Fueled by the Dot Com boom, billions of dollars were invested in constructing and lighting fiber networks in the late 1990s.   Valuations soared, and those who timed their exits right became multi-millionaires.   Those who didn’t exit by the early 2000s saw their fortunes evaporate.

Like all massive corrections, the telecom meltdown was fueled by truisms.   The Internet would change everything, and it did.  Bandwidth would grow rapidly for as far as the eye could see, and it has.  Fiber would be the workhorse of the Internet, and it is.  These trends are as powerful today as they were speculated to be in the 1990s.  Moreover, they will be prominent a decade from now, and the decade thereafter.   The telecom boom was built on a rock solid foundation.

Only partially true was the notion that the meltdown was caused by the overbuilding of fiber and capacity.   The majority of fiber in use today was constructed after 2002.  Without doubt, > 95% of the capacity in use today was created long after the end of the telecom boom.  Looking forward, more fiber will be built in the next ten years than exists today, and 95% of the capacity in use ten years hence has not yet been created.

So what went wrong?   What caused the meltdown?

First, during the telecom boom, too many fiber companies were created.  In their rush to build network, they focused on the most obvious geographies to build fiber.  They built networks in NYC, in Chicago, in the Washington D.C. market, in Dallas, and in the big California cities.  They connected to the same dozens of buildings in these markets, and they connected up the major markets along similar routes.   In many cases, they traded fiber strands with one another – or leased fiber on a competitor’s network.

Second, these companies rushed to light their networks, creating a glut of finished capacity relative to the embryonic size of the circa 2000 Internet.  Too many competitors combined with too much finished capacity created a blood bath.

Third, over-exuberant investors and inexperienced management teams added fuel to the fire.   Instead of acknowledging the situation, they hid behind story telling, fiber swaps, accounting gimmicks, and acquisition dust clouds.  They looked to buy themselves time, hoping to find an opportunity to exit prior to the boom turning to a bust.   They denied fault and instead blamed their competitors.

For fiber-based providers of bandwidth, the meltdown ended in mid 2005.   Since the mid 2000s, nearly all Bandwidth Infrastructure companies have done very well for their investors.   Revenues grew at double-digit rates.  EBITDA grew even faster, with many producers of bandwidth generating EBITDA margins in the 50-60%+ range.   Most generated free cash flow.

Slowly, the “too many suppliers” problem corrected itself. Today, roughly one of twenty companies remains in business, and only a handful of companies exist with substantial size and scope.  Consolidation will continue–as it does, balance will emerge between those who supply and those who consume bandwidth.

Despite these fact-based observations, a fundamental question lingers.   Is the owning of fiber network, and the production of bandwidth, a path to creating equity value?

The naysayers need only to point to Level 3 Communications.   Level 3 owns the most fiber, across the broadest of geographies, and with the fullest range of service offerings.   It led the consolidation of the industry by purchasing dozens of fiber providers.  Yet, its financial results remain disappointing.   Organic revenue growth is underwhelming and EBITDA margins are in the mid 20%s.  Its stock price remains low.

The dearth of other public companies puts additional weight on Level 3’s results. TW Telecom and Cogent perform well, as did Abovenet when it was a public company.  However, XO Communications (now private) and Global Crossing (acquired by Level 3) performed poorly.   All cite the challenges on pricing pressures, difficulty in growth, and capital intensity.  The development of value added services and the expansion to new geographies are positioned as necessary to preserve revenue and margin, instead of as an opportunity for incremental value creation.  With the exception of Cogent, all are (or were) opaque on their operational financial metrics.

Adding to the murkiness is the impact of traditional telecom companies (Verizon, ATT, Centurylink) and CATV companies (Comcast, Cox, TW Cable).  Will these companies hurt Bandwidth Producers in their quest to develop profitable business models?

Intuitively, powerful trends suggest bandwidth production should be a great way to make money.  Bandwidth demand is growing by 40-50% a year, and this will continue for as far as the eye can see.   Fiber is the critical resource needed to produce bandwidth, and industry consolidation is leading to a favorable balance between those who need and those who produce bandwidth.  New entrant barriers are gigantic, ensuring improving environment will not be disrupted.  Yet, if owning fiber networks and producing bandwidth leads to equity value creation, why aren’t we seeing empirical proof of it? 

The positive results of TW Telecom, Cogent, and Abovenet (when public) are positive signals that bandwidth production might be on a path toward being a lucrative business.   Their business models vary, and their messaging about the state-of-the-industry, raises questions.  Nonetheless, their financial performance in recent years has been strong.  All have seen 8 – 12% revenue growth, achieved EBITDA margins of 35 – 45%, and generated free cash flow.

Perhaps more promising is the valuations credited to private companies that focus primarily on bandwidth production.   Fibertech was purchased by Court Square in late 2010 for 12X LQA.   Abovenet was purchased by Zayo Group, with backing of new investor GTCR, at 9.5X LQA.   Lightower buyout by Berkshire at 12X LQA was announced in early 2013.  Highly respected Private Equity firms facilitated these three transactions.    The healthy multiples suggest a consensus view that owning fiber networks and producing bandwidth will lead to equity value creation.

The ultimate answer to the question seems obvious.  With robust bandwidth demand curve, increasingly healthy industry structure, and high barrier to entry, Bandwidth Production will prove to be lucrative.   However, the path toward this answer is likely to be bouncy.  Not all of the potholes have yet been avoided.

Strategies still need to be sorted out.   Multiple strategies will prove to be effective, but not all strategies.  Some strategies will lead to poor outcomes for investors.

