Finance can be intimidating, and many business executives don’t even try to get their arms around it. But Harvard Business School Professor Mihir Desai says business leaders need to engage with the world of finance in order to succeed.
Desai wrote the book How Finance Works, released earlier this year, with the goal of making the world of finance accessible to broader audiences by providing a rigorous but accessible overview of the biggest topics in finance.
Finance is “the language of business, the lifeblood of the economy, and increasingly a dominant force in capitalism,” writes Desai, who researches tax policy, international finance, and corporate finance. The book grew out of his efforts to make finance more accessible through executive education teaching and his online course Leading with Finance. His previous book, The Wisdom of Finance, was longlisted for the FT-McKinsey Business Book of the Year and connected finance with the humanities.
The book sets out to demystify finance and instill both curiosity and confidence, helping readers answer fundamental questions like: What do financial ratios reveal about a company? How much value does a particular company create? And, what’s the best way for managers to communicate financial information to shareholders?
“People who want to have advanced roles in enterprise confront financial questions more and more, and they have to be more fluent in the financial consequences of their decisions. They have to know how to communicate results and interact with shareholders,” says Desai, who is also a Harvard Law School professor. “The problem is that people perceive finance to be this difficult building block. I want executives to have more comfort with it and to realize it’s not rocket science. It’s really important for them to know that anyone can access these ideas.”
Dina Gerdeman: Finance intimidates people largely because the system is so complex, but you say there’s an easier way to understand it. Can you explain how?
Mihir Desai: Finance is often talked about in an overly complicated way. This serves the interests of those in finance as they benefit from the obfuscation; it creates more mystery about what they do. This is particularly true when one looks at the array of differing institutions that interact in capital markets.
In one of the chapters in "How Finance Works,” I look at the broader financial ecosystem to demystify what capital markets are doing. The key to understanding these varied players is to first understand that financial markets are trying to solve the deep underlying problem of modern capitalism. When owners are no longer managers, the question of who gets capital is complicated by asymmetric information—in other words, managers have a lot of information, and investors don’t know if they can trust them.
We’re all engaged in a large information game where agents don’t always do what their principals want them to. That information game is really hard, and finance is about trying to solve who gets capital in a world where you don’t know who the good managers are and who the bad managers are. Most of what you observe of finance in the world is a manifestation or a reaction to the central problem of creating incentives in a world of imperfect information.
So, a disproportionate stock price hit to an earnings miss reflects that informational problem. The promise of private equity involves solving that gap between owners and managers. Buybacks must be interpreted in that context as either revealing confidence about the future given the presumed undervaluation of a firm or as an effort of managers to massage metrics. The salutary effects of activist investors can be appreciated, just as one also appreciates the information and incentive problems that plague their money management industry. The channeling of capital from savers to firms through layers of intermediaries is largely an information and incentive problem. Once you understand that, you can then really appreciate what all the different players are doing.
Gerdeman: In terms of determining how a company is doing, you describe how cash has come to matter more than profits. Can you explain what you mean?
Desai: People think finance and accounting are fundamentally the same when, in fact, much of the finance approach is a reaction against accounting. If you take the information problem as central, then measuring cash becomes important, as profits can be manipulated. Moreover, many of the central principles of accounting, including accrual accounting, effectively smooth out performance and deliberately obscure the inflows and outflows of cash. The modern finance approach is to return to cash via various metrics that have grown ascendant over the last three decades—EBITDA, operating cash flow, and free cash flow.
The emphasis on cash helps explain how firms have changed their supply chains and how working capital has become a significant financial benefit to major firms ranging from Apple to Walmart. Similarly, emphasizing cash can help explain the promise of asset-light models and why and how investors can disagree so sharply on controversial companies ranging from Netflix to Uber to Tesla.
Gerdeman: When a company has a lot of cash, a CEO can choose to grow the company organically—through expansion—or inorganically—through mergers and acquisitions. In recent years, stock buybacks have been the preferred method. Is this good or bad?
Desai: Much as free cash flow was a little-used metric 30 years ago and is now dominant, the capital allocation problem is now the dominant financial frame on a business. In the book, I lay out the choices embedded in the capital allocation problem and the various pathologies that are associated with it. In short, the capital allocation problem is simple. The dominant question for managers is: Do you keep free cash or do you distribute it? If you keep it, should you invest it organically or inorganically through M&A, and if you distribute it, should you use dividends or buybacks?
In the last 20 years, we’ve seen this shift from keeping cash to distributing cash through buybacks. This trend is either demonized or heralded while the truth is more subtle. The demonization arises because the rise in buybacks may be associated with underinvestment in the economy and managers trying to buy back stocks to appease shareholders while neglecting good investments. Or, worse yet, managers could be trying to boost earnings metrics to flatter themselves.
At the same time, distributing cash to shareholders is important, as it prevents managers from pursuing value-destroying opportunities within the firm just for the sake of deploying capital or because they want to run larger companies. And, distributing cash through buybacks can help reward loyal shareholders who believe in the long-run plans of companies.
Rather than seek regulations on buybacks as some propose, I’m in favor of boards being much more active in evaluating buybacks, limiting accelerated share buybacks, and changing the accounting treatment of buybacks so that managers are not tempted by their less beneficial effects. And, the book lays out the many ways in which the capital allocation problem is the central way to evaluate management.
