Ahead of the Curve (15 page)

I asked Annette about this. I had admired her since her angry intervention in our section discussion of bathroom breaks. She had grown up in Chicago and spent five years at a major Wall Street investment bank before coming to HBS. She did not speak often in class but had a real presence in the section. She was committed to the African American community at HBS and to encouraging more African Americans to apply to the school. She had been an accomplished college athlete and a dancer before going into banking. She admitted that her life up to now, from college to Wall Street to HBS, had been modeled on that of African American women she admired. But there was going to come a time, very soon, she felt, when she would have to find her own path. She had intervened in the discussion of bathroom break, she said, because she felt it was an affront to her as an adult. She seemed to take the right things seriously. “You can’t get upset about these valuations’ not being right,” she told me after one of Ruback’s classes. “They make no claim to be exactly right. They are negotiating tools. If you spent any time at a bank you would see that all these techniques and models just serve the political needs of the bankers and their clients. If the bankers come up with one valuation and the client says, can’t we make that a little higher or lower, the bankers will go back to their model and adjust it to get it where the client wants it. And the more complex-seeming the model, the more tricks there are to pull. You should never mistake what they do for objective science. All that matters is the assumptions, and anyone can have a discussion about them, regardless of how much finance they know. The main thing is understanding the business in question.”

The only necessary tool in the chaos of finance, then, was not a computer or a set of formulae—which were incapable of grasping the complexity of risk—but old-fashioned judgment, honed by experience. In fact, experience is really the only backward-looking metric worth trusting. The rest are the products of idle mathematical minds. Once I reached this conclusion, I saw that all these weeks battling to build even the simplest financial models had not been in vain. They had forced me to understand how the pieces fit together. I was starting to see the structure, the plumbing and wiring of finance, where before all I had seen was the façade. I recalled Mihir Desai saying in Analytics that if we could not explain finance to our mothers, then we did not properly understand it ourselves. My mother was due a telephone call.

Accounting, to my great relief, had undergone a similar transition, from the numerical to the philosophical. I could crunch the numbers more easily, though, still, I was repeatedly surprised in class by how far ahead others were in this regard.

During our study group sessions, Alan consoled me: “Number games are what consultants play all day long,” he said. “They reach big conclusions from a handful of numbers. You know, they get the aspirin sales for one store and the number of people who use the store, then they figure out that number as a percentage of the people who live in the area, then they apply the percentage to the entire population of the United States, and now they gross up the sales at that one store and they’ve got a pretty good estimate of national aspirin sales. It’s like a party trick. It sounds great at first, but it gets old fast.”

In an FRC case about a medical products company that was selling products through television commercials, we had to decide if their advertisements were assets or expenses. These were not any old commercials, but direct-to-consumer ads, the kind that drag on forever on late-night television and include a specific toll-free number to call to buy your product. Each number in each ad was different, so the company knew exactly how much revenue each ad generated, unlike with more generic television advertising, where you never really know who is watching or whether they are responding to what you’re selling. In the latter case, where the benefit of the ad is uncertain, you would expense it. In the former case, where the revenue from the ad is measurable, you could treat it like an asset and depreciate the cost over time.

This led to a discussion about the nature of an asset. It was an economic resource, we decided, which produced measurable and reliable cash benefits. So what was an expense? It was more like throwing your money away in the hope of getting it back. Everything accountants called an asset had a degree of uncertainty to it. Even a chemical plant could collapse or its chemicals could cease to be used. But the more uncertainty surrounding an asset, the more like an expense it became. The founder of modern accounting, Luca Pacioli, a fifteenth-century Venetian monk, was also the first man to describe card tricks, and accounting, I found, was more impressionistic than I had ever imagined. There could be rigorous accounts that stuck to every accounting standard yet that somehow made no sense at all. And then there were accounts that broke every rule and yet seemed to reflect the truth about a company. It was the difference between a formal studio photograph that failed to capture a sitter’s character and a portrait in thick, crude oils that summed up a person in a few brushstrokes. As Eddie kept repeating, it was economic truth we sought, and accounts, properly kept and interpreted, helped us find it. They themselves were not the truth.

I once heard a church sermon in which the priest said you could tell most of what you needed to know about a person from looking at their bank and credit card statements. How they prioritize their spending will tell you how they prioritize their life. So it was with companies. You looked through the numbers for very human traits such as character, resilience, or imagination. Then you could apply versions of the old high-school yearbook tag “most likely to . . . go bust, produce steady returns, make me a billionaire.”

In one case, we looked at Microsoft’s financial reporting strategy. It had often baffled investors why Microsoft kept so much cash on its books. Investors tend to like to see cash either invested in improving the business or returned to them as dividends. Accountants and financiers and corporate strategists who looked at that cash number had come up with all kinds of explanations. Software was an intensively competitive business. Microsoft needed a cash cushion to carry it through the dark times. Others said it was a typical Microsoft trick. They persistently created this aura of doom and gloom around their prospects to minimize earnings expectations so that, quarter after quarter, they could beat Wall Street’s predictions and keep their stock price on a steady upward curve. But Bill Gates gave a very different reason in a panel discussion at the University of Washington with his friend Warren Buffett: “The thing that was scary to me was when I started hiring my friends and they expected to be paid. And then we had customers that went bankrupt—customers that I counted on to come through. And so I soon came up with this incredibly conservative approach that I wanted to have enough money in the bank to pay a year’s worth of payroll, even if we didn’t get any payments coming in. I’ve been almost true to that the whole time.”