Execution Matters.  Though bandwidth producers have strong tailwinds behind them, they also face execution challenges.  With bandwidth growing at 40-50% annually, the business environment is in a constant state of flux.  Technologies change.  Pricing is fluid.  Integrations are hard.  Industry consolidation creates murkiness.   Processes and systems are complex.

Poor Track Record in Creating Value.  Telecom management teams have a poor track record in creating value for their investors.   Perhaps circumstances dictated this outcome.  Perhaps weaker management teams have been weeded out.   Nonetheless, the fact remains that most telecom management teams do not have a sustained history of running large fiber businesses in a way that creates value for their equity investors.   Until proven otherwise, investors will remain susceptible to unproven management teams.

Effects of Remaining Consolidation.   Most of the consolidation has already occurred.  However, the remaining steps will be the most profound.  The long term industry structure will undoubtedly benefit, but some investors might not fare well along the way.

New Fiber Construction Projects / Entrants will Face Steep Hurdles.   The past five years have proven to be lucrative to many owners of fiber networks.   Some investors will over-react to these successful outcomes and, in hopes of achieving similar results, will make poor investment decisions.   They may overlook the cost of developing new fiber networks, and the difficult inherent in competing against focused competitors with established business models and deep customer relationships.

In the 1950s, Oil Production must have been a lucrative business.   Imagine a conversation that might have taken place between two savvy investors in the space.

“We certainly are fortunate to be in the Oil industry during its heyday,” says one magnate as they sip cognac at their country club.

“Ah Yes.  We are lucky to have been in the right place at the right time,” agrees his colleague, as he puffs his Cuban cigar.

The first ponders out loud: “The question is ‘how long do you think this Oil Boom can last?’.   Should we sell now before this Oil trend subsides?”

Fiber, like oil, is a scarce resource that will be relevant for multiple generations.  Bandwidth production, like oil refinement, will be a lucrative industry for many decades to come.   The telecom boom and meltdown was the first chapter of a long novel, one that will be played out over 100 years.   Though the remaining chapters will be less dynamic, many fortunes will be made and lost in the coming years.


Introduction

Management’s job is to create equity value for the owners of the business at a pace that exceeds the owners’ cost of capital.   Though the goal is clear and crisp, the measurement is evasive.   Nonetheless, if creating equity value is the goal, the ability to measure equity value creation is paramount.   When management discusses the company’s performance with its board, the equity value calculation should be the focal point of the dialogue.

Equity Value Created

The equation for calculating how much equity value is created in a given period is:

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The equation is applicable for companies that are in an industry where using an EBITDA Multiple is an acceptable approximation for valuing businesses.

The result of the equation is the absolute amount of equity value that was created during the period for which the measurement is being made.   A few examples will be used to illustrate.  For all examples, assume the following:

  • Gross debt (e.g., bank loans, revolver) is unchanged
  • No additional equity is invested and no dividends are paid
  • 10X is an acceptable EBITDA multiple for the company

Example 1: In a quarter, EBITDA increases by $2M.   Cash increases by $10M.   Equity Value Created = [(2 * 4) * 10] + 10 = $90M

Example 2: Over the past 6 months, EBITDA increases by $6M.   Cash declines by $20M.   Equity Value Created = [(6* 2) * 10] -20 = $100M

Example 3: Over the past 12 months, EBITDA decrease by $5M.   Cash increases by $75M.   Equity Value Created = [-5 * 10] + 75 = $25M

In the examples, we assumed Gross Debt and Equity were unchanged.  Note, however, that the change in cash might instead have been a change in gross debt or equity, and the calculation would have yielded the same result.   For example, the $10M in Example 1 could have been a dividend to equity holders.  Cash in net indebtedness would have been zero, but change in equity investment would have been negative $10M.   Or, in Example 2, the $20M of cash decline might have been funded through an increase in gross debt or an additional equity investment.  If so, cash would be unchanged during the six months, but either net indebtedness or equity would have been $20.   In Example 3, the $100M could have been used to buy back equity or reduce debt.

Further notice that no assumptions were made as to whether the change in EBITDA was the result of organic growth or an acquisition of another business.  In Example 2, where cash flow is a negative $20M, it might have been that a $10M acquisition occurred during the period and that this acquisition contributed $2M to the gain in EBITDA.   The methodology captures value that is created through the combination of organic and inorganic activities.

Also note, no assumptions were made on how much capital was invested; how much interest and tax payments were made; or how much working capital changed.  All of these are important—but all are implicitly considered in the calculation.    The change in net indebtedness and the change in equity investment would have captured how much cash was needed to fund capital expenditures and working capital, to pay interest and taxes.   A management team that uses the equation will realize how each of sources and use of cash affects the calculation of equity value created.

Hopefully, the power of the equation is becoming clear.  The calculation itself is simple.  The comprehensive nature of the measurement captures the broad range of variables that affect equity value generation.   The result is a singular measurement of how management performed against its primary responsibility of creating equity value for its owner.  It doesn’t get much better than this.

EQUITY IRR

Let’s return to the full statement of management’s job of creating equity value for the owners of the business at a pace that exceeds the owners’ cost of capital.   The prior equation calculated how much equity value was created.  It did not grapple with how the pace compared to the owner’s cost of capital.  To complete the performance measurement, the internal rate of return (“IRR”) of equity value creation must be calculated.  This Equity IRR can then be compared to return expectation of the equity owners.  The comparison spotlights whether investors should be disappointed, satisfied, or thrilled with the performance over the period being measured.

The following equation can be used for calculating Equity IRR:

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Returning to the early examples, let’s assume each company had an Equity Value at the Beginning of the Period of $1B.   For Example 1, Equity IRR = ($90M / $1B) x 4 = 36%.   Example 2: Equity IRR = ($100M / $1B) x 2 = 20%.   Example 3: ($25M / $1B) x 1 = 2.5%.

