[Re-print from a long ago bearonbusiness post--but one I think is appropriate for the times...]

So you are sold?  You want to be like Warren Buffett–a contrarian investor.  The expression “easier said than done” is apropos.

First, simply being contrarian isn’t nearly enough.  You also have to be right.  The overwhelming percentage of contrarian ideas are not just wrong, they’re downright horrible.  Said differently, there is a reason why most people believe otherwise.  It is why the style of investing is named based on the word root contrary.

Second, even “right” contrarian views tend to sound wrong.  This isn’t a problem for Warren Buffett, but it probably is for you.  Why?

Do you feel compelled to run your contrarian ideas by others for validation?

Do you need to convince others to back you financially to pursue your contrarian ideas?

If the answer to either of these is a “yes”, the fact that your idea is viewed by most people as flawed poses a problem.  Most other people won’t validate it for you–hence you will lose confidence and become discouraged.  Most financial backers will dismiss you, hence raising money will be difficult.  Some might even poke fun at you behind your back.

Let’s review.  Your ideas have to be right, even if they sound wrong.  You have to raise money, even though most money sources think the idea is flawed.  You have to trust your convictions, even as others chip away at your confidence.

Do you still want to be a contrarian investor?

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Steve Wilson, the veteran account executive at Envysion, wrote a blog post titled The Right Tool for the Job.

We funded Envysion a few years’ ago.  The underlying investment thesis was that a Software as a Service approach to video surveillance would be superior for customers who wanted to view video from dozens or hundreds of locations.    A consistent question we faced was “will there be any features or capabilities that cannot be done through a traditional solution?”.  This turned out to be a hard question to answer.

Certainly a SaaS approach promised dramatic efficiencies to administrators and users.  Many of these are proving to be game-changers.  But most of the capabilities could be provided via a traditional solution (albeit in a far inferior way).   However, identifying capabilities that simply can’t be replicated was less obvious.

Enter My Clips.  Envysion’s MVaaS solution allows a user to point-and-click a interesting video clip to a personal folder in the computing/server cloud.  The URL for this clip can then be sent to other users.  Also, a “friends” list can be maintained to allow others–such as all the store managers in California–to view certain clips.

MyClips enables video to be viewed and shared in ways that traditional systems simply aren’t equipped to handle.  MyClips is becoming one of the most tangible answers to “what features does MVaaS enable that are unique?”.

Thanks Steve for the post.

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One of my most memorable Bruce Springsteen songs is one that few have heard.  It is from the fairly recent album “Devils and Dust” and the song it titled The Hitter.

The Hitter takes place with an aging boxer knocking on his mother’s locked door. He hasn’t seen his mother in years–not since he was sent out of town at a young age to escape the law. The Hitter isn’t returning home to ask for money or to move back in. As he explains, he is just tired and needs to rest in a comforting place.

Come to the door, Ma, and unlock the chain
I was just passin’ through and got caught in the rain
There’s nothin’ I want, nothin’ that you need say
Just let me lie down for a while and then I’ll be on my way

To help his mom understand, he reflects on the time he last saw his mom.

I was no more than a kid when you put me on the Southern Queen
With the police on my back I fled to New Orleans
I fought in the dockyards and with the money that I made
And the fight was my home and any blood was my trade

It turned out he was quite the boxer.  Not only did it pay the bills, but he enjoyed beating up on other men.

Baton Rouge, Ponchatoula, and La Fayette town
Well they paid me the moon, Ma, to knock the men down
I did what I did, when it come easily
Restraint and mercy were always strangers to me

Eventually, he made it to the championship fight.   It was a tough fight, but even with a broken jaw he pressed on.  And he prevailed…

I fought champion Jack Thompson in a field full of mud
Rain poured through the tent to the canvas and mixed with our blood
In the twelfth, I slipped my tongue over my broken jaw
And I stood over him, pounded his blooded body into the floor

Well the bell rang and rang, still I kept on
‘Til I felt my glove leather slip ‘tween his skin and bone

And then he enjoyed the spoils of being the champ. But even as he did, he knew he was a play-thing for the rich guys–but he was fine with what he received in return.

And the women and the money came fast, in the days I lost track
The women red, the money green, but the numbers were black
I fought for the men in their silk suits to lay down their bets
Well I took my good share, Ma, and I had no regret

When the rich guys were ready to move, our champ eyed the payoff and went along with the fix.

