first, I think companies think that training is going to make mistakes go away. But as I said, bias is the much bigger problem in finance.
And I think they need to look at the processes they use to pick projects and to follow them a lot more to see where is the bias coming from. You know where it usually comes from? How you reward and remunerate people.
If you got a system where you reward people for taking projects, they're going to take projects. You have a system where you reward people for growing, they're going to grow companies, right? I mean, it's, it's human nature.
So, I think that rather than focus on thinking of training as a solution to problems, they have to start thinking about, "What is it that we do in the process that's allowing bad investments to get through, or good investments to not be taken?"
Now that you brought up incentives, I didn't have this on my list, but I want to ask you, um, about a certain type of an incentive plan. Um, so my background was with Stern Stewart, with the EVA company, before I started my own company, and I've worked with economic profit for over three decades now with companies. Um, and one of the things I like about it is using it in incentives, because when people know they're going to be charged for capital, and, you know, we capitalize R&D and so forth, so it's, it's really all investment. Um, and, and we don't measure against the budget, but we always measure against last year. So, if the measure goes up, you get paid more. If it goes down, you get paid less. We get a couple of dynamics that are pretty interesting. One is that bias toward the lofty forecasts. I mean, we can't eliminate all biases. I'm not trying to claim that we do, but we get people to be a little more realistic because they know that they're going to get charged a capital charge, and if they don't cover that cost of capital, they're going to make less money. And by always measuring against last year, they know the deal for year two, three, and four. I mean, I've sat in a room with an executive team when they've said, "Look, if we do this, we're going to make about half the bonus this year, but if we're right about our forecast, we're going to make three times that back over the next two years. Are we willing to put our own money on the line, you know, like an investor?" And I found that that leads to really, you know, good behavior. Uh, I'm curious, just what your thoughts are on that. You know, do you think that, uh, makes sense to you? Do you have concerns about it? What, what is your view?
Yeah, in principle, I agree with you. Your compensation should be tied to value creation. But let's go back to the core choice you face.
Until Stern Stewart and others came along, you tied it to market price, implicitly said the market's judgment about value creation is basically what we're going to do. Now, Stern Stewart's pushback was, markets essentially, the implicit assumption is, markets can sometimes be wrong. So, let's focus on EVA or return on capital minus cost of capital.
I, I hate to say this, but after 40 years of seeing that play out, I'm not a great believer in tying it because it gets gamed. It gets gamed in spades. Stern Stewart did more damage to value creation than help by creating EVA. EVA, after all, is a, is a, is a very simple, it's basic corporate finance. But when you make it the center of your compensation mechanism, the gaming is going to begin. The gaming is not so much on the cost of capital, it's on the return on capital side. And God, was it gamed? You lease things rather than buying them, and you say, "I'm going to fix that." The problem with trying to fix gaming is every fix you make is going to create further gaming. So, after 40 years of trying this, I've come to the conclusion that it's better just to tie this to market price and let this play out, because markets, in spite of all of their mistakes, are far better than any single metric that I've seen out there in measuring value creation.
No. And I, you know, it's, it's, I think part of the problem is the way we measure value creation is so noisy. The standard error is so large, that it creates the gaming problem that we just talked about.
I respect your opinion. I have a very different opinion. So, I just, uh, wanted to establish that, uh, but I don't want to get into a debate about it. Now, the, um, the one thing I will say is that for, for a public company, at the top of the house, I agree completely. The lion's share of their compensation should be tied to share price performance, not anything internal. They'll need some internal measures just to make sure people are hitting their milestones and making progress, but the lion's share of their economic opportunity should come from actual changes in market value. I completely agree with that. Uh, I think as you go down into a company and you have, you know, eight or 10 business units of a company that are, you know, really run like separate businesses, you need some way of rewarding them. Uh, I know Thermal Electron years ago had, um, uh, shares, partially listed some of their subsidiaries, so they all had a public market price. That's great. That trend never really took off. But without that, you need some measure to go by in those businesses, because if you only reward based on the top of the house, those 10 business unit leaders, you know, it's a problem of the commons now, right? Uh, that you wind up with. So, you need something in there. So, it's imperfect. It's, I'll agree with you, but I think it's better than paying them based on EBITDA versus budget or a lot of the other EPS, a lot of the common practices that are out there.