If the equity owners have a cost of capital of 20%, they would be thrilled with Example 1, satisfied with Example 2, and certainly disappointed with Example 3.

Instead of assuming all three companies had an beginning Equity Value of $1B, let’s assume Example 1 was $4B, Example 2 was $500M, and Example 3 was $125M.

Equity IRR for #1 = ($90M / $4B) x 4 = 9%.   Example 2: Equity IRR = ($100M / $500M) x 2 = 40%.   Example 3: ($25M / $125M) x 1 = 20%.

If cost of capital remains at 20%, now owners would be disappointed in #1, thrilled in #2, and satisfied in #3.

Equity Value at Beginning of the Period

In the prior section, the equation for calculating Equity IRR was discussed.  The IRR equation requires “Equity Value at Beginning of Period” as an input.  To derive equity value, follow three simple equations:

  • Equity Value = Enterprise Value – Net Indebtedness
  • Enterprise Value = Annualized EBITDA X EBITDA Multiple
  • Net Indebtedness = Debt less Cash Balance

In the following examples, assume the appropriate EBITDA multiple is 10X.

Example 4:  A company had $50M EBITDA the prior quarter.  It owed $550M of debt and had $50M of cash on the balance sheet.    Net Indebtedness = $550M minus $50M = $500M.  Enterprise Value = $50M * 4 * 10 = $2B.   Equity Value = $2B – $500M = $1.5B.

Discussion of EBITDA Multiple

Central to this methodology is the use of EBITDA multiple as an indicator of value.   The true value of a company is its Intrinsic Value (see Intrinsic Value posts).   A management team cannot become overly reliant on EBITDA multiple to estimate Intrinsic Value.  Instead, the management team must be on a never-ending quest to improve its determination of Intrinsic Value based on ever-improving understanding of what its cash flows will really be.   As Intrinsic Value is better understood, it will lead to fine tuning what EBITDA Multiple should be used in the methodology above.

Methodology Self-Corrects for Incorrect EBITDA Multiples

What if the EBITDA Multiple is a poor placeholder for estimating Intrinsic Value?  The methodology will reveal this, leading to adjustments.  It is best to use examples to illustrate this.

A management team is able to make a reliable estimate of their cost of equity.  A large cap public company with low leverage and highly predictable cash flow might have a cost of equity of 12%.   A 18% might be a more appropriate estimate for a smaller company with less certain cash flows and lots of debt.  The 6% premium is necessary due to the higher risk profile.

Let’s assume a particular company has a 15% cost of equity.  Further, assume this company uses an 8x EBITDA multiple and, using this multiple, calculates that it is consistently delivering a 30% IRR to its equity holders.  What can be deduced?  The 8x EBITDA multiple is understated because the price of the company is too low.  The buyer, who has a 15% cost of equity, is buying at a price that will lead to a 30% return.  The seller is leaving a lot of money on the table.

Now, let’s consider a company that also has a 15% cost of equity and also assumes an 8x EBITDA multiple.  This company, however, calculates that it delivering only 5% IRR to its equity holders.  The 8x is overstated.  Sellers are right to sell at this price.  Buyers beware.

Of course, Intrinsic Value is based on forward looking cash flows, not past results.  Therefore, judgment must be applied as to how prior importance will inform future results.

Application of Equity Value Methodology to Business Units

Many companies are sub-divided into Business Units defined around some combination of Products and/or Geographies.  General Management positions are created and their charter is to maximum the value of their Business Units.   The shorthand “P&L responsibility” suggests these managers have comprehensive financial responsibility for their sector of the company.

The Value Creation methodology could (and should!) be applied to General Management positions.  Each business unit or product group should know how much equity value it is creating each quarter and what Equity IRR it is achieving.  This requires a more comprehensive tabulation of financial results, as capital and cash flow are integral to the calculation.  The benefits: are better decision making within each unit or group, an improved understanding of the sources of value creation, and a more appropriate way of measuring performance of business unit leaders.

Public Company Applicability

The ultimate measure for public companies is stock price.   Nonetheless, the ability to measure equity value creation independent of stock price remains is important.

Stock price can be thought of as shareholders’ consensus view at a particular moment of Intrinsic Value.   The stock market is volatile, which means shareholders’ view is prone to material swings.  Often, the variability is driven by macro-economic factors instead of company performance.   The unavoidable conclusion is that stock price, though an important indicator, is neither a precise nor reliable measure of Intrinsic Value.

In some quarters, a stock price will increase.  In others, a stock price will decline.  The correlation to the company’s performance in the particular quarter is modest.  An executive team that relies on stock price as the primary measure of its quarterly performance will be overly dependent on the ebbs and flows of the market.  If stock price is up, they will attribute to their performance.  If down, it is too easily written off to externalities.

With this as backdrop, the Value Creation methodology has clear applicability for a public company.  The management team is required to consider its Enterprise Value without simply resorting to the then-current stock price.  Moreover, it is able to measure its progress in advancing equity value over shorter (e.g., quarterly) periods of time.  Finally, the methodology allows a company to describe to its shareholders how it sets value creation goals and how it measures achievement.

Industry Analysts and Prospective Investors

A further feature of the methodology is that external interested parties can perform the measurement using only publically available information.  The external party can apply a range of EBITDA multiples when performing the calculation.   The remainder of the input should come directly from data published by the company.

An industry analyst can determine the relative Equity IRR performance of companies in the industry.  A prospective investor can tabulate the track record of a company in creating equity value over multiple periods.

