The Mobile MBA: 112 Skills to Take You Further, Faster (Richard Stout's Library) (8 page)

•
Business cycle sensitivity:
some businesses are highly insensitive to the cycle, like water utilities. Restaurant chains, which depend on discretionary spending, are very cyclical. This means their cash flows can be volatile: adding high levels of debt, which demands cash to pay the interest rates in bad times as well as good, simply adds another layer of risk to an already risky business. Utility companies have stable cash flows in good times and bad, so can (and do) take on much higher levels of debt.

•
Pensions and other fixed commitments:
these are hidden fixed costs for many businesses, and are becoming increasingly important as regulation requires firms to maintain adequate funding of their pension funds. They are effectively hidden debt that has first call on your cash flows. The greater these obligations, the more risky it is to use debt to finance your firm.

If you have high operational leverage and high business cycle sensitivity it makes little sense to double your bets by taking on lots of debt as well. Equally, if you have very predictable cash flows, then you can afford to load up with debt. This is what water utilities have done, and typically private equity houses like to buy businesses with stable cash flows.

When you decide the level of debt your firm takes on, ask two questions:

• How much funding do we require to fulfil our ambitions (and perhaps we can be self-funding)?

• What will happen if we take on debt and our more pessimistic planning scenarios occur? Look at the required banking covenants, and if you breach them your bank will squeeze you for your last drop of blood. Banks are not paid to be nice. This is a basic financial risk assessment which tells you how much debt you can afford to take on. If there is too much risk, raise equity or scale back your ambitions and reduce your funding requirements.

Behind every business there is a very simple financial model. Understand that model and you will understand what drives the business. Financial analysts will often try to capture performance in one simple metric; for instance, consider:

•
Retailers
: change in like-for-like sales (after the effect of new store openings and closures)—this captures the underlying health of the business

•
Subscription television
: average revenues per customer, and churn rate

•
Hotels
: occupancy and average revenue per room night

These are useful measures of the overall health of the business. As managers, it pays to go one step further and identify the specific levers that you can pull to improve the performance of the business. Three examples will help to make the point:

1. Retailing.
The gross profit of a store is a result of five factors that can inform management decision making:

a.
Number of people passing the store (location decisions)

b.
Multiplied by the proportion of people entering the store (marketing decisions)

c.
Multiplied by the number of people buying in the store (merchandising decisions and sales effectiveness)

d.
Multiplied by the average value of each sale (merchandising and sales)

e.
Multiplied by the average margin of each sale (buying and pricing decisions)

2. Consulting.
This works on the basis of finders (partners who sell business), minders (managers who manage the business) and grinders (associates who do the work). The business model is then based on four variables:

a.
Billing rates: how much you charge per hour, which varies for finders, minders and grinders

b.
Utilization: how much billable time you expect from each level of the firm

c.
Breadth of the pyramid: fewer finders means more leverage and more profit, but makes it harder to sell enough business

d.
Rate of attrition and promotion: the faster you promote people, the faster you have to grow, or your pyramid goes awry. Alternatively, fire people in the middle and you create room for promotions from the bottom while keeping the shape of the pyramid and your economics together. New joiners do not understand the brutal economic reality that forces the up or out system of consulting firms

3. Credit cards.
The credit card business depends on acquiring and keeping the right sort of customer. The simplified model of the business can be built around the value of each customer. The value of the customer is the result of:

a.
The cost to acquire the customer: channel and marketing decisions

b.
The average spend per customer: customer targeting, profiling, marketing

c.
Average length of retention per customer: quality of service and operations

These are very crude ways of looking at your business. And that is the whole point. The simpler the system, the easier it is to see past the noise of day-to-day issues. Unless you manage the basic drivers of the business, the monthly variances appear as noise and you have to react to them on an ad hoc basis. Once you control the basic drivers of the business, you control its future.

Financial accounting is the bedrock on which the performance of the firm (and management bonuses) is based. Financial accounts should give a true and fair view of the financial position of the firm. In practice, most firms are proficient at managing the presentation of financial accounts, so that they are less of a bedrock of financial performance and more like quicksand in which you can easily sink.

Financial manipulation never improves the underlying performance of the firm. In most cases, it simply makes this year look good at the expense of future years. So bear in mind the following:

• As a manager, and potentially as an investor, it pays to read behind the headline numbers that are presented in the annual report and to understand the underlying performance of the firm. Here is what to look for: the exceptionals game. Many firms incur “exceptional” items every year: conveniently, these are removed from the headline P&L number. It is an easy way of boosting the reported P&L.

• Convert expenses into capital investment. Some capital investment is legitimate, like building a new factory. But some firms have happily capitalized marketing and IT spending on the basis that the benefit will be felt for years to come. Conveniently, that boosts profits this year and leaves a depreciation headache for your successor next year. M&A accounting is a law unto itself. There are two favorite tricks. First, buy a company with a lower PE (price to earnings) ratio than yours. Your earnings per share rise without any further effort on your part. Second, write off massive amounts of goodwill on the acquisition. This will be taken as an exceptional (see above) and will give you the chance to write back goodwill in later years if you want to boost profits later.

• Ignore impaired assets (like invoices which have no hope of ever being paid, or loans that will never be paid back to you). Keep them on the balance sheet, and avoid the expense of writing them off. Play the pensions game: take pension holidays when you can and then when you have to make extra payments to make up the shortfall, count them as exceptional.

