Value creation v/s redistribution

Why do firms exist? There are two broad views. The capitalistic view pushed by the US until recently insists that a firm must create value to its shareholders. The European view, however, is that a firm must create value to its stakeholders, which includes employees, investors, customers, society etc. The difference between the two shows up when value is not “created” but simply “redistributed”. Typically, value creation, implies an improvement in status quo. Where such value is tangible, its creation is by way of making things or processes faster, better or cheaper. But where the said value is intangible, its creation is determined by the perception of customers or consumers.

When a bank implements an IT system that speeds up its processes, it definitely creates value. Employees work better, customers transact faster, and risks of improper or fraudulent transactions are reduced. Or a power plant for that matter so long as it does not disturb the natural ecosystem.

On the other hand, let’s take expressways, which reduce travel time, thus creating value for commuters. But we overlook the loss incurred by fuel pumps because of increased fuel efficiency, auto mechanics because cars are on the road for fewer hours, hotels because people reach their destination much faster and need to stop for the night, roadside eateries, which are not allowed on expressways, and even if there is one, commuters might give it a skip and so on. This is a case of value redistribution – from fuel pumps, hotels, restaurants, to commuters. This is also the case with IT outsourcing. In these cases, the first definition comes up as myopic, focusing solely on the firm and its shareholders with total disregard to other players. And sooner or later, such cases will inevitably lead to agitation and outcry.

Recently, the WSJ reported how Mumbai’s black-and-yellow cabbies resorted to physical protests and violence against fleet operators such as Meru. Meru offers incredible value to a certain class of commuters, by simply not screwing up. People don’t pay more for the air-conditioning, but for such basic manners as courtesy and promptness. Nonetheless, it is a case of value redistribution, and is bound to rankle the sentiments of certain groups. Not that I support the case of taximen. Rather, I am appalled at their stupidity for I don’t know what else it can be. The unique prepaid system in our country doesn’t benefit anyone. Passengers pay nearly 50% more than the normal rate and I am quite certain the cabbies get paid less than the regular fare. It is only the middlemen who make money. But how did we get here? Simply because our cabbies refused to be honest. I can pardon them for lack of polish and manners for it is a matter of upbringing, and even the burgeoning middle class is woefully short on this. But there can be no excuses for dishonesty, and unless they are willing to see this, no amount of agitations and protests will help.

The business of business...

Continuing with thoughts on business models...

To exist, businesses must deliver value to its customers - this is different from the debate on creating value for shareholders vs stakeholders. Preferably, value must be tangible, but in some cases, it is notional. The industry that best demonstrates value creation is IT. Just imagine the time and effort wasted on mundane tasks everyday if we didn't have Windows and Microsoft Office.

Of course, value creation is not as obvious in all cases. Entertainment and television, for example. Some people would argue that television is turning us into morons and is actually value destroying. Yet, the industry is exploding. This is a case of notional value, where people are ready to lap up any and every form of entertainment. It can be risky to bet on such models because they fundamentally rely on exploiting consumer preferences. Very similar to what the fashion industry does. The value created is not by clothing people but rather by making people feel that their clothes are better than others. This is also the business model of our local quack, palmist and other fortune tellers – they all make the consumer feel better.

The ability to deliver notional value on top of real value is the holy grail of a successful business. Which means, not only is the product good, but you also take pride in ownership. The ipod and iphone are perfect examples. World-class products enhanced by the “Apple” brand. Even here, the relative magnitude of the tangible and notional values matter. So long as the tangible value is much larger than the notional one, the business is stable. Microsoft, for example, probably has a negative notional value, but is yet a profitable business because it offers unmatched tangible value. On the other hand, FMCG products do have some tangible value, but rely heavy on notional value. I doubt if any of us can differentiate between two shampoos in a blind test.

The simplest way to check whether a business adds value is to ask if it helps people do stuff “faster, better and cheaper”. Ideally, all three aspects must be addressed but sometimes addressing even two is okay.

I mint?

Great ideas sound exactly like foolish ones - until they work that is. That's my favorite Scott Adams' quote.

The thought occurred to me when I saw the ad for imint on the back of a bus. It is a rewards system where you earn points every time you spend, which can be later redeemed for gifts or vouchers. Nothing radical about the concept itself. Credit cards have been doing this for a long time now. But here's what puzzled me. Is there an opportunity for a third-party to make a business out of it?

I dont know for a fact how imint works, but my guess is they have consolidated the rewards system of some retailers and cards so that the customer is able to get points for all transactions in a single "currency". So no more 100 points with ICICI, 250 points with HP, 50 points with Jet with none of them sufficient by themselves to do anything. Now, we get 450 imint points that is good enough to get a mug or something.

I guess imint adds some value thru the economies of scale it gets by consolidating the rewards system. So that explains why ICICI, HP and Air India have hopped on. Their points now make some sense to customers. But how would imint get new customers? For instance, why would HDFC or Jet sign on? Its destructive to both HDFC and ICICI because their customers wont see any difference in using either card, thus resulting in mutual cannibalization. In fact, I wont be surprised if ICICI has an deal that prevents imint from signing on competing financial institutions.