I took the fixed staid hombre with Big Diamond Don
From high in the rafters I watched myself fall
So he raised his arms, my stomach twisted, and the sky it went black
I stuffed my bag with their good money, and I never looked back

Worried his mom might see it different, the Hitter explained his choice to her:

Understand me, and Ma, every man plays a game
If you know anyone different, then speak out his name

As he talks through the door, he is not sure his mom even recognizes his voice–and if he gets her to open the door, he is not sure she’ll recognize his face either.  He has been through a tough life.   So he tells her to look into his eyes–and in those she will recognize to be the same as her own.

Well Ma, if my voice, now you don’t recognize
And just open the door and look into your dark eyes

He is proud and independent.   He doesn’t want his mom to misunderstand his intentions.  He doesn’t want her to have any regrets nor does he want her to see any of his frailties.  So he reminds her that he is not seeking anything, not even an “I love you”.    He just needs to return to the home he grew up in, lay down in the bed he slept in when he was young and innocent, and then he’d be ready to continue on.

I ask of you nothin’, not a kiss, not a smile
Just open the door and let me lie down for a while

The Hitter’s best days are behind him and he knows it.  But fighting is all he knows.  He is tough and lives with something he still needs to prove, though he is not sure to who.  Perhaps only to those who are like him–who think they are tougher and who too have a checkered past.

Now the grey rain is fallin’ and my ring fighting’s done
So in the work fields and alleys, I take them who’ll come
If you’re a better man than me then just step to the line
And show me your money and speak out your crime

Well tonight in the shipyard, a man draws a circle in the dirt
Like I always do, I move to the centre and I take off my shirt
I study him for the cuts, the scars, the pain man no time can erase
I move hard to the left and I strike to the face

If you are a Springsteen fan and haven’t heard this song, consider yourself lucky–as when you do, you are in for a treat.

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About two months ago, advertising was introduced on bearonbusiness. Actually, I cut a revenue-sharing deal with Rob Powell of Telecom Ramblings. Since inception, I think we divvied up about $31.59 between us.

Is my aim to make money? Many years ago, Bruce Springsteen (or more precisely a character in a Springsteen song) courted a gal who apparently had a sizable bank account. He explained her money wasn’t what he sought: “I ain’t after your money, ‘cause ‘I got plenty of that’ “. Nope: he just wanted to hang with her in the back of her Pink Cadillac.

My intent with ads pales in comparison to Bruce’s with the Pink Cadillac lady but, like Bruce, “I ain’t after your money, ‘cause ‘I got plenty of that’ “. My intent is to gain some first hand experience on how advertising works in the web 2.0 world.

So far, the answer is: “not all that well”.

Seth Godin of the fabulous Seth’s Blog wrote a recent post: When the writer becomes the publisher. I quote:

In a world in which just about everyone is a writer and just about every writer wouldn’t mind benefiting from their work, there’s a huge need for people who can help us publish profitably. Or, failing that, figuring out a way to get your own words published profitably. Some people will happily remain amateurs, but history shows us that the real explosion in content happens after people figure out how to make money.

Mark this down as another job for the new economy: someone who can collate, amplify and leverage the work of writers and turn it into cash. I don’t believe that there’s one solution, not this time. But I’m confident that around the edges and deep into niches, there’s money being made.

You betcha, Seth. Blogging is producing an incredible amount of interesting, insightful, and downright humorous content. And I am not just talking about bearonbusiness. Publishing is easy. And evidently lots of people have a lot to say. However, the opportunity for “someone who can collate, amplify and leverage the work of writers and turn it into cash” is bigger than a Pink Cadillac.

Newspapers are struggling. Perhaps they should change their business model entirely. Stop focusing on the production of unique content. Instead, focus on how to “collate, amplify and leverage the work of writers and turning it into cash”. What do you think Seth?

