Valuation: Measuring and Managing the

Value of Companies 7th Edition Tim

Koller
Visit to download the full and correct content document:
https://ebookmass.com/product/valuation-measuring-and-managing-the-value-of-com
panies-7th-edition-tim-koller/
Valuation
MEASURING AND
MANAGING THE
VALUE OF
COMPANIES
The Wiley Finance series contains books written specifically for finance and
investment professionals as well as sophisticated individual investors and
their financial advisors. Book topics range from portfolio management to
e-commerce, risk management, financial engineering, valuation and financial
instrument analysis, as well as much more. For a list of available titles, visit
our Web site at www.WileyFinance.com.
Founded in 1807, John Wiley & Sons is the oldest independent publish-
ing company in the United States. With offices in North America, Europe,
Australia and Asia, Wiley is globally committed to developing and marketing
print and electronic products and services for our customers’ professional and
personal knowledge and understanding.
VALUATION
MEASURING AND
MANAGING THE
VALUE OF
COMPANIES
SEVENTH EDITION

McKinsey & Company

Tim Koller
Marc Goedhart
David Wessels
Cover design: Wiley

Copyright © 1990, 1994, 2000, 2005, 2010, 2015, 2020 by McKinsey & Company. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.

Published simultaneously in Canada.

No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any
form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise,
except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without
either the prior written permission of the Publisher, or authorization through payment of the
appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers,
MA 01923, (978) 750-8400, fax (978) 646-8600, or on the Web at www.copyright.com. Requests to
the Publisher for permission should be addressed to the Permissions Department, John Wiley
& Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748-6011, fax (201) 748-6008, or online at
http://www.wiley.com/go/permissions.

Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best
efforts in preparing this book, they make no representations or warranties with respect to the
accuracy or completeness of the contents of this book and specifically disclaim any implied
warranties of merchantability or fitness for a particular purpose. No warranty may be created or
extended by sales representatives or written sales materials. The advice and strategies contained
herein may not be suitable for your situation. You should consult with a professional where
appropriate. Neither the publisher nor author shall be liable for any loss of profit or any other
commercial damages, including but not limited to special, incidental, consequential, or other
damages.

For general information on our other products and services or for technical support, please contact
our Customer Care Department within the United States at (800) 762-2974, outside the United
States at (317) 572-3993 or fax (317) 572-4002.

Wiley publishes in a variety of print and electronic formats and by print-on-demand. Some
material included with standard print versions of this book may not be included in e-books or
in print-on-demand. If this book refers to media such as a CD or DVD that is not included in the
version you purchased, you may download this material at http://booksupport.wiley.com. For
more information about Wiley products, visit www.wiley.com.

Library of Congress Cataloging-in-Publication Data

Names: McKinsey and Company. | Koller, Tim, author. | Goedhart, Marc H.,
author. | Wessels, David, author.
Title: Valuation : measuring and managing the value of companies / McKinsey
& Company, Tim Koller, Marc Goedhart, David Wessels.
Description: Seventh edition. | Hoboken, New Jersey: Wiley, [2020] |
Series: Wiley finance | First edition entered under: Copeland, Thomas E.
Identifiers: LCCN 2020013692 (print) | LCCN 2020013693 (ebook) | ISBN 978-1-119-61088-5
(Hardcover) | ISBN 978-1-119-61087-8 (ePDF) | ISBN 978-1-119-61092-2 (ePub) | ISBN
978-1-119-61186-8 (University Edition) | ISBN 978-1-119-61246-9 (Cloth edition with
DCF Model Download) | ISBN 978-1-119-61181-3 (Workbook) | ISBN 978-1-119-61086-1
(DCF Model Download)
Subjects: LCSH: Corporations—Valuation—Handbooks, manuals, etc.
Classification: LCC HG4028.V3 C67 2020 (print) | LCC HG4028.V3 (ebook) |
DDC 658.15—dc23
LC record available at https://lccn.loc.gov/2020013692
LC ebook record available at https://lccn.loc.gov/2020013693

Printed in the United States of America

10 9 8 7 6 5 4 3 2 1
Contents

About the Authors   ix

Preface   xi
Acknowledgments   xv
Part One Foundations of Value
1 Why Value Value?   3
2 Finance in a Nutshell   17
3 Fundamental Principles of Value Creation    27
4 Risk and the Cost of Capital    55
5 The Alchemy of Stock Market Performance    69
6 Valuation of ESG and Digital Initiatives    83
7 The Stock Market Is Smarter Than You Think    99
8 Return on Invested Capital   127
9 Growth   155
Part Two Core Valuation Techniques
10 Frameworks for Valuation   177
11 Reorganizing the Financial Statements    205
12 Analyzing Performance   239
13 Forecasting Performance   259

v
vi Contents

14 Estimating Continuing Value   285

15 Estimating the Cost of Capital    305
16 Moving from Enterprise Value to Value per Share    335
17 Analyzing the Results   357
18 Using Multiples   367
19 Valuation by Parts   391
Part Three Advanced Valuation Techniques
20 Taxes   413
21 Nonoperating Items, Provisions, and Reserves    427
22 Leases   443
23 Retirement Obligations   457
24 Measuring Performance in Capital-Light Businesses    467
25 Alternative Ways to Measure Return on Capital    483
26 Inflation   493
27 Cross-Border Valuation   507
Part Four Managing for Value
28 Corporate Portfolio Strategy   527
29 Strategic Management: Analytics   547
30 Strategic Management: Mindsets and Behaviors    571
31 Mergers and Acquisitions   585
32 Divestitures   613
33 Capital Structure, Dividends, and Share Repurchases    633
34 Investor Communications 667
Part Five Special Situations
35 Emerging Markets   691
36 High-Growth Companies   709
37 Cyclical Companies   725
 Contents vii

38 Banks   733
39 Flexibility   759
Appendix A Discounted Economic Profit Equals Discounted Free
Cash Flow   793
Appendix B Derivation of Free Cash Flow, Weighted Average Cost
of Capital, and Adjusted Present Value    799
Appendix C Levering and Unlevering the Cost of Equity    805
Appendix D Leverage and the Price-to-Earnings Multiple    813
Appendix E Other Capital Structure Issues    817
Appendix F Technical Issues in Estimating the Market Risk
Premium   823
Appendix G Global, International, and Local CAPM    827
Appendix H A Valuation of Costco Wholesale    835
Appendix I Two-Stage Formula for Continuing Value    859

Index   861
About the Authors

The authors are all current or former consultants of McKinsey & Company’s
Strategy & Corporate Finance Practice. Together they have more than 85 years
of experience in consulting and financial education.
* * *
Tim Koller is a partner in McKinsey’s Stamford, Connecticut, office, where he
is a founder of McKinsey’s Strategy and Corporate Finance Insights team, a
global group of corporate-finance expert consultants. In his 35 years in consult-
ing, Tim has served clients globally on corporate strategy and capital markets,
mergers and acquisitions transactions, and strategic planning and resource
allocation. He leads the firm’s research activities in valuation and capital mar-
kets. Before joining McKinsey, he worked with Stern Stewart & Company and
with Mobil Corporation. He received his MBA from the University of Chicago.
* * *
Marc Goedhart is a senior expert in McKinsey’s Amsterdam office and an en-
dowed professor of corporate valuation at Rotterdam School of Management,
Erasmus University (RSM). Over the past 25 years, Marc has served clients
across Europe on portfolio restructuring, M&A transactions, and performance
management. He received his PhD in finance from Erasmus University.
* * *
David Wessels is an adjunct professor of finance at the Wharton School of
the University of Pennsylvania. Named by Bloomberg Businessweek as one of
America’s top business school instructors, he teaches courses on corporate
valuation and private equity at the MBA and executive MBA levels. David is
also a director in Wharton’s executive education group, serving on the execu-
tive development faculties of several Fortune 500 companies. A former con-
sultant with McKinsey, he received his PhD from the University of California
at Los Angeles.

ix
x About the Authors

* * *
McKinsey & Company is a global management consulting firm committed to
helping organizations create change that matters. In more than 130 cities and
65 countries, teams help clients across the private, public, and social sectors
shape bold strategies and transform the way they work, embed technology
where it unlocks value, and build capabilities to sustain the change. Not just
any change, but change that matters—for their organizations, their people,
and, in turn, society at large.
Preface

The first edition of this book appeared in 1990, and we are encouraged that
it continues to attract readers around the world. We believe the book appeals
to readers everywhere because the approach it advocates is grounded in uni-
versal economic principles. While we continue to improve, update, and ex-
pand the text as our experience grows and as business and finance continue
to evolve, those universal principles do not change.
The 30 years since that first edition have been a remarkable period in busi-
ness history, and managers and investors continue to face opportunities and
challenges emerging from it. The events of the economic crisis that began in
2007, as well as the Internet boom and its fallout almost a decade earlier, have
strengthened our conviction that the core principles of value creation are gen-
eral economic rules that continue to apply in all market circumstances. Thus,
the extraordinarily high anticipated profits represented by stock prices during
the Internet bubble never materialized, because there was no “new economy.”
Similarly, the extraordinarily high profits seen in the financial sector for the
two years preceding the start of the 2007–2009 financial crisis were overstated,
as subsequent losses demonstrated. The laws of competition should have
alerted investors that those extraordinary profits couldn’t last and might not
be real.
Over time, we have also seen confirmed that for some companies, some of
the time, the stock market may not be a reliable indicator of value. Knowing
that value signals from the stock market may occasionally be unreliable makes
us even more certain that managers need at all times to understand the under-
lying, intrinsic value of their company and how it can create more value. In
our view, clear thinking about valuation and skill in using valuation to guide
business decisions are prerequisites for company success.
Today, calls mount for changes in the nature of shareholder capitalism.
As we explain in Chapter 1, we believe this criticism derives largely from

xi
xii Preface

a misguided focus by corporate leaders on short-term performance that

is ­inconsistent with the value-creation principles we describe in this book.
­Creating value for shareholders does not mean pumping up today’s share
price. It means creating value for the collective of current and future share-
holders by applying the techniques explained in this book.

Why This Book

Not all CEOs, business managers, and financial managers possess a deep
understanding of value, although they need to understand it fully if they
are to do their jobs well and fulfill their responsibilities. This book offers
them the necessary understanding, and its practical intent reflects its origin
as a handbook for McKinsey consultants. We publish it for the benefit of
current and future managers who want their companies to create value,
and also for their investors. It aims to demystify the field of valuation and
to clarify the linkages between strategy and finance. So while it draws on
leading-edge academic thinking, it is primarily a how-to book and one we
hope you will use again and again. This is no coffee-table tome: if we have
done our job well, it will soon be full of underlining, margin notations, and
highlighting.
The book’s messages are simple: Companies thrive when they create real
economic value for their shareholders. Companies create value by investing
capital at rates of return that exceed their cost of capital. These two truths
apply across time and geography. The book explains why these core prin-
ciples of value creation are genuine and how companies can increase value by
­applying them.
The technical chapters of the book aim to explain, step-by-step, how to do
valuation well. We spell out valuation frameworks that we use in our consult-
ing work, and we illustrate them with detailed case studies that highlight
the practical judgments involved in developing and using valuations. Just as
important, the management chapters discuss how to use valuation to make
good decisions about courses of action for a company. Specifically, they will
help business managers understand how to:

• Decide among alternative business strategies by estimating the value of

each strategic choice.
• Develop a corporate portfolio strategy, based on understanding which
business units a corporate parent is best positioned to own and which
might perform better under someone else’s ownership.
• Assess major transactions, including acquisitions, divestitures, and
restructurings.
 Preface xiii

• Improve a company’s strategic planning and performance management

systems to align the organization’s various parts behind improved ex-
ecution of strategic priorities and create value.
• Communicate effectively with investors, including whom to talk with
and how.
• Design an effective capital structure to support the corporation’s ­strategy
and minimize the risk of financial distress.