Yeah. I mean, and I think we overestimate the role that management has in success. I mean, I'm, I'm sorry to say this, but in most companies, ChatGPT could run these companies and the divisions. Having people in there actually creates a more negative consequence than having so much as we attribute success to management and failure to management not doing its job.
You know, the reality is so much of what you see in business is out of the control of management. In an oil company, what the heck are we doing rewarding and punishing management on EVA or any other measure returns? 96% of the revenue growth at Royal Dutch over the last 40 years can be explained just by oil price every year.
I don't even care who runs Royal Dutch. To be, it's an oil, it's a pure oil play. So, I know it's a cynical view of management, but I think management matters less and less as you go into the mature phase. The one thing management can do when you're a mature company is it can do damage. Does the, it becomes a very asymmetric game. I want to put in restraints on you doing damage rather than reward you for trying to do good, because the more you try, the more my pocketbook feels it as a shareholder, right? Because how do you try? If you're a mature company, you try to do acquisitions, you try to enter in, stop trying so hard. This is like a 70-year-old saying, "I'm going to run 20 marathons next year." You're going to drop dead if you do. So, one of the reasons I wrote that book, "Corporate Life Cycle," is I'm sick and tired of mature and declining companies trying to reclaim their youth.
And unfortunately, it's a sweet spot for consultants, right? Those are the companies that call in the McKinseys of the world, say, "How can I be young again?" And McKinsey obliges, says, "Look, you do these seven things, you're going to be young again." They do the seven things. Guess what? Gravity works its magic, and the facelift drops again. You have to do this over and over again. I think companies try too hard. There are times when you have to say, "Our best days are behind us, and maybe our future is going to be a much more modest one." But no management ever wants to do that, cuz that seems like you're giving up. I think we need, and I, and I blame business schools for this, because we make the CEOs of growing companies into superstars. Hey, heck, it's not just business schools. You know, Hollywood makes movies about those CEOs, right? You know, what was the last movie you saw about a CEO made his company smaller? No, but we, you know, we celebrate the Steve Jobs of the world and the Ray Crocs of the world because they took small business, made them big empire builders.
And by doing so, we create a system where a CEO comes into a company, their mindset is, "I have to be the next Steve Jobs. I have to turn this company around," rather than saying, "Hey, this is a company producing a product that fewer and fewer people need. It's still a cash cow."
Maybe look to the tobacco companies to recognize what a best way to manage a company in decline is. Don't try too hard. You've got a product that people still buy. You make great cash flows. Your margins are 50% plus. You're managing other people's money. You don't have to rescue this company for them to make money. And unfortunately, that's a tough sell to management because their mindset is, "I've got to rescue this company and make it a growth company again." Lots of my viewers are executives, so I'm going to feel obliged to push back on that a little bit with a, with a query. Um, so let me give, let me take an industry you just mentioned, um, oil and gas. Um, in this country, oil and gas, if you went back 20 years, was very much, um, you know, performing poorly, and we got a significant amount of our petroleum product from overseas. Through research and development, geological research and development, and, uh, you know, mechanical ingenuity and so forth, they developed the shale boom, which has created us a much more independent energy future, you know, for our country as a result of this. You know, I agree with you that the revenue of those companies, you know, most of the movement period to period, especially, is driven by commodity prices, but underlying that, there's a, there can be a volatile trend that's heading up, or there can be a volatile trend that's heading down. And in that industry, you know, on average, there have been some fantastic disasters. I'm not, not denying that. But on average, you know, they've managed to find more ways to create value than I ever would have thought. I mean, I've worked with energy companies for for decades. Um, the having management being clever and trying to pursue, um, good outcomes has led to, you know, an enhanced situation for society, at least I believe so. Um, if we only had ChatGPT doing it, they would have just, they would have done a better job at running the status quo, but there wouldn't have been the innovation, uh, that has led to the, the sort of value creation and the economic impact. So, what, what do you think about that?