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“Just Doing Job” is Bogus Excuse
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Today, we will wrap up the series on Measuring Value Creation all together.   The formula is:

Value Creation = Intrinsic Value less Paid-In Capital-Net less Opportunity Cost

Focus on the time period ~”three quarters from now”.  Two principles underpin this:

First, performance in near term drives financial results “three quarters from now”.  Sales that are made in 2Q09 lead to installs next quarter which leads to financial statement revenue in 4Q09.  Likewise, cost reduction projects that are identified and approved in 2Q09 improve the cost structure in 4Q09.   Examples of these are network expense optimization and SG&A savings initiatives.  If service has been great in the recent past, customers will be more likely to not disconnect their service and to order more.  If service is poor, churn will increase and it will be harder to win new sales.   If the marketing/product group, with support of other groups, has a well tuned in quoting and pricing process, sales success will be higher, and results a few quarters hence will be boosted.

Second, Financial results can be forecasted with a high degree of accuracy for the next few quarters.    Per #1, most of the events that will drive 4Q09 performance have happened already.   A fine-tuned forecasting process produces an accurate bottoms-up projection of Income Statement, Cash Flow Statement, and Balance Sheet for the next handful of quarters.

Use the projected Balance Sheet to tabulate Paid-In Capital-Net at the end of “three quarters from now”.  If your business unit is returning cash, it is reducing its Paid-In Capital-Net and thereby helping the Value Creation equation.  If it is consuming additional cash, it is increasing the Paid-In Capital-Net.  Note that even one-time changes that help or harm cash are accounted for in the Value Creation equation.   Using Paid-In Capital-Net maintains emphasis on the flow of capital between the business unit and its parent.

Calculate Opportunity Cost by Multiplying the Paid-In Capital-Net by Cost of Capital.   Recall this is a cumulative calculation, where the calculation is made every quarter to “three quarters from now”, and these numbers are summed together to reflect the Opportunity Cost.  As part of this calculation, the management team assesses what Cost of Capital would leave investors neither thrilled nor disappointed in the business unit’s performance.

Derive an appropriate EBITDA Multiple for the Business Unit: Understand the relationship between EBITDA and Cash Flow.  Consider what longer-term growth rate is appropriate to assume for the business unit.  Peg what income tax and capital will be at the long term growth rate.  Show what EBITDA Multiple is implied by these assumptions and the business unit’s Cost of Capital.  Use EBITDA multiples of similar public companies to provide color to the analysis, but not as a substitute for showing a bottoms up derivation.

Estimate Intrinsic Value by multiplying EBITDA “three quarters from now” by the EBITDA Multiple.

There you have it.   Hopefully many BearOnBusiness readers are helped by this long-winded but very important series of Measuring Value Creation.

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How to Calculate Value Creation
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Estimating your EBITDA Multiple

We are nearing the end of the series on Measuring Value Creation. Before I provide the wrap up, I need to return to the topic of prior posts: Choosing an EBITDA Multiplier. Let’s recap what we learned about EBITDA Multiples:

1. The true value of a business–called Intrinsic Value–is determined by summing up those future cash flows -appropriately discounted – that the business is really going to generate. Multiplying EBITDA by a number is nothing more than a back-of-the-envelope approximation of discounted cash flows.

2. In many businesses including telecom, EBITDA is preferred over Cash Flow because capital expenditures are a significant component of Cash Flow. A capital intensive business that is growing rapidly will have low or perhaps negative Cash Flows, despite that the business is presumably in a rapid value-creation mode (else, why is it investing capital?). Conversely, slow or negative growth usually is accompanied by low capital expenditures and, hopefully, higher Cash Flow. Therefore, a multiple of near term Cash Flow is an extremely unreliable back-of-the-envelope approximation of Intrinsic Value.

3. Insight can be gained from similar companies that are publicly traded. However, there is danger in relying solely on market comps. First, market comps can change suddenly and substantially. Some of this might be due to legitimate new insights into Intrinsic Value. However, much of it also is due to the inherent difficulty in calculating Intrinsic Value, as small changes in assumed growth rates and Cost of Capital cause wild changes in EBITDA Multiples.  Making market comps even less reliable is that emotions e.g., fear and exuberance introduce noise into the market’s ability to efficiently estimate Intrinsic Value.   Moreover, no two firms are identical.  All and all, there is danger in blindly pegging your business’ multiple to that of a somewhat-similar public company.

4. EBITDA Multiples are highly sensitive to assumptions about growth rates, cost of capital, and the long term durability of cash flows.