Structure of the Book

In this seventh edition, we continue to expand the practical application of

finance to real business problems, reflecting the economic events of the past
decade, new developments in academic finance, and the authors’ own experi-
ences. The edition is organized into five parts, each with a distinct focus.
Part One, “Foundations of Value,” provides an overview of value cre-
ation. We make the case that managers should focus on long-term value
creation for current and future shareholders, not just some of today’s share-
holders looking for an immediate pop in the share price. We explain the two
core principles of value creation: (1) the idea that return on invested capital
and growth drive cash flow, which in turn drives value, and (2) the con-
servation of value principle, which says that anything that doesn’t increase
cash flow doesn’t create value (unless it reduces risk). We devote a chapter
each to return on invested capital and to growth, including strategic prin-
ciples and empirical insights.
Part Two, “Core Valuation Techniques,” is a self-contained handbook for
using discounted cash flow (DCF) to value a company. The reader will learn
how to analyze historical performance, forecast free cash flows, estimate the
appropriate opportunity cost of capital, identify sources of value, and inter-
pret results. We also show how to use multiples of comparable companies to
supplement DCF valuations.
Part Three, “Advanced Valuation Techniques,” explains how to analyze
and incorporate in your valuation such complex issues as taxes, pensions, re-
serves, capital-light business models, inflation, and foreign currency. It also
discusses alternative return-on-capital measures and applications.
Part Four, “Managing for Value,” applies the value-creation principles to
practical decisions that managers face. It explains how to design a portfo-
lio of businesses; how to run effective strategic-planning and performance
management processes; how to create value through mergers, acquisitions,
and divestitures; how to construct an appropriate capital structure and pay-
out policy; and how companies can improve their communications with the
financial markets.
xiv Preface

Part Five, “Special Situations,” is devoted to valuation in more complex

contexts. It explores the challenges of valuing high-growth companies, com-
panies in emerging markets, cyclical companies, and banks. In addition, it
shows how uncertainty and flexibility affect value and how to apply option-
pricing theory and decision trees in valuations.
Finally, our nine appendixes provide a full accounting of our methodol-
ogy in this book. They provide theoretical proofs, mathematical formulas, and
underlying calculations for chapters where additional detail might be helpful
in the practical application of our approach. Appendix H, in particular, pulls
into one place the spreadsheets for the comprehensive valuation case study of
Costco featured in this edition.

Valuation Spreadsheet

An Excel spreadsheet valuation model is available via Web download. This

valuation model is similar to the model we use in practice. Practitioners will
find the model easy to use in a variety of situations: mergers and acquisi-
tions, valuing business units for restructuring or value-based management,
or testing the implications of major strategic decisions on the value of your
company. We accept no responsibility for any decisions based on your in-
puts to the model. If you would like to purchase the model (ISBN 978-1-118-
61090-8 or ISBN 978-1-118-61246-9), please call (800) 225-5945, or visit www
.wileyvaluation.com.
Acknowledgments

No book is solely the effort of its authors. This book is certainly no exception,
especially since it grew out of the collective work of McKinsey’s Strategy &
Corporate Finance Practice and the experiences of its consultants throughout
the world.
Most important, we would like to thank Tom Copeland and Jack Murrin,
two of the coauthors of the first three editions of this book. We are deeply
indebted to them for establishing the book’s early success, for mentoring the
current authors, and for their hard work in providing the foundations on
which this edition builds.
Ennius Bergsma deserves our special thanks. Ennius initiated the develop-
ment of McKinsey’s Strategy & Corporate Finance Practice in the mid-1980s.
He inspired the original internal McKinsey valuation handbook and mustered
the support and sponsorship to turn that handbook into a real book for an
external audience.
Bill Javetski, our lead editor, ensured that our ideas were expressed clearly
and concisely. Dennis Swinford edited and oversaw the production of more
than 390 exhibits, ensuring that they were carefully aligned with the text.
Karen Schenkenfelder provided careful editing and feedback throughout the
process. We are indebted to her excellent eye for detail.
Tim and Marc are founders of McKinsey’s Strategy & Corporate Finance
Insights team, a group of dedicated corporate-finance experts who influence
our thinking every day. A special thank-you to Bernie Ferrari, who initiated
the group and nurtured its development. The team is currently overseen by
Werner Rehm and Chris Mulligan. Other leaders we are indebted to include
Haripreet Batra, Matt Bereman, Alok Bothra, Josue Calderon, Susan Nolen
Foushee, Andre Gaeta, Prateek Gakhar, Abhishek Goel, Baris Guener, Paulo
Guimaraes, Anuj Gupta, Chetan Gupta, Peeyush Karnani, David Kohn, Tarun
Khurana, Bharat Lakhwani, Ankit Mittal, Siddharth Periwal, Katherine Peters,

xv
xvi Acknowledgments

Abhishek Saxena, João Lopes Sousa, Ram Sekar, Anurag Srivastava, and
Zane Williams.
We’ve made extensive use of McKinsey’s Corporate Performance Ana-
lytics (CPAnalytics), led by Peter Stumpner, which provided data for the
analyses in this book. We extend thanks also to the R+I Insights Team,
led by Josue Calderon and Anuj Gupta. The team, which prepared much
of the analyses for us, includes Rafael Araya, Roerich Bansal, Martin Bar-
boza, Abhranil Das, Carlo Eyzaguirre, Jyotsna Goel, Dilpreet Kaur, Kumari
Monika, Carolina Oreamuno, Victor Rojas, and Sapna Sharma. Dick Foster,
a former McKinsey colleague and mentor, inspired the development of
CPAnalytics.
Michael Cichello, professor of finance at Georgetown University, expertly
prepared many of the teaching materials that accompany this book, including
the end-of-chapter problems and answers for the university edition and exam
questions and answers. These teaching materials are an essential supplement
for professors and students using this book for finance courses. Thank you to
our Costa Rica research team for their help in preparing and answering ques-
tions for these materials.
Concurrent with the fifth edition, McKinsey published a shorter book,
titled Value: The Four Cornerstones of Corporate Finance, which explains the
principles of value and their implications for managers and investors without
going into the technical detail of this how-to guide. We’ve greatly benefited
from the ideas of that book’s coauthors, Richard Dobbs and Bill Huyett.
The intellectual origins of this book lie in the present-value method of capi-
tal budgeting and in the valuation approach developed by Nobel laureates
Merton Miller and Franco Modigliani in their 1961 Journal of Business article
titled “Dividend Policy, Growth, and the Valuation of Shares.” Others have
gone far to popularize their approach. In particular, Professor Alfred Rap-
paport (Northwestern University, Professor Emeritus) and the late Joel Stern
(Stern Stewart & Co.) were among the first to extend the Miller-Modigliani
enterprise valuation formula to real-world applications. In addition to these
founders of the discipline, we would also like to acknowledge those who have
personally shaped our knowledge of valuation, corporate finance, and strat-
egy. For their support, teachings, and inspiration, we thank Buford Alexander,
Tony Bernardo, Richard Dobbs, the late Mikel Dodd, Bernie Ferrari, Dick Fos-
ter, Bob Holthausen, Bill Huyett, Rob Kazanjian, Ofer Nemirovsky, Eduardo
Schwartz, Chandan Sengupta, Jaap Spronk, the late Joel Stern, Bennett Stew-
art, Sunil Wahal, and Ivo Welch.
A number of colleagues worked closely with us on the seventh edition,
providing support that was essential to its completion. In Part One, “Founda-
tions of Value,” David Schwartz, Bill Javetski, and Allen Webb helped with the
always-difficult task of writing the first chapter to position the book properly.
The discussion of valuation and ESG in Chapter 6 was based on an article
 Acknowledgments xvii

coauthored by Witold Henisz and Robin Nuttall. The discussion of valu-

ing digital initiatives in the same chapter benefited from collaboration with
Liz Ericsson.
Over the years, we have valued many companies in Parts Two and Three.
We would like to thank Wharton graduates Caleb Carter and Daniel Romeu
for the extensive analysis they have conducted to underpin these sections.
Part Four, “Managing for Value,” adds substantial new insights on how
companies can improve the translation of their strategies into action and
aligned resource allocation. We are indebted to Chris Bradley, Dan Lovallo,
Robert Uhlaner, Loek Zonnenberg, and a host of others for this new mate-
rial. Matt Gage and Steve Santulli provided analysis for the M&A chapter.
The investor communications chapter benefits greatly from the work of Rob
Palter and Werner Rehm. In Part Five, “Special Situations,” Marco de Heer’s
dissertation formed the basis for the chapter on valuing cyclical companies.
Of course, we could not have devoted the time and energy to this book
without the support and encouragement of McKinsey’s Strategy & Corporate
Finance Practice leadership—in particular, Martin Hirt and Robert Uhlaner.
Lucia Rahilly and Rik Kirkland ensured that we received superior editorial
support from McKinsey’s external publishing team.
We would like to thank again all those who contributed to the first six
editions. We owe a special debt to Dave Furer for help and late nights devel-
oping the original drafts of this book more than 30 years ago. Others not yet
mentioned and to whom we owe our thanks for their contributions to the
sixth edition include Ashish Kumar Agarwal, Andre Annema, Bing Cao, Bas
Deelder, Ritesh Jain, Mimi James, Mauricio Jaramillo, Bin Jiang, Mary Beth
Joyce, Jean-Hugues Monier, Rishi Raj, Eileen Kelly Rinaudo, Ram Sekar, Sara-
vanan Subramanian, Zane Williams, and Angela Zhang.
The first five editions and this edition drew upon work, ideas, and analy-
ses from Carlos Abad, Paul Adam, Buford Alexander, Petri Allas, Alexandre
Amson, André Annema, the late Pat Anslinger, Vladimir Antikarov, Ali Asghar,
Bill Barnett, Dan Bergman, Olivier Berlage, Peter Bisson, the late Joel Bleeke,
Nidhi Chadda, Carrie Chen, Steve Coley, Kevin Coyne, Johan Depraetere, the
late Mikel Dodd, Lee Dranikoff, Will Draper, Christian von Drathen, David
Ernst, Bill Fallon, George Fenn, Susan Nolen Foushee, Russ Fradin, Gabriel
Garcia, Richard Gerards, Alo Ghosh, Irina Grigorenko, Fredrik Gustavsson,
Marco de Heer, Keiko Honda, Alice Hu, Régis Huc, Mimi James, Bin Jiang,
Chris Jones, William Jones, Phil Keenan, Phil Kholos, David Krieger, Shyan-
jaw Kuo, Michael Kuritzky, Bill Lewis, Kurt Losert, Harry Markl, Yuri Maslov,
Perry Moilinoff, Fabienne Moimaux, Mike Murray, Terence Nahar, Rafic Naja,
Juan Ocampo, Martijn Olthof, Neha Patel, Vijen Patel, John Patience, Bill Pur-
sche, S. R. Rajan, Werner Rehm, Frank Richter, David Rothschild, Michael Ru-
dolf, Yasser Salem, Antoon Schneider, Ram Sekar, Meg Smoot, Silvia Stefini,
Konrad Stiglbrunner, Ahmed Taha, Bill Trent, David Twiddy, Valerie Udale,
xviii Acknowledgments

Sandeep Vaswani, Kim Vogel, Jon Weiner, Jack Welch, Gustavo Wigman, David
Willensky, Marijn de Wit, Pieter de Wit, Jonathan Witter, David Wright, and
Yan Yang.
For help in coordinating the flow of paper, e-mail, and phone calls, we owe
our thanks to our assistants, Sue Cohen and Laura Waters.
We also extend thanks to the team at John Wiley & Sons, including
Bill Falloon, Meg Freeborn, Purvi Patel, Carly Hounsome, and Kimberly
Monroe-Hill.
Finally, thank you to Melissa Koller, Monique Donders, Kate Wessels,
and our children: Katherine, Emily, and Juliana Koller; Max, Julia, and Sarah
Goedhart; and Adin, Jacob, Lillia, and Nathaniel Wessels. Our wives and fami-
lies are our true inspirations. This book would not have been possible without
their encouragement, support, and sacrifice.
 Part One

Foundations of Value
 1

Why Value Value?

