wealth creation

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Wealth is created by a business organization that provides a unique value to its environment by adding more value to its outputs than the cost of all resources used to produce those outputs. Wealth requires a uniqueness and efficiency. If the offering is unique, and efficiently produced, wealth is the result. If the offering is not unique, but the efficiency in producing it is unique, wealth is the result. If neither case is true, similarly capable producers will drive out the opportunity to produce wealth. At best, best, similar firms will earn no more than their cost of capital. In a highly competitive industry, with relatively equivalent competitors, even the cost of capital may not be covered.

Drucker on wealth creation -- Drucker, 1995
Enterprises are paid to create wealth, not control costs. But that obvious fact is not reflected in traditional measurements. First-year accounting students are taught that the balance sheet portrays the liquidation value of the enterprise and provides creditors with worst case information. But enterprises are not normally run to be liquidated. They have to be managed as going concerns, that is, for wealth creation. To do that requires information that enables executives to make informed judgments. It requires four sets of diagnostic tools: foundation information, productivity information, competence information, and information about the allocation of scarce resources. Together, they constitute the executive's tool kit for managing the current business.

  • Foundation Information -- The oldest and most widely used set of diagnostic management tools are cash-flow and liquidity projections and such standard measurements as the ratio between dealers' inventories and sales of new cars; the earnings coverage for the interest payments on a bond issue; and the ratios between receivables outstanding more than six months, total receivables, and sales.
  • Productivity information -- The second set of tools for business diagnosis deals with the productivity of key resources. The correct measure is total factory productivity. EVA is based on something we have known for a long time: what we generally call profits, the money left to service equity, is usually not profit at all. Until a business returns a profit that is greater than its cost of capital, it operates at a loss. Never mind that it pays taxes as if it had a genuine profit. The enterprise still returns less to the economy than it devours in resources. It does not cover its full costs unless the reported profit exceeds the cost of capital. Until then, it does not create wealth; it destroys it. By that measurement, incidentally, few U.S. businesses have been profitable since World War II. By measuring the value added over all costs, including the cost of capital, EVA measures, in effect, the productivity of all factors of production.
  • Competence information -- An examination of core competence is more of an assessment than a measurement. It raises rather than answers questions. But it raises the right questions. Every organization needs a way to record and appraise its innovative performance. This will be different for every company.
  • Resource-allocation information -- Wealth creation results from the allocation of the scarce resources of capital and performing people. All four of the following measures must be used for a proposed capital appropriation -- return on investment (ROI), payback period, cash flow, and discounted present value. Then, the collective appropriation opportunities should be compared to one another before choosing.

The above information tells us about the current business, informing management about tactics. For strategy we need organized information about the environment. This includes information on markets, customers, non-customers, technology -- both inside and outside the industry, politics, and the world economy.

Christensen on Financial Metrics as Obstacles to Innovation and Wealth Creation --
There are commonly employed financial metrics and platitudes that stand in the way of firms making financial decisions that favor innovation, organization evolution, and wealth creation.

  • Not accounting for fixed and sunk costs -- When considering an investment, managers are taught to calculate the internal rate of return (IRR) on that investment, and compare it with their weighted average cost of capital (WACC). However, the calculation is different for executives who find themselves with extra capacity, such as those running the US steel companies. They have been taught to ignore the sunk or fixed cost of the existing system.

    They, therefore, compare the marginal cost of producing an incremental unit in their existing plant, versus the full cost (and long-run average cost) of building and operating a new plant. Because the marginal cost is the lower of the two, and facing a comparable revenue stream in either case, the calculation gives an incentive for the incumbent to utilize its existing assets more fully-and delay investing in the technology that would put it in a fundamentally different, lower-cost position.

    In contrast, the attacker has no such comparison to make. It simply builds the plant utilizing the latest technology if the expected return exceeds its cost of capital.

  • Discounted cash flows (DCF) and net present value NPV) -- There are two problems with the mathematics of discounting as applied to innovative initiatives. The first problem is that its practice is commonly grounded on the assumption that the base case of not investing in the innovation-the ""do-nothing"" scenario against which the cash flows from the innovation are compared-is that the present health of the company will persist indefinitely into the future if the investment is not made.

    In other words, the mathematics compares the expected present value of the cash stream from investing in an innovation (Cash Stream A), with the expected present value of a do-nothing scenario (Cash Stream B - a flat horizontal line). In most situations, however, the combined impact of competitors' sustaining and disruptive investments results in price and margin pressure, technology changes, market share losses, sales volume decreases, and a declining stock price.