Greg, let me do a pushback on your pushback. I agree. Shale oil has changed the dimension of the, how much of that shale oil disruption came from established oil companies? I mean, I would take a look at that, because from my experience looking at the oil business, much of that disruption came from startups that basically did this. And remember, you had, when you did this, the pushback you got from environmentalists was such that an ExxonMobil or a Royal Dutch would never have been able to do it. And this actually feeds into my point. The boom in oil that you see now, that now Royal Dutch and Exxon might be benefiting from, didn't come from those companies doing it. It came from startups and young companies. And once that process got established, it's allowed another stream of revenues for the existing oil companies. So, have they benefited? Absolutely. So, change did not come from great management at oil companies. It came from entrepreneurs entering this business saying, "There's other ways to get the oil out. And let's see how much oil." So, I think the business has changed. And sometimes change comes, but, you know, the Clayton Christensen adage of disruption, when it comes, almost always comes from the newcomers.
Reflects the fact that if you're a status quo, you have too much to lose to mess with disruption. So, I, you know, I, I would love to attribute this to amazing management at oil companies, but I, I'm not willing to make that concession because that's not what I see as the history of change. And you can take, you know, you can take the same thing with, you know, chips, you know, computer chips.
Much of the revolution has come from Nvidia and AMD, not from the old chip players, right?
So, you go back and look at the top 10 chip makers, and you look at where does change come from. It almost always comes from younger companies in the life cycle. And, you know, and I think that's that's healthy. I mean, Joseph Schumpeter described, you know, capitalism as creative destruction. Key word here is destruction. Mature companies need to fade away sometimes for young companies. I mean, Europe is full of what happens when you let mature companies continue to run economies, right?
You've got 90-year-olds essentially staggering around, unable to have any energy and space to come up with new products, because you've conceded the space to them. So, if you're a manager of a mature company, of course you want to hold on. You want to be, go back to being. I entirely understand the psychology behind your thinking.
But history is not kind to companies that keep trying to grow. There's a time, the old Kenny Loggins, I'm sorry, Kenny Rogers song. "There's a time to hold them and a time to fold them." And businesses need to know when it's time to fold them and move on. And I think that's really tough for management to do, because it's their, especially if they've grown with the company. They've been with the company 50 years. How do you walk away?
AMD, though, is a good example of a company that had lost to Intel, basically, and then remade itself.
I mean, if they had followed your prescription, they would have just faded on.
And, and I can give you examples of, you know, Apple dead in the water in 2000, reincarnated itself. Microsoft, boring mature business in 2014, made itself.
Reincarnations. And this is the place where corporate life cycles vary from human life cycles. Is there are examples of companies that find a way to not just rediscover growth, but go back to being young companies. You know what happens to them? They become case studies at Harvard.
MBAs are taught those case studies. And what do they do? They go out and they try to create the next Microsoft. And I would love to see how many companies have tried that. I mean, business is about odds, right?
Are there odds you could be the next Microsoft? Yeah. But if the odds are 10%, then do I want you trying to do that? I mean, look at Marissa Mayer. She came to Yahoo. What did she want to be? She wanted to make Yahoo into the next Apple. Be the next Steve Jobs.
$5 million later, she said she didn't work, and Yahoo went into cold storage as a company, and Marissa Mayer moved on.
I'm afraid we're rewarding CEOs of mature and declining companies to go to the casino.
Mhm.
Of growth, put shareholder money on long odds, and if it pays off, they're the next heroes. And if it doesn't, they say, "Look, I was trying. This is not a good system. Money is going to get burnt through in the process. I mean, you take brick and mortar retail. Think of how many companies would have been better off shutting their doors 10 years ago, 15 years ago rather than trying and J C Penney, Bed Bath and Beyond. How many CEOs did they cycle through? Each one claiming to find the next know the next growth phase for the company, when anybody with any common sense who walked into a Bed Bath and Beyond would have said this is a dying concept you can't recoup it so I think sometimes acceptance, you know, the the five stages of grief, you know, you keep denying that you're a mature business or a declining business.
Mhm.
And you're denying it with other people's money, your shareholders money, only bad things can end up happening at the business.
So these examples we just talked about are akin to, you know, I could occasionally flip a coin 10 times and get heads 10 times in a row.
It's lightning in a bottle. I mean, I think we attribute it to great management. Steve Jobs, amazing manager. Satin Nadella, may I think they're great managers, but we don't quite compute the fact that even if you replicated everything they did at another company, it's not going to pay off cuz that luck component being at the right place at the right time.