The guiding principle of business value creation is a refreshingly simple con-

struct: companies that grow and earn a return on capital that exceeds their cost
of capital create value. Articulated as early as 1890 by Alfred Marshall,1 the con-
cept has proven to be both enduring in its validity and elusive in its application.
Nevertheless, managers, boards of directors, and investors sometimes
ignore the foundations of value in the heat of competition or the exuberance of
market euphoria. The tulip mania of the early 1600s, the dot-coms that soared
spectacularly with the Internet bubble, only then to crash, and the mid-2000’s
real estate frenzy whose implosion touched off the financial crisis of 2007–2008
can all to some extent be traced to a misunderstanding or misapplication of
this guiding principle.
At other moments, the system in which value creation takes place comes
under fire. That happened at the turn of the twentieth century in the United
States, when fears about the growing power of business combinations raised
questions that led to more rigorous enforcement of antitrust laws. The Great
Depression of the 1930s was another such moment, when prolonged unemploy-
ment undermined confidence in the ability of the capitalist system to mobilize
resources, leading to a range of new policies in democracies around the world.
Today many people are again questioning the foundations of capitalism,
especially shareholder-oriented capitalism. Challenges such as globalization,
climate change, income inequality, and the growing power of technology titans
have shaken public confidence in large corporations.2 Politicians and com-
mentators push for more regulation and fundamental changes in corporate

1 A.Marshall, Principles of Economics (New York: Macmillan, 1890), 1:142.

2
An annual Gallup poll in the United States showed that the percentage of respondents with little or
no confidence in big business increased from 27 percent in 1997 to 34 percent in 2019, and those with
“a great deal” or “quite a lot” of confidence in big business decreased by five percentage points over
that period, from 28 percent to 23 percent. Conversely, those with “a great deal” or “quite a lot” of
confidence in small business increased by five percentage points over the same period (from 63 percent
in 1997 to 68 percent in 2019). For more, see Gallup, “Confidence in Institutions,” www.gallup.com.

3
4 Why Value Value?

governance. Some have gone so far as to argue that “capitalism is destroying

the earth.”3
Many business leaders share the view that change is needed to answer
society’s call. In August 2019, Business Roundtable, an association of chief
executives of leading U.S. corporations, released its Statement on the Purpose
of a Corporation. The document’s 181 signers declared “a fundamental com-
mitment to all4 of our stakeholders.”5 The executives affirmed that their com-
panies have a responsibility to customers, employees, suppliers, communities
(including the physical environment), and shareholders. “We commit to de-
liver value to all of them,” the statement concludes, “for the future success of
our companies, our communities and our country.”
The statement’s focus on the future is no accident: issues such as climate
change have raised concerns that today’s global economic system is short-
changing the future. It is a fair critique of today’s capitalism. Managers too
often fall victim to short-termism, adopting a focus on meeting short-term
performance metrics rather than creating value over the long term. There also
is evidence, including the median scores of companies tracked by McKinsey’s
Corporate Horizon Index from 1999 to 2017, that this trend is on the rise. The
roots of short-termism are deep and intertwined, so a collective commitment
of business leaders to the long-term future is encouraging.
As business leaders wrestle with that challenge, not to mention broader
questions about purpose and how best to manage the coalescing and colliding
interests of myriad owners and stakeholders in a modern corporation, they
will need a large dose of humility and tolerance for ambiguity. They’ll also
need crystal clarity about the problems their communities are trying to solve.
Otherwise, confusion about objectives could inadvertently undermine capital-
ism’s ability to catalyze progress as it has in the past, whether lifting millions
of people out of poverty, contributing to higher literacy rates, or fostering in-
novations that improve quality of life and lengthen life expectancy.
As business leaders strive to resolve all of those weighty trade-offs, we hope
this book will contribute by clarifying the distinction between creating share-
holder value and maximizing short-term profits. Companies that conflate the
two often put both shareholder value and stakeholder interests at risk. In the
first decade of this century, banks that acted as if maximizing short-term profits
would maximize value precipitated a financial crisis that ultimately destroyed
billions of dollars of shareholder value. Similarly, companies whose short-term
focus leads to environmental disasters destroy shareholder value by incurring
cleanup costs and fines, as well as via lingering reputational damage. The best
managers don’t skimp on safety, don’t make value-destroying decisions just

3
G. Monbiot, “Capitalism Is Destroying the Earth; We Need a New Human Right for Future Genera-
tions,” Guardian, March 15, 2019, www.guardian.com.
4 Emphasis added by Business Roundtable.
5 Kevin Sneader, the global managing partner of McKinsey & Company, is a signatory of the statement.
 What Does It Mean to Create Shareholder Value? 5

because their peers are doing so, and don’t use accounting or financial gim-
micks to boost short-term profits. Such actions undermine the interests of all
stakeholders, including shareholders. They are the antithesis of value creation.
To dispel such misguided notions, this chapter begins by describing what value
creation does mean. We then contrast the value creation perspective with short-
termism and acknowledge some of the difficulties of value creation. We offer guid-
ance on reconciling competing interests and adhering to principles that promote
value creation. The chapter closes with an overview of the book’s remaining topics.

What Does It Mean to Create Shareholder Value?

Particularly at this time of reflection on the virtues and vices of capitalism, it’s
critical that managers and board directors have a clear understanding of what
value creation means. For value-minded executives, creating value cannot be
limited to simply maximizing today’s share price. Rather, the evidence points
to a better objective: maximizing a company’s collective value to its sharehold-
ers, now and in the future.
If investors knew as much about a company as its managers do, maximiz-
ing its current share price might be equivalent to maximizing its value over
time. But in the real world, investors have only a company’s published finan-
cial results and their own assessment of the quality and integrity of its man-
agement team. For large companies, it’s difficult even for insiders to know
how financial results are generated. Investors in most companies don’t know
what’s really going on inside a company or what decisions managers are mak-
ing. They can’t know, for example, whether the company is improving its
margins by finding more efficient ways to work or by skimping on product
development, resource management, maintenance, or marketing.
Since investors don’t have complete information, companies can easily
pump up their share price in the short term or even longer. One global con-
sumer products company consistently generated annual growth in earnings
per share (EPS) between 11 percent and 16 percent for seven years. Managers
attributed the company’s success to improved efficiency. Impressed, investors
pushed the company’s share price above those of its peers—unaware that the
company was shortchanging its investment in product development and brand
building to inflate short-term profits, even as revenue growth declined. Finally,
managers had to admit what they’d done. Not surprisingly, the company went
through a painful period of rebuilding. Its stock price took years to recover.
It would be a mistake, however, to conclude that the stock market is not
“efficient” in the academic sense that it incorporates all public information.
Markets do a great job with public information, but markets are not omni-
scient. Markets cannot price information they don’t have. Think about the
analogy of selling an older house. The seller may know that the boiler makes
a weird sound every once in a while or that some of the windows are a bit
6 Why Value Value?

drafty. Unless the seller discloses those facts, a potential buyer may have great
difficulty detecting them, even with the help of a professional house inspector.
Despite such challenges, the evidence strongly suggests that companies
with a long strategic horizon create more value than those run with a short-
term mindset. Banks that had the insight and courage to forgo short-term
profits during the last decade’s real-estate bubble, for example, earned much
better total shareholder returns (TSR) over the longer term. In fact, when we
studied the patterns of investment, growth, earnings quality, and earnings
management of hundreds of companies across multiple industries between
2001 and 2014, we found that companies whose focus was more on the long
term generated superior TSR, with a 50 percent greater likelihood of being in
the top decile or top quartile by the end of that 14-year period.6 In separate
research, we’ve found that long-term revenue growth—particularly organic
revenue growth—is the most important driver of shareholder returns for com-
panies with high returns on capital.7 What’s more, investments in research
and development (R&D) correlate powerfully with long-term TSR.8
Managers who create value for the long term do not take actions to in-
crease today’s share price if those actions will damage the company down
the road. For example, they don’t shortchange product development, reduce
product quality, or skimp on safety. When considering investments, they take
into account likely future changes in regulation or consumer behavior, espe-
cially with regard to environmental and health issues. Today’s managers face
volatile markets, rapid executive turnover, and intense performance pres-
sures, so making long-term value-creating decisions requires courage. But the
fundamental task of management and the board is to demonstrate that cour-
age, despite the short-term consequences, in the name of value creation for the
collective interests of shareholders, now and in the future.

Short-Termism Runs Deep

Despite overwhelming evidence linking intrinsic investor preferences to

long-term value creation,9 too many managers continue to plan and execute
strategy—and then report their performance—against shorter-term measures,
particularly earnings per share (EPS).

6
Measuring the Economic Impact of Short-Termism, McKinsey Global Institute, February 2017, www
.mckinsey.com.
7 B. Jiang and T. Koller, “How to Choose between Growth and ROIC,” McKinsey on Finance, no. 25

(Autumn 2007): 19–22, www.mckinsey.com. However, we didn’t find the same relationship for compa-
nies with low returns on capital.
8
We’ve performed the same analyses for 15 and 20 years and with different start and end dates, and
we’ve always found similar results.
9 R. N. Palter, W. Rehm, and J. Shih, “Communicating with the Right Investors,” McKinsey Quarterly

(April 2008), www.mckinsey.com. Chapter 34 of this book also examines the behaviors of intrinsic and
other investor types.
 Short-Termism Runs Deep 7

As a result of their focus on short-term EPS, major companies often pass

up long-term value-creating opportunities. For example, a relatively new
CFO of one very large company has instituted a standing rule: every busi-
ness unit is expected to increase its profits faster than its revenues, every
year. Some of the units currently have profit margins above 30 percent and
returns on capital of 50 percent or more. That’s a terrific outcome if your
horizon is the next annual report. But for units to meet that performance
bar right now, they are forgoing growth opportunities that have 25 percent
profit margins in the years to come. Nor is this an isolated case. In a survey
of 400 chief financial officers, two Duke University professors found that
fully 80 percent of the CFOs said they would reduce discretionary spending
on potentially value-creating activities such as marketing and R&D in order
to meet their short-term earnings targets.10 In addition, 39 percent said they
would give discounts to customers to make purchases this quarter rather
than next, in order to hit quarterly EPS targets. That’s no way to run a rail-
road—or any other business.
As an illustration of how executives get caught up in a short-term EPS
focus, consider our experience with companies analyzing a prospective ac-
quisition. The most frequent question managers ask is whether the transaction
will dilute EPS over the first year or two. Given the popularity of EPS as a
yardstick for company decisions, you might think that a predicted improve-
ment in EPS would be an important indication of an acquisition’s potential to
create value. However, there is no empirical evidence linking increased EPS
with the value created by a transaction.11 Deals that strengthen EPS and deals
that dilute EPS are equally likely to create or destroy value.
If such fallacies have no impact on value, why do they prevail? The impe-
tus for a short-term view varies. Some executives argue that investors won’t
let them focus on the long term; others fault the rise of activist shareholders
in particular. Yet our research shows that even if short-term investors cause
day-to-day fluctuations in a company’s share price and dominate quarterly
earnings calls, longer-term investors are the ones who align market prices
with intrinsic value.12 Moreover, the evidence shows that, on average, activist
investors strengthen the long-term health of the companies they pursue—for
example, challenging existing compensation structures that encourage short-
termism.13 Instead, we often find that executives themselves or their boards
are the source of short-termism. In one relatively recent survey of more than
1,000 executives and board members, most cited their own executive teams

10
J. R. Graham, C. R. Harvey, and S. Rajgopal, “Value Destruction and Financial Reporting Decisions,”
Financial Analysts Journal 62, no. 6 (2006): 27–39.
11
R. Dobbs, B. Nand, and W. Rehm, “Merger Valuation: Time to Jettison EPS,” McKinsey Quarterly
(March 2005), www.mckinsey.com.
12 Palter et al., “Communicating with the Right Investors.”
13 J. Cyriac, R. De Backer, and J. Sanders, “Preparing for Bigger, Bolder Shareholder Activists,” McKinsey

on Finance (March 2014), www.mckinsey.com.