Consider the power of this.  A company that generates Equity IRR at a 40% pace must be viewed differently than a peer who is performing at a 20% Equity IRR.   Revenue growth or EBITDA versus expectations are far less powerful indicators than the Equity IRR calculation.

Evaluating Forecasts

Management, or an external analyst, typically can develop a highly reliable forecast extending 3 or 4 quarters.  Assuming the forecast is achieved, what does it imply about the Equity IRR that was achieved in each of these quarters?  Using the industry norm EBITDA multiple, would the IRR be high (e.g., 30%) or low (e.g., 5%)?

This analysis can reveal whether stock price is likely to rise or fall if results are achieved.  If used internal to a company, it could reveal whether the company should be thrilled, ho-hum, or upset if the forecast is achieved.  A sandbagger is not rewarded for barely beating a 5% IRR forecast.   A manager who barely misses a 30% IRR is the hero.

Summary

If the job of management is to create equity value for its owners at a pace that exceeds the owners’ cost of capital, management should measure how well it performs against the goal.   Likewise, if a general manager has “P&L Responsibility”, she should know the pace in which her group creates equity value.

The value creation methodology provides the ability to measure equity value created and equity IRR.  This drives better decision-making within the organization and a frame of reference for resource allocation.  When applied to individual business units, high-performing areas are spotlighted, and value-destroying parts are exposed.   External analysts have a more comprehensive tool to assess performance both on an absolute basis and when comparing a company to its peer group.   Prospective investors can assess a company’s historical track record of creating equity value.


My second principle under Management Ethics is ” be clear, open and honest in our communications with investors“.  A sub-bullet of principle #2 is “financial performance should be tracked and reported in a clear and unbiased way“.

It might seem odd that this is embedded in an ethics principle. Is it not commonplace that companies follow this principle, as every company has to abide by GAAP?

In the early 2000′s, Enron and Worldcom collapsed.  These companies followed GAAP.  In fact, they “knew” GAAP so well that they found ways to use GAAP to deceive their investors. Were they clear with their financials? Were they unbiased? With the benefit of hindsight, the obvious answers are shouts of No and No.

Sarbanes-Oxley, also called SOX, was to fix this. Did it? My less-than-educated guess is that it helped a fair amount. However, the Great Recession of the late 2000s provides plenty of examples of public companies who were anything but clear and unbiased in their reporting to shareholders.  Plenty of SOX-compliant public companies were culprits in the housing crises.

SOX, by holding CEOs and directors personally liable for bad deeds, has inspired many companies to simply cut back on their public reporting.  They comply with SOX, but they do so with providing the minimum required information.  As a CEO of a company with public debt, I understand where these companies are coming from.  It is very demanding to meet SOX compliance.  Even if intentions are noble, legal exposure is a very-real risk to companies, individual directors, the CFO, and the CEO.

I view SOX as having raised the expectations for minimum information to be reported and as raising the stakes for failing to comply.  However, simply complying with SOX does not mean that my Management Ethics Principle 2 is satisfied.  To understand why, let’s focus on the word “Performance”.  Why was “Performance” used instead the word “Results”?  There is a subtle but important difference.  Results implies a backward-looking activity.  What did the company accomplish last quarter or last year?  GAAP, by the way, is all about how to account for past results.

“Performance” implies more real time. How is the company performing?  It is a continuum of what results were posted in prior quarters as well as the leading indicators that foreshadow what to expect in future quarters.   Leading indicators are metrics such as Gross New Sales (“Bookings”), quality of the Bookings such as capital intensity, Churn, Revenue under Contract, and Pricing Trends.  All of these are non-GAAP terms, but are extremely helpful to an investor whose goal it is to gain insight into future financial results.

Many companies provide leading indicators, but they do so in an inconsistent or unclear fashion.  For example, they might share some metrics in certain quarters, but different ones in other quarters.  Is it shocking that the ones they choose to share are favorable in the quarter they share them?  I strive to share a robust set of consistent metrics, so that insight can be gained on both positive and negative leading indicators.   Moreover, I share the data for prior quarters alongside the most recent quarterly data–so that it is easier for investors to see trends.  When I review the data with prospective investors, I focus equally on positive, neutral, and negative trends.  I try to refrain from using positively-biased adjectives.   I prefer to let the data do the talking.

It is management’s responsibility to be clear, open and honest when communicating with existing and prospective investors.  To accomplish this, financial performance should be tracked and reported in a clear and unbiased way.  Management should make it easier for investors to understand financial performance and trends.  The reward is that investors will buy and sell at prices that are better informed by company results.  The transparency also removes uncertainty, which means investors will apply lower discount rates when determining the value of the company.  This too leads to a fairer outcome for both new and exiting investors.

 


I am committed to the highest level of management ethics.  I would rather see the company fail financially than compromise ethics.  With this in mind, below are four ethics principles that I believe capture the responsibilities management has with its investors.

1.  Treat shareholders as long term business partners; and view management as managing partners.

    • An enterprise must be managed with the perspective that investors (not management) own the assets contained within the company.
    • It is management’s responsibility to ensure all executive compensation and perks are clearly understood and approved by its investors.

2.  Be clear, open and honest in our communications with investors.

    • Whether the news is good, neutral, or bad, management is responsible for making it easy for investors to understand what is happening in the business.
    • Financial performance should be tracked and reported in a clear and unbiased way.
    • Management should understand and clearly articulate the risk profile inherent in the businesses decisions being made.

Warren Buffet writes “Elsewhere, triumphs are trumpeted, but dumb decisions either get no follow-up or are rationalized.”This behavior finds its way into the culture and operations of a company.  High risk business decisions are encouraged because if they pay off, the rewards are high and if they don’t, the ramifications are less than they should be.  Though human nature might resist, management must be candid in its self-assessment, even when it comes up short.”