I knew many people thought of Bill Gates as the devil. And they would rather believe that everything he did was the product of some fiendish strategy dreamed up while he hung upside down in his dank cellar beside the Pacific Ocean. But when he said he simply wanted enough money to pay his friends, I believed him. Imagine starting a business, getting all your friends to leave their jobs to come work with you, and then not being able to pay them. It would be a betrayal. The cash number on Microsoft’s balance sheet was not some accounting gimmick. It was a direct reflection of Bill Gates’s start-up mentality. Whatever happened, if his little rinky-dink software company was ever going to have a chance, he could not let down his friends. And if it worked then, why stop when the company had grown to be worth billions? Was it not still worth knowing that whatever happened, he could pay all the people who depended on him for their livelihoods? Perhaps, I began to wonder, accounting firms should hire psychoanalysts as well as accountants. The accountants could work on the numbers, and the shrinks could explain those numbers as indicators of ordinary human behavior.

One day Eddie brought in a newspaper article in which the CFO of an airline explained why he had accounted for his aircraft in a particular way, saying, “all I do is follow the rules as they are written.” Eddie tossed the newspaper to his desk in disgust. “If I ever, ever hear any one of you saying something as stupid as that, I promise I will personally come around to your house and noogie you.” The rules are the messy by-product of corporate and technological change, lawyers, lobbyists, politicians, and companies all scrapping for some advantage. Sometimes the rules make sense; other times they don’t. But economic truth remains constant. If accounting ceases to reflect what is actually going on but becomes some game in itself, it becomes worthless and possibly dangerous.

It was dispiriting, then, to discover the extent to which companies exploited the murk around accounting. For example, there was the “earnings game.” Wall Street, it was claimed, liked companies that showed smooth, frictionless growth, quarter by quarter. To achieve this, chief financial officers deployed all their tricks, deferring losses with one hand while booking unearned income with another, accruing expenses one year so as to stash profits from the tax collector the next. This may have produced a smooth curve, but to what real purpose, beyond the aesthetic? Could investors not accept that companies might have good and bad years? What was so wonderful about smoothness? Didn’t it seem in the least bit sinister or suspect to find all this orderly perfection amid the jungly chaos of business? A company with a seamless upward curve of earnings seemed no more credible to me than a man whose brow never furrowed or whose eyes never blinked.

From the accounts companies showed to the world, we then turned to the internal accounts companies could use to track their business, the Control half of Financial Reporting and Control. These internal accounts were less like a self-portrait and more like the control room of an ocean liner. A wall covered with dials and gauges told you how fast you were going and how much fuel you had left. Each day a different set of charts arrived detailing how much lobster salad your passengers consumed, how much they spent in the casino and spa, how much time they spent in their cabins watching movies instead of shopping in the designer stores. You might also want to know how well your staff was doing. Were the chefs churning out meals fast enough and the waiters waiting charmingly enough? Were the personal trainers standing around the water cooler all day or actually training people? Was it even worth having such a lavish gym when all anyone wanted to do was eat? Perhaps you could ditch the gym and use the space for another restaurant. Who spent more? Young families or retirees? Was anyone stealing from the cash registers? Your ship, or business, was a vast organism whose health you were constantly monitoring and hoping to improve.

At some point, the cost of monitoring every little thing that went on would exceed the benefit from any improvements. Trying to find that point was just another damn thing to think about. But, still, it’s worth doing. We studied the case of a small grocery store, like a 7-Eleven, and Chad took a break from tracking his investment portfolio and summed up the challenge with a salty question: “How long will it take for a dead rat on the floor to show up in the financial metrics?”

Robert Kaplan, an HBS accounting professor, took on the challenge of how to monitor the myriad aspects of a business and came up with the balanced scorecard, which has since been adopted by hundreds of small and large companies. It incorporates financial metrics with customer feedback, assessments of managerial and employee behavior, and opportunities for learning and growth. Done right, a balanced scorecard should tell the story of a business, incorporating all the strands that matter. It will tell you what a good, trustworthy manager would tell you. Done poorly, it is just a lot of money wasted generating a lot more useless numbers.

During some classes, you could tell from the buzz in the room that the case under discussion would stick in everyone’s mind. One such case, discussed in a LEAD class, dealt with Meg Whitman’s work as CEO of eBay. The case described her rise from Procter and Gamble to HBS to Bain consulting to Disney, on to Stride Rite, FTD, and finally, in 1998, to the online auction company, where she became a billionaire and a business world celebrity. During the class, we watched film of a speech Whitman gave at HBS soon after the dot-com crash of 2001. She reminded me of Katharine Hepburn, tall, a little galumphing, but resolutely jolly, as if at any minute she was going to let rip with a wolf whistle and a “C’mon fellas!” and have us all swimming in a freezing lake or singing around a piano. She spoke of the importance of hewing to classic management principles, even in supposedly new businesses. Returns on assets and investment, she said, would never go out of fashion. Fundamental analysis of things such as costs, customers, and competitors still yields rewards. Experience builds intuition, which is invaluable. Disney, she said, was a great company to work for, something she did not fully appreciate until she worked for a bad company. Culture and mission were not to be sneezed at. Employees are motivated by the feeling that they are on a mission.

But it was when Whitman turned to career advice that I could see everyone in the room perking up, waiting for “the secret.” “You’re never as good as you think you are. But you’re probably never as bad as you think you are,” she said, before going on to elaborate her nine-point personal philosophy. The first point is to do something you enjoy, because if you don’t enjoy it you’re unlikely to be any good at it. Second, deliver the results, whatever you’re doing. Third, codify the lessons learned. Since HBS, she said, she had experienced 1.5 successes, 1.5 failures, and 1 gigantic home run. Fourth, be patient and stick around good people and good things. Fifth, build a team and share credit. Sixth, be fun to work with. Seventh, ask what you don’t know or understand. Eighth, don’t take yourself too seriously. Ninth, never, ever compromise your integrity.