8 Why Value Value?

and boards (rather than investors, analysts, and others outside the company)
as the greatest sources of pressure for short-term performance.14
The results can defy logic. At a company pursuing a major acquisition, we
participated in a discussion about whether the deal’s likely earnings dilution
was important. One of the company’s bankers said he knew any impact on
EPS would be irrelevant to value, but he used it as a simple way to commu-
nicate with boards of directors. Elsewhere, we’ve heard company executives
acknowledge that they, too, doubt the importance of impact on EPS but use it
anyway, “for the benefit of Wall Street analysts.” Investors also tell us that a
deal’s short-term impact on EPS is not that important. Apparently, everyone
knows that a transaction’s short-term impact on EPS doesn’t matter. Yet they
all pay attention to it.
The pressure to show strong short-term results often builds when busi-
nesses start to mature and see their growth begin to moderate. Investors con-
tinue to bay for high profit growth. Managers are tempted to find ways to
keep profits rising in the short term while they try to stimulate longer-term
growth. However, any short-term efforts to massage earnings that undercut
productive investment make achieving long-term growth even more difficult,
spawning a vicious circle.
Some analysts and some short-term-oriented investors will always clamor
for short-term results. However, even though a company bent on growing
long-term value will not be able to meet their demands all the time, this con-
tinuous pressure has the virtue of keeping managers on their toes. Sorting
out the trade-offs between short-term earnings and long-term value creation
is part of a manager’s job, just as having the courage to make the right call is
a critical personal quality. Perhaps even more important, it is up to corporate
boards to investigate and understand the economics of the businesses in their
portfolio well enough to judge when managers are making the right trade-offs
and, above all, to protect managers when they choose to build long-term value
at the expense of short-term profits.
Improving a company’s corporate governance proposition might help. In
a 2019 McKinsey survey, an overwhelming majority of executives (83 percent)
reported that they would be willing to pay about a 10 percent median pre-
mium to acquire a company with a positive reputation for environmental,
regulatory, and governance (ESG) issues over one with a negative reputation.

14 Commissioned by McKinsey & Company and by the Canada Pension Plan Investment Board, the

online survey, “Looking toward the Long Term,” was in the field from April 30 to May 10, 2013, and
garnered responses from 1,038 executives representing the full range of industries and company sizes
globally. Of these respondents, 722 identified themselves as C-level executives and answered questions
in the context of that role, and 316 identified themselves as board directors and answered accordingly.
To adjust for differences in response rates, the data are weighted by the contribution of each respon­
dent’s nation to global gross domestic product (GDP). For more, see J. Bailey, V. Bérubé, J. Godsall, and
C. Kehoe, “Short-termism: Insights from Business Leaders,” FCLTGlobal, January 2014, https://www
.fcltglobal.org.
 Shareholder Capitalism Cannot Solve Every Challenge 9

Investors seem to agree; one recent report found that global sustainable in-
vestment topped $30 trillion in 2018, rising 34 percent over the previous two
years.15
Board members might also benefit from spending more time on their board
activities, so they have a better understanding of the economics of the com-
panies they oversee and the strategic and short-term decisions managers are
making. In a survey of 20 UK board members who had served on the boards
of both exchange-listed companies and companies owned by private-equity
firms, 15 of 20 respondents said that private-equity boards clearly added more
value. Their answers suggested two key differences. First, private-equity di-
rectors spend on average nearly three times as many days on their roles as do
those at listed companies. Second, listed-company directors are more focused
on risk avoidance than value creation.16
Changes in CEO evaluation and compensation might help as well. The
compensation of many CEOs and senior executives is still skewed to short-
term accounting profits, often by formula. Given the complexity of managing
a large multinational company, we find it odd that so much weight is given
to a single number.

Shareholder Capitalism Cannot Solve Every Challenge

Short-termism is a critical affliction, but it isn’t the only source of today’s crisis
of trust in corporate capitalism. Imagine that short-termism were magically
cured. Would other foundational problems suddenly disappear as well? Of
course not. Managers struggle to make many trade-offs for which neither a
shareholder nor a stakeholder approach offers a clear path forward. This is
especially true when it comes to issues affecting people who aren’t immedi-
ately involved with the company—for example, a company’s carbon emis-
sions affecting parties that may be far away and not even know what the
company is doing. These so-called externalities can be extremely challenging
for corporate decision making, because there is no objective basis for making
trade-offs among parties.
Consider how this applies to climate change. One natural place to look for
a solution is to reduce coal production used to make electricity, among the
largest human-made sources of carbon emissions.17 How might the managers
of a coal-mining company assess the trade-offs needed to begin solving envi-
ronmental problems? If a long-term shareholder focus led them to anticipate

15 2018 Global Sustainable Investment Review, Global Sustainable Investment Alliance, 2018, www
.gsi-alliance.org.
16 V. Acharya, C. Kehoe, and M. Reyner, “The Voice of Experience: Public versus Private Equity,”

McKinsey on Finance (Spring 2009): 16–21.

17 In 2011, coal accounted for 44 percent of the global CO emissions from energy production. CO Emis-
2 2
sions from Fuel Combustion online data service, International Energy Agency, 2013, www.iea.org.
10 Why Value Value?

potential regulatory changes, they would modify their investment strategies

accordingly; they might not want to open new mines, for example.
With perfect knowledge a decade or even five years ago, a coal company
could have reduced production dramatically or even closed mines in accor-
dance with the decline in demand from U.S. coal-fired power plants. But per-
fect information is a scarce resource indeed, sometimes even in hindsight, and
the timing of production changes and, especially, mine closures, would in-
evitably be abrupt. Further, closures would result in significant consequences
even if the choice is the “right” one.
In the case of mine closures, not only would the company’s shareholders
lose their entire investment, but so would its bondholders, who are often pen-
sion funds. All the company’s employees would be out of work, with mag-
nifying effects on the entire local community. Second-order effects would be
unpredictable. Without concerted action among all coal producers, another
supplier could step up to meet demand. Even with concerted action, power
plants might be unable to produce electricity, idling workers and causing
electricity shortages that undermine the economy. What objective criteria
would any individual company use to weigh the economic and environmen-
tal trade-offs of such decisions—whether they’re privileging shareholders or
stakeholders?
That’s not to say that business leaders should just dismiss externalities
as unsolvable or a problem to solve on a distant day. Putting off such critical
decisions is the essence of short-termism. With respect to the climate, some
of the world’s largest energy companies, including BP and Shell, are taking
bold measures right now toward carbon reduction, including tying executive
compensation to emissions targets.
Still, the obvious complexity of striving to manage global threats like cli-
mate change that affect so many people, now and in the future, places bigger
demands on governments. Trading off different economic interests and time
horizons is precisely what people charge their governments to do. In the case
of climate change, governments can create regulations and tax and other incen-
tives that encourage migration away from polluting sources of energy. Ideally,
such approaches would work in harmony with market-oriented approaches,
allowing creative destruction to replace aging technologies and systems with
cleaner and more efficient sources of power. Failure by governments to price
or control the impact of externalities will lead to a misallocation of resources
that can stress and divide shareholders and other stakeholders alike.
Institutional investors such as pension funds, as stewards of the millions of
men and women whose financial futures are often at stake, can play a critical
supporting role. Already, longer-term investors concerned with environmen-
tal issues such as carbon emissions, water scarcity, and land degradation are
connecting value and long-term sustainability. In 2014, heirs to the Rockefeller
Standard Oil fortune decided to join Stanford University’s board of trustees in
a campaign to divest shares in coal and other fossil fuel companies.
 Can Stakeholder Interests Be Reconciled? 11

Long-term-oriented companies must be attuned to long-term changes that

investors and governments will demand. This enables executives to adjust
their strategies over a 5-, 10-, or 20-year time horizon and reduce the risk of
holding still-productive assets that can’t be used because of environmental or
other issues. For value-minded executives, what bears remembering is that
a delicate chemistry will always exist between government policy and long-
term investors, and between shareholder value creation and the impact of
externalities.

Can Stakeholder Interests Be Reconciled?

Much recent criticism of shareholder-oriented capitalism has called on com-

panies to focus on a broader set of stakeholders beyond just its shareholders.
It’s a view that has long been influential in continental Europe, where it is
frequently embedded in corporate governance structures. It’s gaining traction
in the United States as well, with the rise of public-benefit corporations, which
explicitly empower directors to consider the interests of constituencies other
than shareholders.
For most companies anywhere in the world, pursuing the creation of long-
term shareholder value requires satisfying other stakeholders as well. You
can’t create long-term value by ignoring the needs of your customers, suppli-
ers, and employees. Investing for sustainable growth should and often does
result in stronger economies, higher living standards, and more opportunities
for individuals.
Many corporate social-responsibility initiatives also create shareholder
value.18 Consider Alphabet’s free suite of tools for education, including
Google Classroom, which equips teachers with resources to make their work
easier and more productive. As the suite meets that societal need, it also fa-
miliarizes students around the world with Google applications—especially in
underserved communities, where people might otherwise not have access to
meaningful computer science education at all. Nor is Alphabet reticent about
choosing not to do business in instances the company deems harmful to vul-
nerable populations; the Google Play app store now prohibits apps for per-
sonal loans with an annual percentage rate of 36 percent or higher, an all too
common feature of predatory payday loans.19
Similarly, Lego’s mission to “play well”—to use the power of play to in-
spire “the builders of tomorrow, their environment and communities”—has
led to a program that unites children in rural China with their working parents.

18
S. Bonini, T. Koller, and P. H. Mirvis, “Valuing Social Responsibility Programs,” McKinsey Quarterly
(July 2009), www.mckinsey.com.
19 Y. Hayashi, “Google Shuts Out Payday Loans with App-Store Ban,” Wall Street Journal, October 13,

2019, www.wsj.com.
12 Why Value Value?

