Corporate financial management involves valuing businesses and thinking about ways to increase value by optimal investment, financing, pay-out and governance policies. It is an important area of research for INSEAD, as for other top business schools. Here, our leading expert in corporate finance, Professor Theo Vermaelen presents his views.
Valuation is a crucial skill, as it is relevant for many corporate decisions. Most people think of valuation as a skill you need if you want to buy or sell a company. But valuation is also important for other financial decisions such as capital structure choice and payout policy. As a company is supposed to create value for its long-term shareholders, you want to make sure that you do not issue equity when your shares are undervalued. At the same time, you do not want to buy back stock if you believe your shares are overvalued. In that case it would be preferable to pay dividends.
Moreover, any value-driven manager should try to model his or her strategic choices in a discounted cash flow spreadsheet. This allows you to check whether various operating decisions are value creating or value destroying. For example, if you tell your customers to pay later, you may increase profits as revenues will increase, but the net present value of this decision may well be negative, as it increases your investment in working capital.
In short, corporate finance is strategy with numbers. Here at INSEAD, we encourage managers to structure their strategic thinking in a spreadsheet so that the discussion about strategy becomes a discussion about the value drivers of the spreadsheet, such as growth, taxes, margins and capital turnover.
Companies can increase value by making good investment decisions, in particular through mergers and acquisitions. The fact is that most acquisitions do not create value for the buyers. This is not surprising, as a bidder typically has to pay a 30 to 40 % takeover premium. In other words, you have to increase the value of the target significantly before you can make any money. The lack of bidder profits from acquisitions can also be explained by the use of valuation methods that are driven by short-term profitability, such as earnings multiples. And last, but not least, there are good and bad reasons for acquisitions. The value-driven manager has to be able to distinguish between them.
Companies can also generate value by improving their capital structure. Debt is not cheaper than equity. A value-maximizing capital structure trades off the benefits of debt (such as tax advantages and discipline) against the disadvantages (such as the costs of financial distress). Costs of financial distress can be very subtle. If clients, workers, suppliers and providers of short-term financing believe the firm may end up in bankruptcy, they may stop buying the product or service and stop providing finance and human capital. In other words, the fear of bankruptcy may result in the reality of bankruptcy. Hence proper financial risk management and financial innovation are crucial ingredients for capital structure design and management.
Finally, firms have to decide on an optimal payout mechanism. Here the choice is normally between dividend payments and various methods of share buybacks such as tender offers, private repurchases and repurchases in the open market. As Warren Buffett recently pointed out, a share buyback is only justified if your stock is undervalued and you can afford it. Whether managers are capable of timing the market is a controversial issue but I believe it is possible to document global evidence on timing ability.
Most people care about themselves, not about shareholder value. Hence the art of corporate finance is to design incentive systems that align the interest of managers with the interest of long-term shareholder value. Note that long-term shareholder value is not the same thing as stock price (as markets may undervalue or overvalue the company) or profits (i.e. an accounting-driven, short-term measure of performance). This is why we spend significant time at INSEAD doing research and teaching on the link between governance and value creation. Governance is not simply designing compensation for top management, but also creating the right incentives for everyone in the organization to focus on value creation.
Professor Theo Vermaelen is the director of INSEAD’s corporate financial strategy program, Corporate Financial Strategy in Global Markets. He also teaches on our finance training course, Finance for Executives. Corporate finance is also taught as a part of the following general management programs (click on the program titles to find out more):
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