So how can imint grow? Well, by encouraging customers to spend more. That I think, personally, is a friggin stupid model to run a business.

Value of a stock - Part II

Before we move forward, lets discuss the time value of money. This concept is at the core of financial valuations. It states that a $100 today is worth more than $100 a year from now. Why? You can put your $100 in a bank it will be $105 next year. That's the time value of money. In other words, there is an opportunity cost involved.

Back to our stock now. We've determined the return that we are expecting from the stock. And we have the price of the stock as it trades in the market. We can use the two to determine what should the price one year from now. If price is $10 and expected return is 10%, then price of stock 1 year from now is 10*(1+10%) = 10*1.1 = $11. In other words, if the stock price is $11, one year from now, you can pay $10 to buy it today.

A little digression to understand where a stock's value comes from. A company makes and sells products and earns revenue. Out of this, go expenses such as raw materials, salaries etc. If the company has any debt, it needs to pay interest on that. And what remains is the profit. Of course profits are taxed, so a portion of that goes to the govt. What remains after all these is called Profit After Tax (PAT) or Net Income (NI) is available for distribution among shareholders. In reality, of course, companies "reinvest" PAT, meaning they will use this money to fund further expansion and generate more revenues etc. For simplicity, lets say a company is "mature", meaning there are no opportunities of growth. It will just keep making and selling the exact # of units year after year. As a result, all PAT will be distributed as dividends to shareholders that is you and me:) In reality though PAT doesnt equal CASH - that's accounting for you, which is way out of the scope of this article. But understand that some adjustments are made to PAT to arrive at "Cash Flows (CF)".

Now it all comes together. Once you know the CFs of a company year after year, you can discount them all by the expected return rate to get today's value. But we only have data to calculate last year's CF. How do you know what the company makes in future years? This is where assumptions and projections come in. You look at the economy, industry etc., and predict that revenues, expenses will grow or shrink at a certain rate leaving you with a CF. This is one reason why analysts may have differing opinions about a stock's value - because they have different growth assumptions.  Once you buy a share of a company, you own it forever (or until the co shuts down). So you'd have to project CFs out to infinity. To make it mathematically manageable, you project it out 10 years or so, and use a geometric series formula to find the value at the end of 10 years. Now discount all these values to today and you have the value of the firm.

Now, if the firm has taken any debt, that will need to be repaid eventually. So subtract debt from the value of the firm and you have the "equity value" of the firm, which is what shareholders own. Simply, divide the equity value by the number of shares outstanding, and voila! you get value per share.

If this value is less than market price, the stock is overvalued. If it is greater than price, the stock is undervalued.

More Than You Know

Just started Taleb's Fooled by Randomness. As it happens, this is the third consecutive book I am reading which talks about the role luck, randomness etc – I am using these terms to loosely mean uncertainty – plays in our lives. The previous two are Michael J. Mauboussin's More Than You Know and Malcolm Gladwell's Outliers. I will quickly summarize my takeaways from the first one.

The point is stunningly simple. That the market has several players, and the same bit of information is interpreted differently by different players. Naturally, a pre-condition is that the market players be heterogeneous and for the most part they are. When heterogeneity is maintained, the market on average correctly reflects the underlying state of the economy. One particular story (a true one, I believe) is used to convincingly illustrate this phenomenon. At a village contest, people were asked to guess the weight of an ox. The average value of the guesses turned out to be correct answer, although none of the individual guesses was anywhere close. The so-called experts represent only some players in the market, and at best, their predictions may only be close to the actual. When heterogeneity is compromised, however, players fall prey to group-thinking, and we end up with unsustainable booms followed by the unavoidable busts. The practical consequence is that one is better off investing in index funds rather than mutual funds.

Anyone invested in the market would know that "overvalued" and "undervalued" are two terms that every analysts throws in at will in his analysis. The value of a stock is the discounted value of its future cash flows (profits loosely), and the price is what it currently fetches in the market. Now, if the price of a stock is higher than its value, it is overvalued. The typical analyst recommends selling overvalued stocks and buying undervalued ones because sooner than later price adjusts to reflect value. The point made in the book is that it is not enough for you to find a great stock that is undervalued. The premise is that price will adjust to reflect value (in this case, price will go up). Meaning, there are just enough people out there thinking the same way as you are so that the demand for the stock pushes its price upward. If everything thinks the way you do, the stock would skyrocket immediately. And if no one agrees with you, well, the stock might stay undervalued forever.

So the trick is not just to find stocks that are undervalued, but also predict whether the market will agree with your assessment. It is probably for this reason that analysts love to appear on TV shows and rattle out their predictions. If enough people watching the show fall for it, well, you've got yourself a self-fulfilling prophecy. (The last point is my extrapolation).

The book covers such wide range of topics that I don't even remember all the things discussed. It definitely was worth my time, and hopefully I will get around to reading it again.

Tailpiece: Pune Mirror found my post worthy to be included on their website..

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