Programs such as these no doubt play a role in burnishing Lego’s brand

throughout communities and within company walls, where it reports that em-
ployee motivation and satisfaction levels beat 2018 targets by 50 percent. Or
take Sodexo’s efforts to encourage gender balance among managers. Sodexo
says the program has not only increased employee retention by 8 percent, but
also increased client retention by 9 percent and boosted operating margins by
8 percent.
Inevitably, though, there will be times when the interests of a company’s
stakeholders are not entirely complementary. Strategic decisions involve trade-
offs, and the interests of different groups can be at odds with one another. Im-
plicit in the Business Roundtable’s 2019 statement of purpose is concern that
business leaders have skewed some of their decisions too much toward the
interests of shareholders. As a starting point, we’d encourage leaders, when
trade-offs must be made, to prioritize long-term value creation, given the ad-
vantages it holds for resource allocation and economic health.
Consider employee stakeholders. A company that tries to boost profits by
providing a shabby work environment, underpaying employees, or skimping
on benefits will have trouble attracting and retaining high-quality employees.
Lower-quality employees can mean lower-quality products, reduced demand,
and damage to the brand reputation. More injury and illness can invite regula-
tory scrutiny and step up friction with workers. Higher turnover will inevita-
bly increase training costs. With today’s mobile and educated workforce, such
a company would struggle in the long term against competitors offering more
attractive environments.
If the company earns more than its cost of capital, it might afford to pay
above-market wages and still prosper; treating employees well can be good
business. But how well is well enough? A focus on long-term value creation
suggests paying wages that are sufficient to attract quality employees and
keep them happy and productive, pairing those wages with a range of non-
monetary benefits and rewards. Even companies that have shifted manufac-
turing of products like clothing and textiles to low-cost countries with weak
labor protection have found that they need to monitor the working conditions
of their suppliers or face a consumer backlash.
Similarly, consider pricing decisions. A long-term approach would weigh
price, volume, and customer satisfaction to determine a price that creates sus-
tainable value. That price would have to entice consumers to buy the products
not just once, but multiple times, for different generations of products. Any
adjustments to the price would need to weigh the value of a lower price to
buyers against the value of a higher price to shareholders and perhaps other
stakeholders. A premium price that signals prestige for a luxury good can
contribute long-term value. An obvious instance of going too far—or more
accurately, not looking far enough ahead—is Turing Pharmaceuticals. In 2015,
the company acquired the rights to a medication commonly used to treat
 Can Stakeholder Interests Be Reconciled? 13

EXHIBIT 1.1 Correlation between Total Shareholder Returns and Employment Growth

Compound annual growth rate,1 2007–2017, %

United States European Union2

60 60
50 50
40 40
30 30
20 20
10 10
TSR

TSR
0 0
–10 –10
–20 –20
–30 –30
–40 –40
–50 –50
–25 –20 –15 –10 –5 0 5 10 15 20 25 –25 –20 –15 –10 –5 0 5 10 15 20 25
Employment growth Employment growth

1 Samples include companies with real revenues greater than $500 million and excludes outliers with more than 20% employment growth.
2 Sample includes companies in the core 15 EU member states.

AIDS-related illnesses and then raised the price per pill by more than 5,000
percent. The tactic prompted outrage and a wave of government investiga-
tions. The CEO was even derided as “the most hated man in America.”20
But far more often, the lines between creating and destroying value are
gray. Companies in mature, competitive industries, for example, grapple with
whether they should keep open high-cost plants that lose money, just to keep
employees working and prevent suppliers from going bankrupt. To do so in a
globalizing industry would distort the allocation of resources in the economy,
notwithstanding the significant short-term local costs associated with plant
closures.21 At the same time, politicians pressure companies to keep failing
plants open. The government may even be a major customer of the company’s
products or services.
In our experience, not only do managers carefully weigh bottom-line im-
pact, they agonize over decisions that have pronounced consequences on
workers’ lives and community well-being. But consumers benefit when goods
are produced at the lowest possible cost, and the economy benefits when oper-
ations that become a drain on public resources are closed and employees move
to new jobs with more competitive companies. And while it’s true that em-
ployees often can’t just pick up and relocate, it’s also true that value-creating
companies create more jobs. When examining employment, we found that the
U.S. and European companies that created the most shareholder value from

20
Z. Thomas and T. Swift, “Who Is Martin Shkreli—‘the Most Hated Man in America’?” BBC News,
August 4, 2017, www.bbc.com.
21
Some argue that well-functioning markets also need well-functioning governments to provide the
safety nets and retraining support to make essential restructuring processes more equitable.
14 Why Value Value?

2007 to 2017—measured as total shareholder returns—have shown stronger

employment growth (see Exhibit 1.1).22

Consequences of Forgetting Value-Creation Principles

When companies forget the simple value-creation principles, the negative

consequences to the economy can be huge. Two recent examples of many ex-
ecutives failing in their duty to focus on true value creation are the Internet
bubble of the 1990s and the financial crisis of 2008.
During the Internet bubble, managers and investors lost sight of what drives
return on invested capital (ROIC); indeed, many forgot the importance of this
ratio entirely. Multiple executives and investors either forgot or threw out funda-
mental rules of economics in the rarefied air of the Internet revolution. The notion
of “winner take all” led companies and investors to believe that all that mattered
was getting big fast, on the assumption that they could wait until later to worry
about creating an effective business model. The logic of achieving ever-increasing
returns was also mistakenly applied to online pet supplies and grocery deliv-
ery services, even though these firms had to invest (unsustainably, eventually)
in more drivers, trucks, warehouses, and inventory when their customer base
grew. When the laws of economics prevailed, as they always do, it was clear that
many Internet businesses did not have the unassailable competitive advantages
required to earn even modest returns on invested capital. The Internet has revo-
lutionized the economy, as have other innovations, but it did not and could not
render obsolete the rules of economics, competition, and value creation.
Shortsighted focus can breed dishonorable dealing, and sometimes the con-
sequences can shake confidence in capitalism to its foundations. In 2008, too
many financial institutions ignored core principles. Banks lent money to in-
dividuals and speculators at low teaser rates on the assumption that housing
prices would only increase. Banks packaged these high-risk debts into long-
term securities and sold them to investors who used short-term debt to finance
the purchase, thus creating a long-term risk for whoever lent them the money.
When the home buyers could no longer afford the payments, the real estate
market crashed, pushing the values of many homes below the values of the
loans taken out to buy them. At that point, homeowners could neither make the
required payments nor sell their homes. Seeing this, the banks that had issued
short-term loans to investors in securities backed by mortgages became unwill-
ing to roll over those loans, prompting the investors to sell all such securities at
once. The value of the securities plummeted. Finally, many of the large banks
themselves owned these securities, which they, of course, had also financed
with short-term debt they could no longer roll over.

22
We’ve performed the same analyses for 15 and 20 years and with different start and end dates, and
we’ve always found similar results.
 This Book 15

This Book

This book is a guide to how to measure and manage the value of a company.
The faster companies can increase their revenues and deploy more capital
at attractive rates of return, the more value they create. The combination of
growth and return on invested capital (ROIC), relative to its cost, is what
drives cash flow and value. Anything that doesn’t increase ROIC or growth at
an attractive ROIC doesn’t create value. This category can include steps that
change the ownership of claims to cash flows, and accounting techniques that
may change the timing of profits without actually changing cash flows.
This guiding principle of value creation links directly to competitive ad-
vantage, the core concept of business strategy. Only if companies have a well-
defined competitive advantage can they sustain strong growth and high returns
on invested capital. To the core principles, we add the empirical observation
that creating sustainable value is a long-term endeavor, one that needs to take
into account wider social, environmental, technological, and regulatory trends.
Competition tends to erode competitive advantages and, with them, re-
turns on invested capital. Therefore, companies must continually seek and
exploit new sources of competitive advantage if they are to create long-term
value. To that end, managers must resist short-term pressure to take actions
that create illusory value quickly at the expense of the real thing in the long
term. Creating value is not the same as, for example, meeting the analysts’
consensus earnings forecast for the next quarter. Nor is it ignoring the effects
of decisions made today that may create greater costs down the road, from en-
vironmental cleanup to retrofitting plants to meet future pollution regulations.
It means balancing near-term financial performance against what it takes to
develop a healthy company that can create value for decades ahead—a de-
manding challenge.
This book explains both the economics of value creation (for instance, how
competitive advantage enables some companies to earn higher returns on in-
vested capital than others) and the process of measuring value (for example,
how to calculate return on invested capital from a company’s accounting
statements). With this knowledge, companies can make wiser strategic and
operating decisions, such as what businesses to own and how to make trade-
offs between growth and return on invested capital. Equally, this knowledge
will enable investors to calculate the risks and returns of their investments
with greater confidence.
Applying the principles of value creation sometimes means going against
the crowd. It means accepting that there are no free lunches. It means relying
on data, thoughtful analysis, a deep understanding of the competitive dynam-
ics of your industry, and a broad, well-informed perspective on how society
continually affects and is affected by your business. We hope this book provides
readers with the knowledge to help them throughout their careers to make and
defend decisions that will create value for investors and for society at large.
 2

Finance in a Nutshell

Companies create value when they earn a return on invested capital (ROIC)
greater than their opportunity cost of capital.1 If the ROIC is at or below the
cost of capital, growth may not create value. Companies should aim to find
the combination of growth and ROIC that drives the highest discounted value
of their cash flows. In so doing, they should consider that performance in the
stock market may differ from intrinsic value creation, generally as a result of
changes in investors’ expectations.
To illustrate how value creation works, this chapter uses a simple story.
Our heroes are Lily and Nate, who start out as the owners of a small chain of
trendy clothing stores. Success follows. Over time, their business goes through
a remarkable transformation. They develop the idea of Lily’s Emporium and
convert their stores to the new concept. To expand, they take their company
public to raise additional capital. Encouraged by the resulting gains, they
develop more retail concepts, including Lily’s Furniture and Lily’s Garden
Supplies. In the end, Lily and Nate are faced with the complexity of managing
a multibusiness retail enterprise.

The Early Years

When we first met Lily and Nate, their business had grown from a tiny bou-
tique into a small chain of trendy, midpriced clothing stores called Lily’s
Dresses. They met with us to find out how they could know if they were
achieving attractive financial results. We told them they should measure their
business’s return on invested capital: after-tax operating profits divided by
the capital invested in working capital and property, plant, and equipment.

1
A simple definition of return on invested capital is after-tax operating profit divided by invested
capital (working capital plus fixed assets). ROIC’s calculation from a company’s financial statements is
explained in detail in Chapters 10 and 11.