    This means that the most likely stream of cash in the do-nothing scenario is not the line represented by Cash Stream B. It in fact is a non-linear decline in performance as suggested by the trajectory of Cash Stream C.

    It's tempting, but wrong, to analyze a proposal by asking whether, if the new investment were made, it will make you better off than you are now. Why? Because, if conditions are deteriorating on their own, you well might be worse off in the future than you are now after making the proposed investment, but you still will be better off than you would have been without it.

    Philip Bobbitt, a law professor at the University of Texas, calls this logic ""Parmenides' Fallacy,"" after the ancient Greek logician who claimed to have proved that the world must necessarily be entirely unchanging and, thus, that all change is illusion. In Professor Bobbitt's words, ""This fallacy occurs when one tries to assess a future state of affairs by measuring it against the present, as opposed to comparing it to other possible futures.""

  • Maximizing shareholder value -- Through the 1960s, this assumption actually wasn't at odds with reality: the average holding period of shares in shareholders' portfolios was between five and six years. Managers seeking to maximize the long-term strength and growth of their companies could reward their shareholders over that somewhat extended time period.

    By 2005, however, the world had changed dramatically. Over 8,200 hedge funds managing $1.2 trillion in assets held 10 percent of the market value of publicly traded stocks. But because the average holding period of stocks in hedge fund portfolios is about 60 days, they account for approximately 35 to 40 percent of the trading volume on stock exchanges.

    Another 72 percent of shares, by value, are held in institutional portfolios-primarily pension and mutual funds. The average holding period in these portfolios is 10 months, which means that many funds don't hold a stock long enough to vote the proxy. (This information on hedge funds and mutual funds comes from a 2006 speech by Louis M. Thompson, president & CEO of the National Investor Relations Institute.)
    Ought managers regard mutual funds, and hedge funds as shareholders, when their average holding periods are 10 and two months, respectively? Their holding period is shorter than the investment horizon of the most near-sighted of managers.

    A paradigm rooted in the convenience of mathematical optimization has run amok. It is possibly time to adjust the paradigm of management responsibility to the reality of today's financial markets. Instead of worrying about returns to funds, managers could say to these fund managers:

    ""You are investors and speculators, not shareholders-and you temporarily find yourselves holding the securities of our company. You are responsible for maximizing the returns on your investments.

    ""Our responsibility is to maximize the long-term value of this company. We will therefore act in the interest of those whose interests coincide with our long-term prospects-including employees, customers, the communities in which our employees live, and that small minority of investors who plan to hold our securities for several years.""

  • Using gross margins to measure competitive health -- Analysts often build spreadsheet models that segregate fixed and variable costs in order to estimate the impact that sales volume changes in various products and markets will have on the financial performance of a company. The perspective that these models offer is that if managers increase revenues from products that generate higher percentage gross margins, more revenue will drop to the bottom line-and vice versa. It is quite common, as a result, for stock prices to rise or fall in response to quarterly announcements that reveal changes in gross margin percentages.

    While these measures indeed signal how changes in product mix are likely to affect profitability, they make it difficult for managers to move down-market to counter disruptive competitors attacking from below. The low-end of most markets in which disruptive competitors typically take root usually can be characterized by higher unit volumes, at lower prices and lower gross margin percentages. Although the total gross margin dollars generated at the low end often exceeds the total gross margin dollars generated at the high end of many markets, the instincts generated by analysts' financial models cause most managers to ""flee"" up-market towards customers who will pay for higher margin products, even though unit volumes are smaller, when attacked from below by disruptive competitors. This proclivity to focus exclusively on gross margin, in many ways, causes the innovator's dilemma.

    Some companies have come to measure financial health differently. For example, some measure gross margin x inventory turns-a metric that has amply helped discount retailers, such as Wal-Mart. Others create a common product or service platform that can extend from the low to high end of the market by adding and removing features and functionality.

    They then measure profitability not by gross margin percentages, but by net operating profit after fully allocated fixed costs. When they do that, it actually creates an incentive to defend the low end of the market-because the volume there absorbs overhead costs, and can make high-end products appear to be even more profitable. In other words, it makes both ends of the market appear to managers and sales people to be attractive. Many firms that do this find that they escape the innovator's dilemma that causes up-market flight.

Source: Christensen, Clayton M., Failed Paradigms of Financial Analysis: Sunk Costs, Strategy & Innovation, January-February 2007, Vol 5, No. 1 and Christensen, Clayton M., Failed Paradigms of Financial Analysis, Strategy & Innovation, March-April 2007, Vol 5, No. 2