Gerdeman: You say that valuation is both an art and a science, and even the best equity analysts and investors confuse the two and get things wrong. Why is that?
Desai: People think valuation is a scientific endeavor. But it’s a forward-looking, subjective, creative exercise that requires a lot of imagination. Think about valuing Facebook today. It requires predicting the future of privacy policies around the world, the actions of Google and Amazon in the advertising market, the future of the cost structure to support being possibly regulated as a publisher, and many, many other things! Unsurprisingly, people get valuations wrong all the time. That’s part of what makes finance so much fun and so interesting. People’s forecasts will differ, and valuations will often be wrong.
What’s more disturbing is that sometimes we observe people getting it wrong systematically. In M&A settings, we observe people getting valuations wrong in one direction—they’re overvaluing targets systematically. This, in part, is what leads to mergers failing, as overpayment is a terrible obstacle to overcome at the beginning of a merger, given the cultural issues it creates. So, why are people not just getting valuation wrong in this setting but getting it wrong systematically? The book lays out the information and incentive issues that go wrong in these settings—deal teams that desperately want to do deals, advisors that get paid when deals are done, and the fever pitch of auctions. And guarding against these pathologies is a critical role for senior management.
Gerdeman: What are the most important things you think people should understand about finance?
Desai: There are three things. The first and most important is that finance is not rocket science. It’s really pretty intuitive and extremely accessible. It’s critical and fun for people who understand and appreciate business. They can enjoy learning about companies in deep ways once they understand finance. The opening chapter of the book is a game that uses finance to manifest how much fun finance can be for those with a curiosity about business.
The second is that finance is not really about money. Finance is about understanding the information and incentive problems in capital markets and how those incentives can affect the ways we think about companies and managers and investors.
Finally, I hope people will understand that learning finance is a lifelong endeavor. Reading about companies and analyzing them can become almost a hobby. Indeed, for some people, finance becomes an avocation rather than a vocation as one ages. And that is a wonderful thing, but like all avocations, you need a firm foundation to really enjoy it, and you never stop learning.
Book Excerpt
How Finance Works: The Three Mistakes Made in Valuation
By Mihir Desai
Whether you’re buying stock, acquiring a company, buying a house, or investing in education, you need to go through a process of valuation. Is the proposed investment justified? How much should you pay?
But after an acquisition, it’s fairly common for the stock of the acquirer to fall, indicating that it likely overpaid and transferred value from itself to the target. That begs the question: Why are firms systematically overpaying? The answer is, they must be doing something wrong in valuation:
Ignoring incentives
The first, and most pervasive, mistake is that it is easy to ignore the incentives of the people involved in an acquisition. Certainly, sellers of assets want acquirers to overpay. And sellers control important sources of information, including historic financial information. What do you think the seller has been doing, as it prepares for a sale? It might make itself look particularly good by accelerating sales, deferring costs, and underinvesting. This circumstance makes due diligence a critical part of any acquisition process.
The problem doesn’t stop with the seller. Typically, investment bankers get paid only on completion, so they want you to make the deal. Even people within your company who have analyzed the transaction have perverse incentives. They may well anticipate getting a promotion to run the new division just acquired. Everyone involved in the transaction wants the transaction to happen and may subtly change assumptions or forecasts to help make that eventuality a reality. As a result, this sea of unbalanced information leads to overpayment and overconfidence.
Exaggerating synergies and ignoring integration costs
Synergy is the idea that once merged, the value of two companies will be greater than the sum of the values of each individual company. On the surface, the idea of synergies isn’t unreasonable. For example, if you bring two sales forces together and rationalize them, this should result in cost savings. If you bring two companies together, you will control more capacity within an industry and gain more pricing power.
Imagine if Amazon wanted to merge with eBay. The ability to use both sets of customer lists or both sets of vendors in the combined entity might be powerful. Alternatively, there might be a number of back-office and computing expenses that could be reduced by combining the two companies. Both cases are examples of synergy. The company could access customers it couldn’t have otherwise, or could cut costs in a way that it wouldn’t be able to individually.
The problem with synergies is that people tend to overestimate how quickly those synergies will work and overestimate the magnitude of their effects. They ignore the fact that mergers are complicated, and that changing cultures and changing workforces takes time. The second, related problem is that, even if the synergies are legitimate, people will often incorporate all those synergies into the price they pay for a company. That too can lead to overpayment since the rewards from the value creation of synergies are transferred to the acquired company’s shareholders, instead of being part of the value creation the merger brings to the acquiring company.
Underestimating capital intensity
One final error that sellers and eager bidders make is to understate the capital intensity of the business. Ongoing growth in EBIT or free cash flows typically requires increasing the asset base through capital expenditures. But those capital expenditures reduce free cash flows dollar-for-dollar—and are conveniently ignored by people anxious to do deals. For example, terminal values will assume perpetual growth rates but in the final year you are modeling (which serves as the basis of the terminal value), capital expenditures will just equal depreciation, indicating no growth in assets. In effect, understating capital intensity inflates values.
Reprinted by permission of Harvard Business Review Press. Excerpted from How Finance Works: The HBR Guide to Thinking Smart About the Numbers. Copyright 2019 Mihir Desai. All rights reserved.