Happened to work out in their favor.
In 2000 for Apple, in 2014, 15.
For Satin Nadella, that's tough to recapture.
Yeah, somebody once said to me, this is more like poker than it is like chess, right? Right? In chess, the more skilled player wins 98% of the time.
It's poker with other people's money. That's what makes it scary. Right? You're the CEO of a publicly traded company. You're paying poker with other people's money. It's, you know, every psychological finding on, you know, house money and found money come into play. So, how you play the game.
And that's, you know, that's a good way to actually think about what happens in mature companies. You're gambling on growth and you're gambling with other people's money.
I have one last question. Um, we went off on that topic for a bit, so I'm going to skip some of my less important questions, but this, I think I I'd be remiss if I didn't go down this uh this one last question. How is the the AI evolution that's happening or revolution that's happening right now similar and how is it different from the technology surge we had around the turn of the century? Um, what do you think is different?
Yeah, I think there are two big differences. One is much more capital intensive.
Than the techn than the dot boom. I mean, you the internet and service, but the amount of money needed for capital investments was much smaller than the capital investments you're seeing with AI.
The second difference is the companies making those capital investments in the dotcom boom were often companies which were money losing companies, some at debt. The companies making those investments today are often cash-rich big tech companies with huge positive cash flows in existing businesses.
Mhm.
Which I think makes me a little more upbeat about what'll happen when the correction hits. When the dot boom bust, the companies that had invested didn't have the capacity to survive.
Right?
This AI boom corrects, the tech companies have the buffer. Their shareholders are going to feel the pain. As a shareholder in five of the seven, it terrifies me how much money these companies are investing. But you know what? They could write off. I mean, my take MetaF Facebook. They just wrote off 72 billion of the metaverse fiasco that they had from a decade ago.
Mhm.
Nobody even noticed. They make so much money. They have such solid free cash flows that these companies can write off tens of billions of dollars. So I think it's more capital intensive than it was, which is more money being invested. But at the same time, the companies making those investments tend to be financially more capable of taking the hit than they used to be. There's a subset of AI though where companies are borrowing money to build data centers. That's a dangerous space. I would not want to be there because when the correction hits, you're going to be much more exposed.
So you're betting on the AI space. Steer away from AI companies because much of the, you know, what you're investing in now is the AI architecture companies, the chip companies, the data centers, the power companies.
Stay away from those companies that have significant amounts of debt because those companies are going to be much more exposed from the correction hits.
Interesting. That's an interesting assessment. Anything else that you'd like to cover before we uh before we wrap up?
Not really. I mean, it's, you know, I think, you know, value creation is something at the core of my thinking going back in corporate finance and valuation, having looked at it, you know, I I think it's really difficult to create value in the world we live in as disruption and competition and globalization have all come into play.
And I think that no, we shouldn't be greedy.
So if you have companies which have these, and I've never understood companies that use hurdle rates of 15 or 20%. Come on guys, come back to the real world. We live in a world where the market is pricing you to earn an 8% cost of capital. Just try to deliver a 9% return on capital. Cuz when you set these unrealistic hurdle rates, we know exactly what's going to happen. It's not like you're going to take fewer projects, but people internally are going to pump up the numbers to beat your 15% hurdle rate.
Mhm. Mhm.
They're making up revenue numbers. They're making up margin numbers because they've decided already they want to build this factory or take this project. So my advice to companies is be realistic. Live, I mean, operate in the world you're in, not the world you wished you were in.
Mhm.
Or the world you used to be in. And I think if you do that, I think there's a much better shot you can actually create value.
That's really great. I um, really appreciate you joining me. We've been speaking with Professor Aswalt Motor and thank you Professor for joining me. This has been a great conversation.
Thank you, Greg.
You have been listening to Create More Value sponsored by Fortuna Adviserss and I am your host Greg Milano, founder and CEO of Fortuna Adviserss. I hope you have enjoyed this episode. Fortuna Advisers helps companies with strategy, capital deployment, business management, corporate culture, and incentive compensation. All aimed at driving top quartile total shareholder return and the equivalent for private companies. To learn more, contact us at info@fortuna-advisors.com.