As part of effective communication, management must strive to measuring and reporting financial performance in a clear and unbiased way.  As part of this, management should seek to understand and clearly articulate the risk profile inherent in the businesses decisions being made.

3.     Understand the meaning of “Intrinsic Value” and make maximizing Intrinsic Value the basis for business decisions.

Warren Buffett refers to intrinsic value as an all important concept.  He defines it as the discounted value of the cash that can be taken out of a business during its remaining life.  Maximizing intrinsic value needs the guide for all business decision making.   At times, this may cause conflict with the notion that the CEO’s job is “maximize stock price”.  Inappropriate behavior—such as hyping exciting developments or masking unfavorable results—could result from defining the goal as “Maximize Stock Price” instead of “Maximize Intrinsic Value”.

Buffett says: “If Intrinsic Value increases, the stock price will eventually follow.”

4.   Investors should be informed of the company’s true Intrinsic Value, not more and not less.

Buffett points out that Intrinsic Value is easier to define than to accurately calculate.  Management’s goal should be to help investors gain an accurate understanding (to the best of management’s ability) of the Intrinsic Value.  This principle could be a source of  conflict with the common-held belief that a CEO’s goal is to “maximize stock price”.  If a stock price reflects an enterprise value that differs from Intrinsic Value, the result is one class of shareholder will benefit at the expense of another class.  For example, if the valuation implied by the stock price exceeds the Intrinsic Value, new shareholders will be overpaying exiting shareholders.

The ethics goal is to be fair to all shareholders.  To accomplish this, management must strive to ensure their investors’ perceived value of the firm (whether the entity is a public or private company) is in line with management’s estimation of Intrinsic Value.


I am committed to the highest level of management ethics.  I would rather see the company struggle financially than see it compromise on its ethics.  With this in mind, I articulate four management ethics principles that capture the responsibilities management has to its investors.  Principle 1 is:  Treat shareholders as long-term business partners; and view management as managing partners.

Principle 1 has two parts.  1a is:  An enterprise must be managed with the perspective that investors (not management) own the assets contained within the company.  

I’ve seen too many situations where management teams lose sight of their role as managers of a company.  At the end of the day—and at the beginning of the day for that matter—the company belongs to the investors.  A company’s purpose is to maximize value for its owners.  Conversely, an enterprise does not exist to serve management nor its employees.  This might sound cold—but it is essential belief a for-profit enterprise must have to maintain long-term success.  When it loses this perspective, it begins to make inappropriate decisions.  Over time, the viability of the business erodes.  As this happens, investors suffer but so do employees and customers.

How many of the disaster stories circa the telecom, dot.com, or housing meltdowns are attributable to management teams failing to treat their shareholders as long-term business partners? Lots!

By the way, “long term” is an important part of this principle.  Without doubt, short-term extraordinary high-risk tactics were at the core of the 2008 housing and banking collapse.  A management team that consistently focused on the long-term treatment of their business partners will resist tempting short-term tactics.

Now, let me shift to 1b:  It is management’s responsibility to ensure all executive compensation and perks are clearly understood and approved by its investors.

I am a staunch advocate of the Free Market.  Whether a star athlete, talented movie star, or effective executive, an individual should be paid as much as the market dictates.  It is not government’s role to restrict this, any more than it is government’s charter to dis-allow LeBron James from signing a $100M+ contract.  Likewise, government’s role in “helping” investors do a better job of managing executive pay is limited. Instead, the primary role in determining executive pay falls on the market.

In my career, I have been a director of multiple companies and have served on certain compensation committees. As is typical with directors, I am limited in the amount of time I can spend in these duties. As such, I know first-hand that there is a strong dependency on management when it comes to structuring and understanding executive compensation packages.   This leaves directors necessarily dependent on those executives whose compensation packages they are determining.

The extreme importance of executive compensation and these inherent conflicts of interest are why I include it as part of the first management ethics principle.  Even when the topic is his compensation, an executive must embrace (a) their shareholders as long term business partners and (b) the enterprise must be managed with the perspective that investors (not management) own the assets contained within the company.

Again, I believe in the Free Market.  The top 1% of executives—just like a top tier NFL quarterbacks–creates enormous value relative to the business-world equivalent of a middle-of-the-road NFL quarterback.  The executive should be rewarded accordingly. However, unlike a professional athlete, a CEO/executive team has more of an opportunity to game the compensation dynamic. The fact that this opportunity exists does not entitle managers to exploit it.  If they do so, they are violating principle 1a.

When it comes to executive compensation and perks, management’s responsibility to ensure compensation implications are clearly and completely understood by directors.  This principle sounds basic, but consider what temptations management must resist.

  • Allowing employment contract language to be unnecessarily complex, thereby making it difficult for investor representatives (e.g., compensation committee) to evaluate
  • Presenting summaries that, although technically accurate, are incomplete or misleading
  • Providing supporting analysis that fails to identify relevant scenarios—such as a quirk that allows the executive makes substantial sums while the company is crumbling
  • Failing to identify flaws in the plan—for example, if the plan encourages management to pursue inappropriately risky investments which conflict with the overall Management Ethics #1 principle
  • Manipulating accounting results to benefit management compensation without the intended benefit to the owners
  • Initiating compensation negotiations when the company is vulnerable to the departure of the executive, especially if the threat of departure is used as leverage
  • Using professional services experts—such as human resource or financial analyst consultants—who are inappropriately influenced by management
  • Appointing directors (especially compensation committee members) that have inappropriately cozy relationships with management

When executives make large sums of money, their compensation packages will be scrutinized.  A great executive—and an effective director—will not fret when such scrutiny is applied, so long as the compensation package held up to these principles.  In fact, the director will feel like the executive received a just reward for the job that was done on behalf of their stakeholders.