I advocate that a business unit should take it upon themselves to derive and justify an EBITDA Multiple that is appropriate for its business. Understand the relationship between EBITDA and Cash Flow. Assess what Cost of Capital would leave investors neither thrilled nor disappointed. Consider what longer-term growth rate is appropriate to assume for the business unit. Peg what income tax and capital will be at the long term growth rate. Use the methodology described in Estimating your EBITDA Multiple to translate these assumptions into an EBITDA Multiple. Explain the results and underlying thinking to your constituents—and use their feedback to refine the derivation.

For many, this might seem theoretical; perhaps even distracting to the higher priority task of selling or provide good service. In my opinion, the learning that occurs when business unit leaders reflect on their EBITDA Multiple is of monumental importance. It provides a framework to dialogue about (a) how EBITDA translates into Cash Flow over the long term; (b) the durability of revenue and EBITDA and (c) what return would leave investors neither thrilled or disappointed. Each of these is essential to discovering opportunities to increase (or avoid destroying) value. For these very reasons, I have begun to probe my management teams to opine on what EBITDA Multiplier is appropriate for their business.

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Estimating your EBITDA Multiple
Multiples…
Why not Multiple of Free Cash Flow?
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Yesterday’s post returned back to the full form of the Value Creation equation:

Value Creation = Intrinsic Value less Paid-In Capital–Net less Opportunity Cost

We learned that Opportunity Cost captures the return that would leave investors barely satisfied with how their investment did. They are neither disappointed nor excited. As a manager of the business, you were neither a hero nor a goat.

We also learned that Opportunity Cost for a particular quarter is calculated by multiplying Paid-In Capital-Net by Cost of Capital. To determine how much value was created, Opportunity Cost needs to be summed up every quarter since inception. Using 12% as the Cost of Capital, I laid out a simple example:

In quarter 1, your company buys another one, spending $100M on the acquisition. The Opportunity Cost = $3M

In quarter 2, cash flow is negative $2M and cumulative Opportunity Cost is $6.06M

In quarter 3, cash flow is positive $4M and cumulative Opportunity Cost is $9M

In quarter 4, a division of this company is sold and the cash flow for the quarter is positive $10M. Cumulative Opportunity Cost is $11.6M

When managing a company, there are practical aspects of focusing on calculating Opportunity Cost.

1. Opportunity Cost has memory. That is, it looks back as to how the company did on cash flow in prior quarters. If prior quarters were unnecessarily cash flow negative, the Opportunity Cost gets bigger and bigger. Likewise, if a company is cash flow positive, it is rewarded with a lowering Opportunity Cost.

2. One time events that impact cash flow matter. If an asset is sold, it has a permanent positive impact on Opportunity Cost. If an investment is made in the business, such as the purchase of a new piece of equipment, it carries with it an ongoing expectation that positive future cash flows must be generated in the future quarters.

3. With regards to discretionary investments, it puts the emphasis on what really happened instead of on the original business case. How much was really spent? How did cash flows were really generated from this discretionary investment? Etc.

4. The expression of “profitable revenue growth” is often used in business. Opportunity Cost puts in perspective what “profitable revenue growth” really means, including the need to cover the cost of the capital invested

5. The time value of money is at the forefront of the calculation. It forces employees to focus not just on if money will be returned but on how quickly.

All these together create a sense of urgency to return cash flow to corporate or, if further investment is being made into the business, to ensure that the result will be an enterprise value that exceeds the total amount invested, inclusive of the Opportunity Cost of those dollars that were put at risk for a duration of time.

One more thought: The Hurdle Rate itself is also at the forefront. Why 12%, not 10% or 14%? How does management’s decision increase or decrease the “riskiness” of the dollars invested? How does the predictability of cash flows help reduce the Opportunity Cost?

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Opportunity Cost added to Value Creation Forumla
How to Calculate Value Creation
What is your Amount Invested?
Measuring Value Creation Series Wrap Up

The topic of the past few weeks has been Measuring Value Creation. The depth and breadth of the posts is a reflection of Value Creation being both a difficult concept to understand and a hard metric to measure. Let’s back-track a little bit and close the loop on a few important concepts. First I will present a slightly modified (in terminology only) definition of Value Creation and second I will bring back the concept of Opportunity Cost into our discussion.

Value Creation = Intrinsic Value less Paid-In Capital–Net less Opportunity Cost

I substituted Intrinsic Value for Today’s Value. I also replaced Amount Invested with Paid-In Capital-Net.