17
18 Finance in a Nutshell

Then they could compare the ROIC with what they could earn if they invested
their capital elsewhere—for example, in the stock market.
Lily and Nate had invested $10 million in their business, and in 2020 they
earned about $1.8 million after taxes, with no debt. So they calculated their
return on invested capital as 18 percent. They asked what a reasonable guess
would be for the rate they could earn in the stock market, and we suggested
they use 10 percent. They easily saw that their money was earning 8 percent
more than what we were assuming they could earn by investing elsewhere, so
they were pleased with their business’s performance.
We commented that growth is also important to consider in measuring
financial performance. Lily told us that the business was growing at about 5
percent per year. Nate added that they discovered growth can be expensive; to
achieve that growth, they had to invest in new stores, fixtures, and inventory.
To grow at 5 percent and earn 18 percent ROIC on their growth, they rein-
vested about 28 percent of their profits back into the business each year. The
remaining 72 percent of profits was available to withdraw from the business.
In 2020, then, they generated cash flow of about $1.30 million.
Lily and Nate were satisfied with 5 percent growth and 18 percent ROIC
until Lily’s cousin Logan told them about his aggressive expansion plans for
his own retail business, Logan’s Stores. Based on what Logan had said, Lily
and Nate compared the expected faster growth in operating profit for Logan’s
Stores with their own company’s 5 percent growth, as graphed in Exhibit 2.1.
Lily and Nate were concerned that Logan’s faster-growing profits signaled a
defect in their own vision or management.
“Wait a minute,” we said. “How is Logan getting all that growth? What
about his ROIC?” Lily and Nate checked and returned with the data shown
in Exhibit 2.2. As we had suspected, Logan was achieving his growth by

EXHIBIT 2.1 Expected Profit Growth at Logan’s Stores Outpacing Lily’s Dresses

After-tax operating profit,

$ thousand

3,000

Logan’s Stores
2,500
Lily’s Dresses

2,000

1,500

1,000

500

0
2020 21 22 23 24 2025
 A New Concept 19

EXHIBIT 2.2  ily’s Dresses Outperforming in Return on Invested Capital (ROIC) and
L
Cash Flow

ROIC,
%

20
Lily’s Dresses
15 Logan’s Stores

10

0
2020 21 22 23 24 2025
Cash flow,
$ thousand

2,000
Lily’s Dresses
1,500

1,000

500
Logan’s Stores

0
2020 21 22 23 24 2025

investing heavily. Despite all the growth in operating profit, his company’s
ROIC was declining significantly, so cash flow was slipping downward.
We asked the two why they thought their stores earned higher returns on
capital than Logan’s. Nate said one reason was that their products were unique
and cutting-edge fashion, so their customers were willing to pay higher prices for
their dresses than for the products at many other dress shops. Lily added that each
of their stores attracted more customers, so their sales per square foot (a proxy for
fixed costs) were greater than Logan’s. As they saw it, Logan’s products were not
much different from those of his competitors, so he had to match his prices to
theirs and had less customer traffic in his stores. This discussion helped Nate and
Lily appreciate that it was beneficial to consider ROIC along with growth.

A New Concept

Several years later, Lily and Nate called us with a great idea. They wanted to
develop a new concept, which they called Lily’s Emporium. Lily’s Emporium
would operate larger stores carrying a wider assortment of clothes and acces-
sories that their talented designers were working on. But when they looked
at the projected results (they now had a financial-analysis department), they
found that all the new capital investment to convert their stores would reduce
ROIC and cash flow for four years, even though revenue and profits would be
20 Finance in a Nutshell

growing faster, as shown in Exhibit 2.3. After four years, cash flow would be
greater, but they didn’t know how to trade off the short-term decline in ROIC
and cash flow against the long-term improvement.
We affirmed that these were the right questions and explained that
­answering them would require more sophisticated financial tools. We advised
them to use discounted cash flow (DCF), a measure that is also known as
­present value. DCF is a way of collapsing the future performance of the com-
pany into a single number. Lily and Nate needed to forecast the future cash
flow of the company and discount it back to the present at the same opportu-
nity cost of capital we had used for our earlier comparisons.
We helped Lily and Nate apply DCF to their new concept, discounting
the projected cash flows at 10 percent. We showed them that the DCF value
of their company would be $53 million if they did not adopt the new concept.
With the new concept, the DCF value would be greater: $62 million. (Actually,
on our spreadsheet, we rounded to the nearest thousand: $61,911,000.) These
numbers gave them confidence in their idea for Lily’s Emporium.

Should Lily and Nate Try to Maximize ROIC?

As they saw how these financial measures could help them build a more valu-
able business, Lily and Nate began to formulate more questions about mea-
suring value. Lily asked if their strategy should be to maximize their return on
EXHIBIT 2.3 Expansion’s Impact on ROIC and Cash Flow

ROIC,
%

20
Expansion case: Lily’s Dresses and Emporium
18 Base case: Lily’s Dresses

16

14

12

10
2020 21 22 23 24 2025
Cash flow,
$ thousand

2,000 Expansion case: Lily’s Dresses and Emporium

Base case: Lily’s Dresses
1,500

1,000

500

0
2020 21 22 23 24 2025
 Going Public 21

EXHIBIT 2.4 Economic Profit Is Higher with Lower-Performing Stores in the Mix

Cost of Invested Economic

ROIC, capital, Spread, capital, profit,
% % % $ thousand $ thousand
Entire company 18 10 8 12,000 960
Without lower-performing stores 19 10 9 9,500 855

invested capital. She pointed to the fact that some stores outperformed others.
For example, some were earning an ROIC of only 14 percent. If the business
closed those lower-performing stores, they could increase their average return
on invested capital.
Our advice was to focus not on the ROIC itself, but on the combination of
ROIC (versus cost of capital) and the amount of capital. A tool for doing that is
called economic profit. We showed them how economic profit applies to their
business, using the measures in Exhibit 2.4.
We defined economic profit as the spread between ROIC and cost of capi-
tal multiplied by the amount of invested capital. In Lily and Nate’s case, their
economic profit forecast for 2024 would be the 8 percent spread by $12 million
in invested capital, or $960,000. If they closed their low-returning stores, their
average ROIC would increase to 19 percent, but their economic profit would
decline to $855,000. This is because even though some stores earn a lower
ROIC than others do, the lower-earning stores are still earning more than
the cost of capital. Using this example, we made the case that Lily and Nate
should seek to maximize economic profit, not ROIC, over the long term.
For Nate, though, this analysis raised a practical concern. With different
methods available, it wasn’t obvious which one to use. He asked, “When do
we use economic profit, and when do we use DCF?”
“Good question,” we said. “In fact, they’re the same.” We prepared
Exhibit 2.5 to show Nate and Lily a comparison, using the DCF we had previ-
ously estimated for their business: $61,911,000. To apply the economic-profit
method, we discounted the future economic profit at the same cost of capital
we had used with the DCF. Then we added the discounted economic profit to
the amount of capital invested today. The results for the two approaches are
the same—exactly, to the penny.2

Going Public

Now Lily and Nate had a way to make important strategic decisions over
multiple time periods. Lily’s Emporium was successful, and the next time
they called us, they talked excitedly about new ambitions. “We need more
2 See Chapter 10 for a detailed discussion of these two valuation approaches.
22 Finance in a Nutshell

EXHIBIT 2.5 Identical Results from DCF and Economic-Profit Valuation

Valuation, by method, $ thousand

Discounted cash flow Economic profit

(DCF)

61,911 61,911

39,691

22,220

DCF Value Invested Present value Total value

capital of economic
profit

capital to build more stores more quickly,” Nate said. “Besides, we want to
provide an opportunity for some of our employees to become owners. So
we’ve decided to go public.” They asked us to help them understand how
going public would affect their financial decision making.
“Well,” we said, “now’s the time to learn what the distinction is between
financial markets and real markets and how they are related to each other.
You’ll want to understand that good performance in one market does not nec-
essarily mean good performance in another.”
Up until now, we’d been talking with Lily and Nate about the real market.
How much profit and cash flow were they earning relative to the investments
they were making? Were they maximizing their economic profit and cash flow
over time? In the real market, the decision rule is simple: choose strategies or
make operational decisions that maximize the present value of future cash
flow or future economic profit.
When a company enters the capital market, the decision rules for the real
market remain essentially unchanged. But life gets more complicated, because
management must simultaneously deal with the financial market.
When a company goes public and sells shares to a wide range of investors
who can trade those shares in an organized market, the interaction (or trading
activity) between investors and even market speculators sets a price for those
shares. The price of the shares is based on what investors think those shares
are worth. Each investor decides what he or she thinks the value of the shares
should be and makes trades based on whether the current price is above or
below that estimate of the intrinsic value.
 Going Public 23

This intrinsic value is based on the future cash flows or earnings power of
the company. This means, essentially, that investors are paying for the perfor-
mance they expect the company to achieve in the future, not what the com-
pany has done in the past (and certainly not the cost of the company’s assets).
Lily asked us how much their company’s shares would be worth. “Let’s
assume,” we said, “that the market’s overall assessment of your company’s
future performance is similar to what you think your company will do. The
first step is to forecast your company’s performance and discount the future
expected cash flows. Based on this analysis, the intrinsic value of your shares
is $20 per share.”
“That’s interesting,” said Nate, “because the amount of capital we’ve
invested is only $7 per share.” We told them that this difference meant the
market should be willing to pay their company a premium of $13 over the
invested capital for the future economic profit the company would earn.
“But,” Lily asked, “if they pay us this premium up front, how will the
investors make any money?”
“They may not,” we said. “Let’s see what will happen if your company
performs exactly as you and the market expect. Let’s value your company
five years into the future. If you perform exactly as expected over the next
five years and if expectations beyond five years don’t change, your company’s
value will be $32 per share. Let’s assume that you have not paid any divi-
dends. An investor who bought a share for $20 per share today could sell the
share for $32 in five years. The annualized return on the investment would
be 10 percent, the same as the discount rate we used to discount your future
performance. The interesting thing is that as long as you perform as expected,
the return for your shareholders will be just their opportunity cost. But if you
do better than expected, your shareholders will earn more than 10 percent.
And if you do worse than expected, your shareholders will earn less than 10
percent.”
“So,” said Lily, “the return that investors earn is driven not by the perfor-
mance of our company, but by its performance relative to expectations.”
“Exactly!” we said.
Lily paused and reflected on the discussion. “That means we must manage
our company’s performance in the real markets and the financial markets at
the same time.”
We agreed and explained that if they were to create a great deal of value
in the real market—say, by earning more than their cost of capital and grow-
ing fast—but didn’t do as well as investors expected, the investors would be
disappointed. Managers have a dual task: to maximize the intrinsic value of
the company and to properly manage the expectations of the financial market.
“Managing market expectations is tricky,” we added. “You don’t want in-
vestor expectations to be too high or too low. We’ve seen companies convince
the market that they will deliver great performance and then not deliver on
those promises. Not only does the share price drop when the market realizes
24 Finance in a Nutshell

that the company won’t be able to deliver, but regaining credibility may take
years. Conversely, if the market’s expectations are too low and you have a
low share price relative to the opportunities the company faces, you may be
subject to a hostile takeover.”
After exploring these issues, Lily and Nate felt prepared to take their com-
pany public. They went forward with an initial public offering and raised the
capital they needed.

