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What is the real Value of Value!

Meaning of word “VALUE” as per Oxford Dictionary:

noun – The regard that something is held to deserve; the importance, worth, or usefulness of something;
verb  – Estimate the monetary worth of;

Current Situation

Going by the recent trends of economic ups and down it seems that the real meaning is lost inside the books. Had that not been the case we wouldn’t have been sitting and contemplating about how to ride over the current economic crises which have long been in making. And for all the talk that has surrounded the causes of the recession and try to justify their reasoning, the main cause that has caught most of the attention is the investment into activities which were assumed to create value i.e. either returns or growth which cumulatively would be greater than the cost of capital. In that process forgot the principles of value creation.

It is all about following the basics i.e. understanding about which investments create real value. The guiding principle of value creation is that companies create value by deploying capital they raise from investors to generate future cash flows at rates of return exceeding the cost of capital (the rate investors require as payment). The faster companies can increase their revenues and deploy more capital at attractive rates of return, the more value they create.

The company, the investor and the government not following this basic principle of value creation are doing nothing but creating a problem for themselves in which they are bound to be caught one day or the other.

What is Value Creation

As per the prevailing fact put forward by various economists, value creation takes place when there is an increase in profits based on controlling the value drivers which create a competitive advantage reflected in either an increase in income from the core business areas of the firm or from controlling the major cost drivers.

A company can have growing revenues when there are certain competitive advantages in which they create an edge over their competitors and especially when these competitive advantages are closely related to the value drivers of that industry in which they operate. With this knowledge, companies can make wiser strategic and operating decisions, such as what businesses to own, which one to sell, when to go in a market for IPO, when to go for acquisition or divestment etc.

All these activities are related to understanding as to how to make trade-offs between growth and returns on invested capital—and investors can more confidently calculate the risks and returns of their investments.

Ways to Create Value

There are various factors that need to be taken care for the above situation to fully materialize. These are –

    • Setting Realistic Targets: Many leaders set unrealistic growth targets. Often, they don’t properly consider how fast their underlying markets are growing and thus how much market share must be grabbed to meet ambitious goals. Or they ignore the likelihood that their competitors are doing many of the same things to grow. They also underestimate the ongoing need to find new products to replace revenue declines from current offerings as they mature.
    • Excessive Leverage: As many economic historians have described, aggressive use of leverage is the theme that links most major financial crises. The pattern is always the same: companies, banks, or investors use short-term debt to buy long-lived, illiquid assets. Typically, some event triggers unwillingness among lenders to refinance the short-term debt when it falls due. Since the borrowers don’t have enough cash on hand to repay the short-term debt, they must sell some of their assets. But because the assets are illiquid, and other borrowers are trying to do the same, the price each borrower can realize is too low to repay the debt. In other words, the borrower’s assets and liabilities are mismatched.
    • Biasness towards investment: One of the puzzles of the sluggish global economy today is why companies aren’t investing more. They certainly seem to have good reasons to it. Yet many companies seem to be holding back. A number of factors are doubtless involved, ranging from market volatility to fears of a double-dip recession to uncertainty about economic policy.
      One factor that might go unnoticed, however, is the surprisingly strong role of decision biases in the investment decision-making process (a role that revealed itself in a recent McKinsey Global Survey). Most executives, the survey found, believe that their companies are too stingy, especially for investments expensed immediately through the income statement and not capitalized over the longer term. Indeed, about two-thirds of the respondents said that their companies underinvest in product development, and more than half that they underinvest in sales and marketing and in financing start-ups for new products or new markets. Bypassed opportunities aren’t just a missed opportunity for individual companies: the investment dearth hurts whole economies and job creation efforts as well.Value of ValueSuch biases, left unchecked, amplify this conservatism, the survey suggests. Executives who believe that their companies are under-investing are also much more likely to have observed a number of common decision biases in those companies’ investment decision making. These executives also display a remarkable degree of loss aversion—they weight potential losses significantly more than equivalent gains. The clear implication is that even amid market volatility and uncertainty, managers are right now probably foregoing worthy opportunities, many of which are in-house. The survey respondents held a wide range of positions in both public and private companies. All had exposure to investment decision making in their organizations. Nearly two-thirds of them reported that their companies generated annual revenues above $1 billion, and the findings are consistent across industries, geographies, and corporate roles.
    • Liquidity: The two types of markets operate very differently. Equities are highly liquid because they trade on organized exchanges with many buyers and sellers for a relatively small number of securities. In contrast, there are many more debt securities than equities because there are often multiple debt instruments for each company and even more derivatives, many of which are not standardized. The result is a proliferation of small, illiquid credit markets. Furthermore, much debt doesn’t trade at all. For example, short-term loans between banks and from banks to hedge funds are one-to-one transactions that are difficult to buy or sell. Illiquidity leads to frozen markets where no one will trade or where prices fall to levels far below that which reflect a reasonable economic value. Simply put, illiquid markets cease to function as markets at all.
      In the past 30 years, the world has seen at least six financial crises that arose largely because companies and banks were financing illiquid assets with short-term debt.
    • Any Alternatives? : In cases where companies have moderate growth and high returns on capital, it’s functionally impossible for them to reinvest every dollar they earn. But in most cases, simple math leaves such companies with little choice i.e. either go for share purchase or declare dividends.
      But some executives and board members argue that returning cash to shareholders reflects a failure of management to find enough value-creating investments. Share repurchases and dividends, these people argue, send a negative signal to the markets that a company can find nothing better to do with its cash.

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Value & M&A

And as the legendary investor, Warren Buffett has said “Price is what you pay. Value is what you get”. This is as far as stock buying is concerned. In an M&A deal, there mostly exist a gap between the value of a firm that has arrived by using valuation techniques and the price the investor pays. This is because the price paid by the acquirer is a price for present business + part of the synergy value creation which can happen post acquisition. This is even more difficult in the case of the vertical or conglomerate merger as compared to the horizontal merger. Synergy value raised actual depend on so many factors and there is always a substantial difference value estimated at the time of acquisition, value though there not being captured and a difference in the perception of the value. The reason for failure or less success to mergers is mainly due to these uncertainties. But when this gap is big enough like in many big acquisitions to be justified then there are bound to have implications in the long run which may not be of the liking of investors and the shareholders.

Big mergers and acquisitions make for splashy headlines, but do they make financial and strategic sense? Executives, board members, and investors are wise to be skeptical. As high-profile failures have demonstrated, big deals can destroy significant value for shareholders. The difference between success and failure often comes down to strategies and one of the most important factors being where companies have a clear, compelling reason to take on a big deal’s risks and integration complexity.


The term “Value” is one of the most talked words in the field of finance but if often misunderstood. We fail to capture the real essence of value and what are the fundamentals to value creation. This has led to situations from where we have been trying to buy back our actions ever since. The simple equation is to invest in projects where the returns on investment are greater than the cost of capital and such choices need to be guarded against various misconceptions.

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