Intrinsic Value is an all-important business concept. The expression speaks to what the true worth of an enterprise. How, though, does one know the Intrinsic Value of an enterprise?

An enterprise’s Intrinsic Value is equal to what its free cash flows, appropriately discounted, are really going to be.

This might sound basic. If you know the future cash flows and apply an appropriate discount rate, you will know Intrinsic Value.

The overwhelming criteria for making business decisions is (or at least should be) the quest to maximize Intrinsic Value. That is, the singular focus when evaluating a decision should be the cash flows that will really result from the range of choices available.

A mistake often made by businesses is overweighing the need to beat their budget for revenue, EBITDA, or capital. No doubt that missing a budget will have immediate and typically negative ramifications. What if, though, management has opportunity to satisfy budget expectations by making decisions that are sub-optimal to Intrinsic Value?

This choice occurs frequently. Though unspoken, the temptation to overlook Intrinsic Value optimization in favor of achieving budget goals is high. It can be rationalized as well. “We always make our numbers.” A true commitment to Intrinsic Value means that maximizing Intrinsic Value will trump making budget.

Generally speaking, the pace of revenue and EBITDA growth positively influences the value of an enterprise. Growth can be accelerated through decisions that are suboptimal to maximizing Intrinsic Value. Same question as earlier: What if management has opportunity to show higher growth through decisions that are sub-optimal to Intrinsic Value? Will they resist the temptation?

Management rarely approves a business plan that shows a poor IRR or lousy NPV. Does this mean all approved business plans maximize Intrinsic Value? Let’s focus on the words “what free cash flows are really going to be”. The question shifts to whether the business plan is an accurate portrayal of future cash flows. Often, too little scrutiny is placed on the accuracy of the cash flow prediction. A good faith attempt to accurately forecast isn’t sufficient. At the end of the day, Intrinsic Value will reflect the real cash flows, not  the business plan forecast. Competency, in the area of business plan analyses, is tied to the degree of accuracy of cash flow predictions. To what degree does a management team focus on knowing and improving the accuracy of their predictions?

Most industries have rules of thumb for approximating the enterprise values. Telecom often uses EBITDA Multiple. Revenue multiple is used in earlier stage growth industries, and EBIT Multiple is used in more mature industries. Management teams must realize that none of these is an acceptable proxy for Intrinsic Value. Management must maintain its focus on Intrinsic Value, and use its ever-improving understanding of Intrinsic Value to guide thinking around rule of thumb multiples of a simple accounting metric.

Intrinsic Value is a simple concept. It is true worth of an enterprise, and will be revealed as the true free cash flows play out. A management team’s commitment to using maximization of Intrinsic Value as the overwhelming compass for decision-making is paramount. This commitment cannot be compromised even when confronted by conflicting goals such as achieving budgets, growing revenue, or funding interesting projects.


Enterprise Value is a term that is closely related to Intrinsic Value and, depending on usage, the two expressions could be used interchangeably.   Let me focus though on the term Enterprise Value as it pertains to a public company.

Enterprise Value = Equity Value + Net Indebtedness

Equity Value = Shares Outstanding * Price Per Share

Net Indebtedness = Debt Outstanding less Cash Balance

For a public company, Enterprise Value is tabulated every day.  Enterprise Value can be viewed as the stock market’s then-current estimate of Intrinsic Value.  It represents the consensus opinion of all those who bought and sold the stock a particular day as to what the enterprise’s Intrinsic Value.

Recall, though, that Intrinsic Value is defined not as an estimate of an enterprises’ value.    Instead, Intrinsic Value is the true value of the business, and will reveal itself as the true cash flows over time become known.

The delta between Intrinsic Value and Enterprise Value can be viewed as the inaccuracy of the stock market’s consensus estimate on a particular day.   A long-term investor, such as Warren Buffett, does well if he or she can deduce when a wide delta exists between Intrinsic Value and Enterprise Value.  The wider the delta, the more lucrative it is to either buy or sell.

A management team performs best when they have better knowledge of Intrinsic Value than the stock market.  To understand why, let’s consider the alternatives.

  1. One alternative is the management team’s best estimate of Intrinsic Value is the stock market’s daily estimate.  We all know the stock market is fickle and their best guess is subject to wild swings.  If the management team’s understanding is linked to the market’s daily consensus, management’s decision-making criteria will also be volatile.
  2. The second alternative is the management team’s best estimate is inferior to the stock market.   Perhaps this creates more stable decision-making environment.  However, the basis for decisions is concerning, as it is predicated on management having a lessor understanding of the cash flows that will result from their decisions than the collective view of the stock market.  It is hard to see how anything good can come from this.
  3. The third alternative is that management team must rely on an averaging of the stock market’s view over multiple weeks or months.  This normalizes for daily volatility, and hence is better than #1.  And it is certainly better than #2.  Nonetheless, this third alternative doesn’t compare well to a management team that has a superior (relative to the stock market’s) understanding of future cash flows.

Is it a realistic expectation that a management team have a better understanding than the stock market?  The short answer is “absolutely yes”.   I qualify this with a word of caution.  Nearly all management teams believe they have this ability; yet it is unclear how many really do.


The author Michael Lewis is famous for Liar’s Poker and Moneyball – both are among my favorite books.