Expansion into Related Formats

Lily and Nate’s business was successful, growing quickly and regularly beat-
ing the expectations of the market, so their share price was a top performer.
They were comfortable that their management team would be able to achieve
high growth in their Emporium stores, so they decided next to try some new
concepts they had been thinking about: Lily’s Furniture and Lily’s Garden
Supplies. But they grew concerned about managing the business as it became
more and more complex. They had always had a good feel for the business,
but as it expanded and they had to delegate more decision making, they were
less confident that things would be managed well.
They met with us again and told us that their financial people had put in
place a planning and control system to closely monitor the revenue growth,
ROIC, and economic profit of every store and each division overall. Their team
set revenue and economic-profit targets annually for the next three years, mon-
itored progress monthly, and tied managers’ compensation to economic profit
against these targets. Yet they told us they weren’t sure the company was on
track for the long-term performance that they and the market expected.
“You need a planning and control system that incorporates forward-look-
ing measures besides looking backward at financial measures,” we told them.
“Tell us more,” Nate said.
“As you’ve pointed out,” we said, “the problem with any financial mea-
sure is that it cannot tell you how your managers are doing at building the
business for the future. For example, in the short term, managers could im-
prove their financial results by cutting back on customer service, such as by
reducing the number of employees available in the store to help customers, by
cutting into employee training, or by deferring maintenance costs or brand-
building expenditures. You need to make sure that you build in measures
related to customer satisfaction or brand awareness—measures that let you
know what the future will look like, not just what the current performance is.”
Lily and Nate both nodded, satisfied. The lessons they so quickly absorbed
and applied have placed their company on a solid foundation. The two of
them still come to see us from time to time, but only for social visits. Some-
times they bring flowers from their garden supplies center.
 Some Lessons 25

Some Lessons

While we have simplified the story of Lily and Nate’s business, it highlights
the core ideas around value creation and its measurement:

1. In the real market, you create value by earning a return on your invested
capital greater than the opportunity cost of capital.
2. The more you can invest at returns above the cost of capital, the more
value you create. That is, growth creates more value as long as the re-
turn on invested capital exceeds the cost of capital.
3. You should select strategies that maximize the present value of future
expected cash flows or economic profit. The answer is the same regard-
less of which approach you choose.
4. The value of a company’s shares in the stock market equals the intrinsic
value based on the market’s expectations of future performance, but the
market’s expectations of future performance may not be same as the
company’s.
5. The returns that shareholders earn depend on changes in expectations
as much as on the actual performance of the company.

In the next chapter, we develop a more formal framework for understand-

ing and measuring value creation.
Another random document with
no related content on Scribd:
 Varieties.

Pun.—While the repairs were going on in State street, Boston,

two gentlemen of the bar happening to meet, one said, “I think this
looks like putting new cloth upon an old garment.” “I think so too,”
replied the other; “but it will make the rent greater.”

Humor.—A number of years ago, an eccentric old gentleman,

residing in a cottage in England, was greatly annoyed by noctural
depredators, who broke the fences in his garden, in order to get at
the good things contained therein. As he did not care so much for
the loss of the fruit as the damage done to the enclosures, and as he
was rather fond of witticisms, he had the following notice put up: “All
thieves are in future to enter by the gate, which will be left open for
the purpose.”

Has a Dog Wings?—“Father, has a dog got wings?”

“No, my son.”
“Well, I thought so—but mother told me, the other day, that as she
was going along the road, a dog flew at her.”

Irish Wit.—An honest Hibernian, upon reading his physician’s

bill, replied, that he had no objections to pay him for his medicines,
but his visits he would return.
 Death of the President.

William Henry Harrison, who became President of the United

States on the 4th of March last, died on the night of the 4th of April,
just thirty days after he had entered upon the duties of his high
office.
This event is calculated to cast a gloom over the whole nation, for
Gen. Harrison was generally esteemed a good man, and most
persons believed that he would govern the country in a manner to
promote the happiness of the people. He had lived to be almost
seventy years of age; and now, being elevated to the highest office
in the gift of the people, he is suddenly cut down, and laid in the
same dust that must cover ordinary men. This dispensation of
Providence seems almost like quenching a great beacon-light upon
the sea-shore at night, just at the moment when its illumination had
begun to scatter the darkness around.
A solemn thought is suggested by this event. Gen. Harrison has
lived a long life, and has often been in the midst of seeming peril. He
has often been in battle with savages and with the British soldiery.
He has often trodden the forest amid all the dangers and vicissitudes
that beset the traveller there. He has spent many days of toil in the
field, laboring as a farmer. In all these situations and conditions—
from youth to age—he has enjoyed the protecting care of
Providence. But at last he was elevated to a great office; he became
the occupant of a palace; he was the hope of a great nation; he was
surrounded with friends, with mighty men, with skilful physicians,
with tender nurses—with the great, the good, the prayerful—but all in
vain. His time had come—the arrow was sped from the bow, and no
human arm could stay its flight. And this should warn us all to
consider well the lesson conveyed by this event—which is, that life
and death are in the hands of God. He can protect us everywhere—
in the cottage or the log-cabin, in the forest or the field; or he can
take us away in the midst of power and pomp and riches. Let us
therefore be ever prepared for the decisions of his wisdom.
 THE APRIL SHOWER, A SONG.
the words and music composed for
merry’s museum.

Patter, patter, let it pour,

Patter, Patter, let it roar,
Down the steep roof let it rush,
Down the hill side let it gush,
’Tis the wlecome April shower
Which will wake the sweet May flower.

Patter, patter, let it pour!

Patter, patter, let it roar!
Let the gaudy lightning flash—
Let the headlong thunder dash—
’Tis the welcome April shower,
Which will wake the sweet May flower.

Patter, patter, let it pour!

Patter, patter, let it roar!
Soon the clouds will burst away—
Soon will shine the bright spring day,
Soon the welcome April shower
Will awake the sweet May flower!
ROBERT MERRY’S MUSEUM.
 My own Life and Adventures.

(Continued from page 71.)

CHAPTER VII.
My uncle’s influence.—​The influence of the tavern.—​State of society
forty years ago.—​Liquor opposed to education.—​The church
and the tavern.—​The country schoolhouse.—​Books used in
the school.—​A few words about myself.

I pass over a space of several years in my history, and come to

the period when I was about fifteen. Up to this time, I had made little
progress in education, compared with what is done at the present
day. I could indeed read and write, and I knew something of
arithmetic, but my advance beyond this was inconsiderable. A brief
detail of certain circumstances will show the reason of this.
In the first place, my uncle had no very high estimation of what he
called larnin; he was himself a man of action, and believed that
books render people dull and stupid, rather than efficient in the
business of life. He was therefore opposed to education in general,
and particularly so in my case; and not only was his opinion
equivalent to law with respect to me, but it was of great force in the
village, on account of his character and position.
He kept the village tavern, which in those days of rum and punch
was an institution of great power and authority. It was common, at
the period of which I speak, for the church or meeting-house and
tavern to stand side by side; but if one day in the week, sobriety and
temperance were preached in the former, hard drinking and
licentiousness were deeply practised in the latter during the other
six. The tavern, therefore, not only counteracted the good effect of
the preacher, but it went farther, and in many cases corrupted the
whole mass of society. The members of the church thought it no
scandal to make regular visits to the bar-room at eleven o’clock in
the forenoon, and at four P. M.; the deacon always kept his jugs well
filled, and the minister took his toddy or his tansy bitters, in open day,
and without reproach.
In such a state of society as this, the tavern-keeper was usually
the most influential man in the village, and if he kept good liquors, he
was irresistible. Now my uncle was a prince of a tavern-keeper for
these jolly days. He was, in fact, what we call a whole-souled fellow:
generous, honest, and frank-hearted. His full, ruddy countenance
bespoke all this; and his cheerful, hearty voice carried conviction of it
to every listener. Beside, his tavern was freely and generously kept:
it was liberally supplied with good beds, and every other luxury or
comfort common to those days. As I have said before, it was situated
upon the great road, then travelled by the mail stages between
Boston and New York. The establishment was of ample extent,
consisting of a pile of wooden buildings of various and irregular
architecture—all painted a deep red. There was near it a large barn
with extensive cow-houses, a corn-crib, a smoke-house, and a pig-
sty, arranged solely with a view to ease of communication with the
house, and consequently all drawn closely around it. The general
effect, when viewed at a distance, was that of two large jugs
surrounded with several smaller ones.
Before this heap of edifices swung the tavern sign, with a picture
of a barn-yard cock on one side, and a bull upon the other, as I have
told you before: and though the artist that painted it was only a
common house-dauber, and though the pictures were of humble
pretensions when compared with the productions of Raphael, still,
few specimens of the fine arts have ever had more admirers than the
cock and bull of my uncle’s sign. How many a toper has looked upon
it when approaching the tavern with his feverish lip, as the emblem
and assurance of the rum that was soon to feed the fire kindled in his
throat; how many a jolly fellow, staggering from the inn, has seen
that sign reeling against the sky, and mixing grotesquely with the
dreamy images of his fancy!
If we add to this description, that in the street, and nearly in front
of the tavern, was a wood-pile about ten feet high, and covering
three or four square rods of ground; that on one side was a litter of
harrows, carts and ploughs, and on the other a general assortment
of wagons, old sleighs, broken stages, and a rickety vehicle
resembling a modern chaise without a top; and if we sprinkle
between all these articles a good supply of geese and pigs, we shall
have a pretty fair account of the famous Cock and Bull tavern that
flourished in Salem nearly forty years ago.
The proprietor of such an establishment could not, in those days,
but be a man of influence; and the free manners and habits of my
uncle tended to increase the power that his position gave him. He
drank liberally himself, and vindicated his practice by saying that
good liquor was one of the gifts of providence, and it was no sin—
indeed it was rather a duty—to indulge in providential gifts freely. All
this made him a favorite, particularly with a set of hard drinkers who
thronged the bar-room, especially of a wet day and on winter
evenings.
As I have said, my uncle was opposed to education, and as he
grew older and drank deeper, his prejudice against it seemed to
increase; and though I cannot easily account for the fact, still every
drunkard in the place was an enemy to all improvements in the
school. When a town-meeting took place, these persons were
invaribly in opposition to every scheme, the design of which was to
promote the cause of education, and this party was usually headed
by my uncle. And it is not a little curious that the tavern party also
had its influence in the church, for my uncle was a member of it, and
many of his bar-room cronies also. They were so numerous as to
cast a heavy vote, and therefore they exercised a good deal of
power here. As in respect to the school, so in the house of worship,
they were for spending as little money as possible, and for reducing
its power and influence in society to the lowest possible scale. They
even held the minister in check, and though he saw the evil tendency
of intemperance in the village, he had not nerve enough to attack it,
except in a very soft and mild way, which probably served to
increase the vice at which he aimed; for vice always thrives when
holy men condemn it gently.
Now I have said that my uncle was a kind-hearted, generous
man, by nature; how then could he be so narrow-minded in respect
to education and religion? The answer to this question is easy. He
was addicted to the free use of liquors, which not only tends to
destroy the body, but to ruin all the nobler parts of the mind. As he
came more and more under the influence of ardent spirits, he grew
narrow-minded, sottish and selfish. And this is one of the great evils
of taking ardent spirits. The use of them always tends to break down
the mind; to take away from us those noble feelings and lofty
thoughts, which are the glory of man; in short, to sink us lower and
lower toward the brute creation. A determined drunkard is usually a
great part of the time but little elevated above a beast.
Now I have been particular about this part of my story, for I wished
to show you the natural influence of the habits of my uncle, and their
operation upon my own fortunes. I have yet a sadder story to tell, as
to the effect of the village tavern, not only upon myself, but upon my
uncle, and several others. That must be reserved for some of the
sad pages through which my tale will lead you. For the present, I
only point out the fact, that a man who encourages the sale of liquors
is usually unfriendly to the education and improvement of mankind;
that his position tends to make him fear the effect of light and wish
for darkness; that hard drinking will ruin even a generous and noble
mind and heart; and that the habit of dealing in liquor is one to be
feared, as it induces a man to take narrow, selfish, and low views of
human nature and human society. It appears to me that a trade
which thrives when men turn drunkards, and which fails when men
grow temperate, is a trade which is apt to injure the mind and soul of
one who follows it. Even my noble-hearted and generous uncle fell
under such sinister influences.
But to return to the school. I have already described the situation
of the house. The building itself was of wood, about fifteen feet
square, plastered within, and covered with benches without backs,
which were constructed by thrusting sticks, for legs, through auger
holes in a plank. On one side, against the wall, was a long table,
serving as a desk for the writers.
The chimney was of rough stone, and the fire-place was of the
same material. But what it lacked in grace of finish, was made up in
size. I believe that it was at least ten feet wide, and five in depth, and
the flue was so perpendicular and ample, that the rain and snow fell
down to the bottom, without the risk of striking the sides. In summer,
the school was kept by a woman, who charged the town a dollar a
week, boarding herself; in winter it was kept by a man, who was paid
five dollars a month and found. Here about seventy children, of all
sizes, were assembled during this latter portion of the year; the place
and manner of treatment being arranged as much as possible on the
principle that a schoolhouse is a penitentiary, where the more
suffering, the more improvement.
I have read of despots and seen prisons, but there are few of the
former more tyrannical than the birch-despot of former days, or of
the latter, more gloomy than the old-fashioned schoolhouse, under
the tyrant to which it was usually committed.
I must enter into a few details. The fuel for the school consisted of
wood, and was brought in winter, load by load, as it was wanted;
though it occasionally happened that we got entirely out, and the
school was kept without fire if the master could endure the cold, or
dismissed if the weather chanced to be too severe to be borne. The
wood was green oak, hickory, or maple, and when the fire could be
induced to blaze between the sticks, there was a most notable
hissing and frying, and a plentiful exudation of sap at each end of
them.
The wood was cut into lengths of about five feet, by the scholars,
each of the larger boys taking his turn at this, and at making the fire
in the morning. This latter was a task that demanded great strength
and patience; for, in the first place, there must be a back-log, five
feet in length, and at least fifteen inches in diameter; then a top-stick
about two-thirds as big; and then a forestick of similar dimensions. It
required some strength to move these logs to their places; and after
the frame of the work was built, the gathering of chips, and the
blowing, the wooing, the courting that were necessary to make the
revolting flame take hold of the wet fuel, demanded a degree of
exertion, and an endurance of patience, well calculated to ripen and
harden youth for the stern endurances of manhood.
The school began at nine in the morning, and it was rare that the
fire gave out any heat so early as this; nor could it have been of
much consequence had it done so, for the school-room was almost
as open as a sieve, letting in the bitter blast at every window and
door, and through a thousand cracks in the thin plastering of the
walls. Never have I seen such a miserable set of blue-nosed,
chattering, suffering creatures as were these children, for the first
hour after the opening of school, on a cold winter morning. Under
such circumstances, what could they do? Nothing, and they were
expected to do nothing.
The books in use were Webster’s Spelling Book, Dilworth’s
Arithmetic, Webster’s Second and Third Part, the New Testament,
and Dwight’s Geography. These were all, and the best scholars of
the seminary never penetrated more than half through this mass of
science. There was no such thing as a history, a grammar, or a map
in the school. These are mysteries reserved for more modern days.
Such was the state of things—such the condition of the school,
where I received my education, the only education that I ever
enjoyed, except such as I have since found in study by myself, and
amid the active pursuits of life. But let me not blame the schoolhouse
alone; I was myself in fault, for even the poor advantages afforded
me there, I wilfully neglected; partly because I was fond of amusing
myself and impatient of application; partly because I thought myself
worth ten thousand dollars, and fancied that I was above the
necessity of instruction; and partly because my uncle and his bar-
room friends were always sneering at men of education, and praising
men of spirit and action—those who could drive a stage skilfully, or
beat in pitching cents, or bear off the palm in a wrestling-match, or
perchance carry the largest quantity of liquor under the waistcoat.
Such being the course of circumstances that surrounded me at
the age of fifteen, it will not be surprising if my story should at last
lead to some painful facts; but my succeeding chapters will show.
(To be continued.)
 The Artists’ Cruise.