• Aggressive revenue recognition. Deep discounts will pull sales forward from next year. Recognize as much of that $100 million project as revenue in this year as possible. One or two firms have resorted to illegal side deals with customers: taking stock today and letting them return it the day after the financial year closes. Thus revenues are recognized, but not achieved.

There is a long and ignoble roll call of dishonor when it comes to accounting trickery: Bernie Madoff, Enron, Lehman Brothers, WorldCom and Tyco are some of the more recent ones. You should be able to see through most of the smoke screens:

•
Read the notes:
they will show what is going on. If the disclosure documents are thick then something nasty may be hidden.

•
Reconstruct the cash flow statement
, from their balance sheets, for several years. This will tell you what is really happening with their sources and uses of funds.

•
Construct the pyramid of ratios
for the target firm for several years, and for its rivals. This will show whether underlying performance is improving or not.

The Capital Asset Pricing Model (CAPM) is one of the fundamental tools of the entire MBA course. It determines how much your project should earn to be viable, and helps you decide which projects are financially attractive and which are not. This is a critical tool. If you set your financial targets too high, you miss out on worthwhile projects. If you set the financial targets too low, you risk going out of business.

This section explores three ideas:

•
How CAPM works in theory

•
Why CAPM is dangerous in practice

•
Why CAPM is unsound in theory

Subsequent sections look at practical alternatives to CAPM that managers can use day to day.

CAPM tells you that your investment (equity) needs to earn a minimum return, which will be the sum of:

• The risk-free rate you can earn on risk-free assets, such as government bonds issued by top quality sovereign borrowers

• A risk premium for investing in equities, which are inherently more risky than risk-free government bonds

• A risk weighting for the specific risk of your project, which may be more or less risky than investing in a typical equity

All of this is captured in a simple equation:

COE
=
R
_f
+
βR
_m

where:

•
COE
is the cost of equity.

•
R
_f
is the risk-free rate.

•
R
_m
is the risk premium on the market.

•
β
(beta) is the specific risk of the project.

So far, so good. It makes sense that the riskier the investment the greater the expected return should be. But this common sense falls in the face of management reality.

CAPM contains three bear traps for the unwary manager: a project that is estimated to earn no more than the firm’s target rate of return will probably fail. Managers who pitch projects are not paid to be pessimistic. They make the best case possible, and then hope that they (or more likely their successors) can deliver on their promises. So a project that promises a 10% return based on a manager’s optimistic assumptions may struggle to break even. If the firm’s CAPM target is 10%, you need to see a project that offers at least a 20% paper return: reality is rarely as rose tinted as the original proposal.

If all your firm’s projects aim for the CAPM target rate of return, you will go bust. Any firm can be thought of as a portfolio of projects (call them brands, or businesses if you wish). Inevitably, some fail. Some meander along in a half life of hope. Others will be at an early stage of development and will be eating cash. To pay for all these cash drains you need some parts of the business that earn vastly more than the target rate of return. These profit sanctuaries are essential to the survival of the business. You do not create profit sanctuaries by focusing on the target rate of return; you need excess profits wherever you can earn them.

CAPM has nothing to say to mission driven firms

Even if a project is financially attractive, it does not mean it is an attractive business proposition. The project has to fit with the business objectives of the firm. And CAPM has nothing to say to mission driven firms such as not-for-profit organizations, the armed forces, and much of the public sector where there is no profit objective.

Look at the CAPM equation again:

COE
=
R
_f
+
βR
_m

Each part of the equation is problematic.

• The risk-free rate (
R
_f
) is fairly harmless, although it makes a difference if you use the one-year or 10-year rate of return (between about 1% and 4%). And if you are based in a country with a financially weak government (currently Ireland or Iceland for example), you will find it hard to establish a sensible risk-free rate: your government’s bonds will already carry a potentially large risk premium to cover the possibility of default.

• The risk premium (
R
_m
) on the market is the stuff of fiction. Historic estimates vary between 5% and 9%, but even these ignore survivor bias. They are based on the long-run average of the UK and US markets. If you had invested in Chinese, Russian, or German markets in the last century, you could have experienced a 100% wipeout. If you had invested in Japan in 1990, you would have lost 75% of your money over 20 years. As an alternative, the forecast risk premium produces a figure of nearer 2%.

• Beta for most investable stocks is around 0.5 to 2, at most. But these stocks are already diversified portfolios of income streams. Within a firm, an individual project can be given a beta of anything from 0.1 (the saving from switching to a lower cost supplier) to about 5 (for an investment in a completely new venture).

Now use the least demanding assumptions above and you can justify a required rate of return of about 3%. Use the most demanding assumptions, and your rate of return shoots up to 50%. So you can use CAPM to justify a target rate of return of somewhere between 3% and 50%. You may as well stick a pin in a dartboard.

CAPM proves one of the eternal truths of management: good thinking beats good math every time.

The simplest rule for managers is to work with whatever rules your firm provides. This is particulary true when it comes to pitching for investment. If your firm uses CAPM, use CAPM. If your firm uses another esoteric method, use that esoteric method, however good or bad it may be. Your job is not to change the system, but to work with it. In practice, that means making friends with the financial planning group early. They will jealousy guard their territory but don’t fight them, work with them. The earlier you involve them, the more likely you are to succeed in adapting your proposal to suit their needs. Show you respect them and they are likely to be flattered to be treated as partners, not as obstacles. Make them into your allies, and they will start finding solutions for you, even as they are finding problems for your colleagues.