Long ago in Bearonbusiness, I positioned Intrinsic Value as the term that is used to discuss the true underlying value of a business. Intrinsic Value is determined by summing up those future cash flows -appropriately discounted – that the business is really going to generate. Therefore, to estimate Intrinsic Value, we need to look forward in time. When it comes to Intrinsic Value, the businesses’ past performance is relevant only to inform estimates of future cash flows.

We also learned that Paid-In Capital-Net is a Balance Sheet term meaning the actual amount that has been invested in a business (or business unit) by the investors (a.k.a Amount Invested). Paid-In Capital-Net is the total amount that has been invested in the business since inception (Paid-In Capital-Gross) less the amount that has been returned to shareholders (Dividends).

Early on, I introduced the concept of Opportunity Cost, which is:

“…the return that would leave investors barely satisfied with how their investment did. They are neither disappointed nor thrilled. It is about what they would have expected if they invested in something else that had the same level of risk. If they were expecting 10%, that is what they got. If they invested $100,000, expected 10%, and received $250,000 back 10 years later, they’d shrug their shoulders. You might not be their hero, but you weren’t their goat either. You did your job, but not much more. If you were a major league baseball player, you might be invited back to Spring Training, but you wouldn’t be playing in the All Star Game.”

To create value for investors, Intrinsic Value must be higher than Amount Invested by a certain minimum threshold, often called a Hurdle Rate; returns must exceed this hurdle to create, instead of destroy, value. Hurdle Rate is the interest rate that the investors would expect to get if they invested the money in a different company that was no more or less risky than yours. Hurdle Rate is, by the way, one and the same as Discount Rate. Another common term is Cost of Capital. Yes, that is right. Hurdle Rate = Discount Rate = Cost of Capital.

How specifically is Opportunity Cost calculated? So long as Paid-In Capital-Net is carefully tracked, it is straight-forward. Simply multiply Paid-In Capital-Net by Cost of Capital. To determine how much value was created, Opportunity Cost needs to be summed up every quarter since inception. Let’s lay out a simple example, using 12% as the Cost of Capital.

Example:

In quarter 1, your company buys another one, spending $100M on the acquisition. The Opportunity Cost = $100M * 12%/4 = $3M

In quarter 2, cash flow is negative $2M, bringing your Paid In Capital-Net to $102M. The Opportunity Cost for the quarter = $102M * 12%/4 = $3.06M. Cumulatively, it is $6.06M

In quarter 3, cash flow is positive $4M, bringing your Paid In Capital-Net to $98M. The Opportunity Cost for the quarter = $2.94M. Cumulatively, it is $9M

In quarter 4, a division of this company is sold and the cash flow for the quarter is positive $10M. Paid In Capital-Net drops to $88M, and the Opportunity Cost for the quarter = $2.64M. Cumulatively, it is $11.6M

Tomorrow, I will make a few observations about Opportunity Cost that I believe drive good management behavior.

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Opportunity Cost drives Management Behavior
Opportunity Cost added to Value Creation Forumla
Measuring Value Creation Series Wrap Up
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Amount Invested and Paid In Capital

[A colleague inquired about a prior post on the topic of Forecasting Cash Flows.   This post is topical to my long-winded series on Measuring Value Creation and therefore I took this as a prompt to re-post this.   It is, as the original title indicates, the foundation of an exceptional company.]

Predicting Cash Flows: The Foundation of an Exceptional Company (from Nov 5, 2007)

The prior post Investing versus Speculating described the difference between “investing” and “speculating”. Investing is only possible if free cash flows can be forecasted with reasonable level of accuracy whereas speculating is more akin to gambling, as future cash flows require guess-work. Warren Buffett is an investor, not a speculator, so he only makes investments in companies whose cash flows he can predict with confidence.

A corollary to this principle pertains to how companies should be run. Management should make it an extremely high priority to build a strong corporate competence around how to reliably forecast cash flows. This capability should be an integral part of their culture. It should permeate the entire employee base. The goal should be to get better and better at both the thoroughness and accuracy of cash flow forecasting.

Further, management should involve the entire organization in this quest. The financial forecasts should be communicated often and in a way that makes it easy for executives and employees alike to understand. Every month, the actual results should be compared to the forecast. Was the forecast as accurate as it should have been? How could it have been more accurate?