Moneyball is an extremely well-written book focused on a young general manager of the Oakland A’s by the name of Billy Beane. In the early 2000s, the small market Oakland A’s achieved surprising success. They did it despite having a payroll that was among the lowest in the league, and a fraction of big market teams such as the New York Yankees and the Boston Red Sox. How did Beane do it? Perhaps this will be a topic of a future post but first I want to discuss Blind Side, which was also authored by Lewis. You might think of Blind Side as the sequel to Moneyball.

Blind Side centered on a kid by the name of Michael Oher. An extraordinarily large kid, Michael was built to be a football player. He had a lot more than size. His speed and strength were off the charts. Making a long story short, Michael had an impoverish upbringing and struggled with grades and discipline in his early teens. He quit football after his freshman year at a Memphis public school, but was discovered by a high school coach and recruited into Briarcrest Christian School. He went to University of Mississippi and became a first round pick in the 2009 NFL draft. His rookie contract for the Baltimore Ravens resulted in him making $13M over a five year contract.

Oher’s story is only a backdrop for Blind Slide. The book was about more about the position that Oher plays—Left Tackle. The offensive line in football had traditionally been the least celebrated positions in the NFL. Offensive linemen don’t throw or catch the ball. They don’t sack the quarterback; nor do they make interceptions. They don’t win games in the last second with a 50-yard field goal. They are big and bulky—and often have a thick layer of fat covering their sizable muscles. Offensive line is the least glorious position in the glorious game of football.

Given all of this, you’d expect that offensive linemen were paid far less than their glorious teammates. Prior to the 2000s, this assumption would have proven accurate. But, in the mid 2000s, the relative compensation of an offensive lineman had changed in an unexpected way. The salaries for one of the offensive lineman positions—the Left Tackle—began to skyrocket. In Blind Side, Michael Lewis explains how the Left Tackle became the 2nd highest paid position in the NFL. Only quarterbacks were paid more. How could this be? And what lessons can we take away and apply to our business?

Quarterbacks are paid a lot of money for a good reason. Quarterbacks are the key to a football team. Franchise players like Tom Brady, Peyton and Eli Manning, Ben Roethlisberger, and Drew Brees win games, fill seats and sell jerseys.

What is the second most important position? Is it running back? Wide receiver? Kicker? Middle linebacker? Defensive end? The answer to all of these is NO.  Surprisingly, the 2nd most important position is the Left Tackle. You know, the big and bulky linemen whose names are called only when a holding penalty is called. And you only notice him when he missed a block and the lucky linebacker delivers a crushing blow to the quarterback.

How do we know the Left Tackle is so valuable? According to Michael Lewis’ book Blind Side, Left Tackles, on average, get paid more than every position other than quarterback. They get paid millions despite being largely invisible to football fans. Owners pay them the big bucks despite gaining no “ego-stroking” value as a side benefit. That is, the owner is far more likely to invite the middle linebacker to the weekend barbecue than the Left Tackle. If the owner is courting a trophy wife, he will introduce her to the wide receiver instead of the Left Tackle.

Why is the Left Tackle so valuable? The answer is quite simple. Quarterbacks are the most valuable and it is devastating when the quarterback gets hurt.  Quarterbacks are most vulnerable to getting hit on their blind side, particularly if the hit was delivered by Lawrence Taylor in his prime.  Since the vast majority of quarterbacks are right handed, the blind side is to their left. As a quarterback goes to throw, he turns his body so that his back is to the left side of the field. If the 350 lb defensive lineman coming from the left gets around his blocker, the lineman comes crashing into the quarterback. Often, the QB just doesn’t see this coming because he has his back to this charging lineman. Hence, “blind side” was coined.

The Left Tackle’s job is to protect the quarterback’s blind side. A great Left Tackle is much more likely to be successful than an average one. Success helps ensure the franchise quarterback stays healthy throughout the season and playoffs. Failure could mean the QB is out for the year, leaving the team to fall apart. That is why the Left Tackle is the second highest paid position in football. Their job is to protect the highest paid position.

No matter how big of a football fan/expert you are, you’d never figure this out by watching a game. Even those who were the biggest experts—coaches and general managers—were slow to figure it out. In Blind Side, Michael Lewis shows that not until the 2000s did the salaries of Left Tackles skyrocket, reflecting new insight into the importance of their role.

A valuable business lesson can be gleaned from this story. Over time, certain NFL coaches discovered the importance of the Left Tackle position. And they quantified its importance. That is, they quantified the relative value of a great Left Tackle relative to an average Left Tackle. And they used this intelligence advantage to sign the best Left Tackles at salaries well below their value.

Certain coaches discovered this intelligence despite the fact that it was not obvious. In fact, conventional wisdom would have steered them elsewhere. Conventional wisdom was that running backs or receivers were more valuable. Conventional wisdom was that the lean and muscular defensive lineman was far more valuable than the big and bulky offensive lineman.

Conventional wisdom was challenged. Perhaps the ideas originated during coaches’ brainstorming sessions over pizza and beers. Perhaps the ideas were a result of highly analytical college grads looking to discover a new angle. Either way, the key was the pursuit of new ideas that create a competitive edge. What might we do different that might give us an advantage over our rivals?

A second key is perhaps more important. Analytics. Fact based financial analysis. The conviction to act on the idea—and to know how to act—comes from quantifying the “value”. That is, a team must carefully compute the relative value of a great Left Tackle relative to a mediocre one. And, even more difficult, the calculation needs to compare the value of a great wide receiver relative to an average one. Are we better off spending $10M on a great Left Tackle, leaving us only $5M for a middle-of-the-road receiver? Or would we create more value by spending $3M on a mediocre Left Tackle, which would leave us $12M to get a prime-time wide-out?