Each month, management should update the forecast. The update should reflect that 30 days have elapsed and more is known than a month ago. Enabled by this new information, the revised forecast should be better than the old one. Moreover, if the company is getting better at projecting cash flows, this should be reflected in bettering solidifyng the forward looking view.

I know what you are thinking: “your company already does this”. I doubt it, at least not anywhere close to the degree I believe it should. I am not talking about an annual budget process. I am not allowing for making loose approximations. If it feels like a bureaucratic waste of time, you can trust we are talking about two different things. If it is primarily an exercise for the finance organization, a warning bell should go off. If the balance sheet is excluded from the exercise, substantial pieces of cash flow are largely ignored. Finally, if the relationship between revenue, expense and capital is extremely hard to follow, know that your company is nowhere close to having a competency in this most critical area.

Buffett requires that he stay grounded in companies that he can reliably predict cash flows. Else, he is a speculator. Executives should require that their companies develop a core competency in accurately predicting cash flows. Otherwise, the executive is taking on more risk than he or she is required to. It is hard to overestimate the importance of this point. The executive cannot allow its employees to make decisions based on unnecessary speculation. The executive should not force investors to speculate on what should be knowable.

I feel so strongly about this point that I make it a centerpiece of every company I am involved with. We will be better at predicting cash flows than any company out there, whether in our industry or not. We will do this not just to be better than our competitors, as this is too low a bar in my mind. Our goal is to earn exceptional returns for our investors. Knowing everything we can know about our future cash flows is the foundation for doing this.

In subsequent blogs, I will discuss what management’s responsibility should be relative to its stock price. As a teaser, I will offer a provocative clue: the executive’s job should not be making the stock be as high as possible.  [See: High Stock Price = Bad]

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Predicting Cash Flows: The Foundation of an Exceptional Company
Really. I mean Really. What Really will your Cash Flows Be?
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“Investing”versus “Speculating”

Yesterday’s post presented the Efficient Market Theory, which asserts that financial markets are “informationally efficient” and therefore stock prices reflect all known information.  It further asserts that the stock prices reflect the consensus of highly skilled valuation professionals.       Naive investors are the prey of skilled investors, which results in a dynamic that leads to stock prices finding their way to that which skilled investors believe appropriate.   And these skilled investors understand the concept of Intrinsic Value.  That is, the most skilled are opining on future cash flows and discount rates.  Therefore, EMT theory implies that stock price reflects Intrinsic Value.

When it comes to measuring value creation, I believe the EMT is the beginning of the story.  As it turns out, like Kool Aid, the EMT comes in multiple flavors:–and understanding these flavors is a launching point to the rest of the story.  The three flavors are:

1. In weak-form efficiency, future prices cannot be predicted by analyzing price from the past. Excess returns can not be earned by using investment strategies based on historical share prices or other historical data.   This implies that future price movements are determined entirely by information not contained in the price series.
2. In semi-strong-form efficiency, share prices adjust to publicly available new information very rapidly and in an unbiased fashion, such that no excess returns can be earned by trading on new public  information.
3. In strong-form efficiency, share prices reflect all information, public and private, and no one can earn excess returns.  Strong Form assumes that information known by management–if relevant in the determination of Intrinsic Value–is known by stock trading experts and is therefore reflected in the share prices.

Note the difference in the Semi-Strong versus the Strong Form.  In the semi strong, only public information is reflected in the share price.  In the Strong, all relevant information is reflected.  The primary difference is whether information exists (e.g., inside knowledge held by management) that, though relevant to Intrinsic Value, is not known by expert stock traders.  I subscribe to the belief that the Semi-Strong is closest to reality.   Specifically, here is my belief:

1. Management teams are in the best position to accurately estimate their future cash flows
2. A great management team exploits this advantage to the benefit of its investors
3. A great management team ensures a strong competency around forecasting cash flows accurately and objectively
4. taking this a step further, a great management team uses their unique insights into future cash flows to (a) make better decisions and (b) objectively estimate Intrinsic Value
5. If a private company, management’s responsibility is to share these insights with their investors so as to allow the investors to make better investment decisions
6. If a public company, management’s responsibility is similar–though in practice they must live within the practical realities of being a public company

More to come….

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Efficient Market Theory
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Intrinsic Value
Stock Price provides Insight into Intrinsic Value
Multiples…