Developing conviction in the answers requires a strong commitment to data gathering and quantitative analysis. Your average football coach circa 1995 was unlikely to be receptive to such an approach. They were more likely to rely on the gut instincts of a 30-year lifer, who almost certainly never used excel and thought NPV was the Swedish expression “No Puck’en Vay”.

How does this apply to what you do? Are you committed to data gathering? Do you challenge conventional wisdom? Do you rely on quantitative analysis to help discover where value can truly be created for the enterprise? Or are you more like a football coach circa 1995, relying on the time-tested instincts on how to get the job done. If so, you should be worried about who is protecting your Blind Side.


In May of 2008, my son Danny and I went to the Colorado Avalanche game.  Adam Foote was back and we wanted to see him in an Avs uniform again.

Adam Foote played for the team from 1995 through 2004, and was a key defender on the team when they twice won the Stanley Cup.  Seeing Adam back in a Colorado uniform brought back a fond memory.

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Years ago, Adam made a lasting impression on my son Danny. Though Danny met Adam only briefly, I suspect that Adam made a meaningful contribution to Danny’s character. Oh, by the way, Danny is a darn good hockey player and Adam Foote remains his all-time favorite player.

The 51st National League All-Star Game took place on February 4, 2001 at the Pepsi Center in Colorado. The skills competition took place the day before. I brought my son and we had a great time. Anaheim Mighty Ducks’ Paul Kariya won his third straight puck control relay event and Boston Bruins’ Ray Bourgue came in first in the shooting accuracy competition.  My friend Marty and his son Christopher joined us at the event. Though Colorado’s #52 wasn’t in the game, my then 6-year-old son wore his Adam Foote jersey.

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Afterwards, we went to the Denver Chop House for dinner. About an hour later, a buzz went through the place that several sports players were hanging out in the bar area. Larry Walker was among them. So was Adam Foote.

I am not the type of guy to bother people in the public eye. However, my buddy Marty is. So Marty took Danny up to Adam Foote to see about getting an autograph.   As my son walked up, Adam smiled ear-to-ear. Adam was already an NHL veteran and was very popular in Colorado. Nonetheless, you would have thought it was the first time he noticed anyone other than himself wearing an Adam Foote jersey.

“You’ve got my jersey on. How cool. I have to bring you to my wife.” He brought Danny over to his wife and they talked for a short while. He then signed Danny’s jersey–and we cherish it to this day.

What happened next was what made the day so memorable.  An hour or so passed and it was time to go. The restaurant was crowded, especially around the bar where the athletes were hanging out. Marty, his son, Danny and I were leaving. As we walked out of the main door, I turned around. No Danny. Marty, Christopher and I looked at each other and, perhaps overreacting a bit, I rushed back in. I looked around frantically and then spotted him in the very crowded bar area.

Again, he was only six years old, so he was hard for anyone to notice him.

I caught him just as he pushed against Larry Walker’s leg, nudging the Colorado Rockies all star out of his way. He stood in the circle of Walker and 3 or 4 others, including Colorado’s #52. He looked up at Foote and waved goodbye. Though I couldn’t hear Foote, he let out a good belly laugh as he caught Danny moving Walker aside. He picked up Danny and wished him well.

Danny, now 16, is a solid defenseman in competitive hockey.  He is always the one that goes out of the way to tap the shin guard of his goalie, just like he saw Adam Foote do oh so many times.  Thank you Adam Foote. You made a difference in two peoples’ lives that day.


The Occupy Wall Street crowd is directing their anger at the 1%.   President Obama repeats a mantra that all he is asking is for the Wealthiest 1% to simply do their “fair share”.  Who are these 1%?   To put names with the 1% tag line, I perused Forbes list of the Wealthiest 300 Americans.  Below is a list of a few of them, and included in the list is the source of their wealth creation.  I am struck by two major themes:

1.     In most cases, the wealth is “first generation”, meaning these individuals created their wealth from humble beginnings.  They didn’t inherit businesses or family wealth.   America remains a land where average Americans can achieve wealth beyond their wildest imaginations.

2.     The contributions to society that resulted from these individuals are monumental.   They are doing more than their “fair share” to improve lives of countless people across the globe.   Given the effect their wealth creation is having on society, would transferring a higher portion of their wealth to government result in a better outcome?

Examples of 1st generation wealth who made enormous contributions to society:

#1 Bill Gates, #23 Paul Allen , and #19 Steve Ballmer of Microsoft

#2 Warren Buffett of Berkshire Hathaway

#3 Larry Ellison of Oracle

#12 Michael Bloomberg of Bloomberg (a Financial Service IT platform)

#13 Jeff Bezos of Amazon

#14 Mark Zuckerberg of Facebook

#15 Sergey Brin and Larry Page of Google

#18 Michael Dell of Dell

#24 Phil Knight of Nike

#327Rupert Murdoch Media

#39 Phil Anschutz of Railroad and Telecom fame

#49 Steve Jobs Apple

#34 Charles Ergor EchoStar

#48 Leonard Alan Lauder of Estee Lauder

#52 Ralph Lauren Fashion

#69 John Malone, the king of Cable TV networks

#107 George Lucas of Star Wars fame

#117 Steven Spielberg of Hollywood fame

#139 Oprah Winfrey

#212 Ted Turner, creator of CNN and other CATV brands

I picked these examples because of the names of the individuals or their companies are recognizable.    Others on the list made their money through retail (e.g., several Walmart family members are on list), hotels (e.g., Marriott), real estate (e.g., Trump), casinos, oil, candy, supermarkets, media, hedge fund investing, and even the rental car business.  We should admire the people on this list, especially the ones whose ideas are bettering society.  We should be proud we live in a society that produces so many self-made billionaires.