About the first of August, 1840, an excursion was set on foot, by

five young men of Boston, for recreation and amusement—one full of
interest and excitement, conducive equally to health and pleasure.
The plan was this—to embark in a small pleasure-boat called the
Phantom, built and owned by one of the company, who was also well
skilled in nautical affairs, and proceed by easy distances along the
coast as far “down East” as time or inclination would admit—letting
the events and adventures of the day determine the movements of
the next.
The company consisted of young artists—lovers of nature—ready
to appreciate all the new and beautiful points that might meet the
eye. The boat was hauled up at Phillip’s beach, Lynn, to which place
the party proceeded, and fitted her out with all the conveniences and
comforts proper for the cruise. Everything being ready, they sailed on
the first of the week, with a fair southwest wind, passed Marblehead
and Salem gaily, and stretched onward for Cape Ann. As night came
on they were becalmed, but it was very clear, and the moon shone
gloriously, as they moved, creeping lazily along, catching a slight puff
at intervals. The musical portion of the company contrived to make
the time pass pleasantly away in singing certain old airs which
chimed in with the feeling and situation of the company. At last the
breeze came again, and about ten at night they found themselves in
the little cove before the quiet town of Gloucester. Here they cast
anchor; and so much pleased were they, that they stayed the next
day and enjoyed the pleasure of a ramble along the rocky shores,
fishing for perch, &c. They found an excellent host at the Gloucester
hotel, where they passed the next night. I cannot do better than to
tell the rest of the story in the words of these adventurers.
 “With a bright sun, a fresh breeze, and a calm sea, we left
Gloucester and shaped our course around Cape Ann for the Isles of
Shoals, a group which lie at the farther extremity of Ipswich bay,
across which we merrily steered, embracing the opportunity of
initiating the inexperienced in the duties of amateur seamanship. In a
few hours we ran in between the rocky isles, which, as we gradually
neared them, seemed to rise from out the waves. Anchoring in the
midst of a fleet of fishing boats, we prepared our supper, which was
soon despatched with much mirth, owing to the primitive simplicity of
our arrangements. We passed the night at our anchorage, after
witnessing the effect of a magnificent thunder-storm, and spent the
morning in strolling among the rocks along the shore, and amusing
ourselves with the characteristic traits of the islanders whom we met;
their isolated position, and constant devotion to the single occupation
of catching and curing fish, appearing to interpose a bar to their
advancement in any other qualification. From the Isles of Shoals we
had the next day a fair run to Wood Island, and anchored in Winter
harbor, near the mouth of Saco river—a place of considerable
importance at the time of the last war, owing to the exertions of an
enterprising merchant by the name of Cutts. During the war the
British entered the harbor and wantonly sawed through the keel of
three of the largest class of merchant vessels, then in progress of
building, and whose remains are still to be seen. We had plenty of
fowling, fishing, and sporting apparatus, and we here had ample
opportunity for exercising our skill as sportsmen—plover, curlew,
sand-birds, &c. being abundant. In this manner we passed the time
until the afternoon of the next day, when we left for Portland.
“Favored with a fine breeze, we dashed merrily over the waves,
which had now begun to be tipped with foam, and, under the
influence of the freshening wind, had assumed a size that, in
comparison with our miniature bark, might have been termed
mountain-high; but there was no danger, for our craft was as buoyant
on the sea as one of its own bubbles. The weather had gradually
been growing “dirty,” as seamen call it, and we raced into the harbor
of Portland with a small squadron of coasting vessels, all crowding
for shelter. The wind during the night blew a gale from the southeast,
which however did not prevent us from sleeping soundly. Our
appetites having assumed a remarkable punctuality since leaving
Boston, reminded us early of breakfast, and, in spite of wind and
rain, we resolved upon cooking a quantity of birds shot the day
previous. Having formed an imperfect shelter by means of a spare
sail, a fire was kindled, coffee made, birds broiled, and our meal
concluded amid a rain so drenching as to be quite a curiosity in its
way. Each person bent over his dish to prevent the food being fairly
washed away, and covered his mug of coffee to avoid excessive
dilution, and used many other notable expedients suited to the
occasion, which will certainly not be forgotten if never again
practised. It was most emphatically a washing-day with us, though
not accompanied with the ill-humor generally reputed to exist upon
those occasions.
“The storm and its effects being over, we received a visit from the
proprietors of the elegant pleasure-boat, Water Lily, who very kindly
invited us to accompany them to Diamond cove, a romantic spot in
one of the many beautiful islands that so thickly stud Casco bay—a
place much frequented by parties of pleasure from the city of
Portland. We left the harbor with a fine breeze, our pennants
streaming gallantly. We were soon upon the fishing-grounds,
anchored, and for a moment all was bustle and excitement, each
hoping to be the first to pull a ‘mammoth’ from the deep. Success
crowned our efforts, and a boat was despatched with the treasure to
the cove, to be there converted into a savory chowder; while we
again anchored near the rocks of one of the smaller islands, where
fortune favored us, and we soon had a goodly store of perch for the
fry.
“The sun was just sinking as we entered the cove, and the gray
shadows of twilight were fast gathering under the grove of fine old
oaks that crowned the shore. Soon the woods resounded with the
shouts and merry laughter of the party. Misty twilight yielded to the
brilliant rays of the full moon, which, streaming through the openings
of the forest, touched here and there, lighting up the picturesque and
moss-grown trunks with almost magical effect. The word was given,
and each one searched for his armful of brush to light us at our feast,
and soon it crackled and blazed away, lighting up a scene almost
beyond description. The party numbered about fifteen or twenty,
including the Phantom’s crew, and were scattered about in all the
various groups and postures that inclination or fancy might suggest,
each with his plate and spoon, or for the want of them a clam-shell
and box-cover, doing such justice to the feast as an appetite
sharpened by fasting, salubrious sea-breeze and wholesome
exercise would induce. Not the least important feature of the scene
was the picturesque costume assumed by our “Phantoms;” it
consisting of white pants, Guernsey frocks, belts, knives, and small
Greek caps tight to the head. Above us hung the blest canopy of
glowing foliage thrown out from those old oaks; each mass, each
leaf was touched and pencilled with a vivid line of light, whose
brightness might compare with that of sparkling gems. The more
distant groups were relieved from the dim and shadowy background
by a subdued and broad half-light. Fainter and fainter grew the light,
till all was lost in the deep and gloomy shadows of the forest.
“Amid this fairy-like scenery all was mirth, jollity, fun, and frolic; not
a moment passed unenjoyed. At ten o’clock our party broke up, and
we returned to our boats. We here parted with our kind friends, who
were soon on their way to Portland. We seized our flutes, and
breathed forth a farewell with all the pathos we were masters of. This
was soon answered by a smart salute from a cannon, which awoke
the echoes of the cove. Three cheers were given and returned, and
all was still.
“The next was a beautiful day, and it being Sunday, we remained
at anchor in the cove, enjoying the silence and repose of nature in
that lovely and sequestered spot. The succeeding morning being
fine, we started with a light southerly wind, which carried us slowly
along among the islands of Casco, and gave us a fine opportunity to
observe all their beauties. The scene was continually changing—
new islands opening upon us almost every moment. Before evening
we had made the little harbor called Small Point, where we remained
that night. The succeeding day we doubled cape Small Point and
made the mouth of the Kennebec, which we entered with a fine
breeze, that carried us briskly up to Bath, where we spent the
remainder of the day. Having taken a pilot, we continued up the river
with a fair wind and tide, which took us as far as Hallowell.
Considerable curiosity was here excited, in consequence of our
having come so far in so small a boat, it being thought a rather
hazardous enterprise. In the morning a council was held, and we
determined to return; accordingly this and the succeeding day were
spent in getting back to Bath. We did but little more than float with
the tide, in consequence of its being so calm. The scenery of the
Kennebec has been so often and minutely described, that it is best
to pass over it without comment.
At Bath we were treated with all the attention and kindness we
could wish for. The succeeding day we beat down the river, and
doubled the point, encountering a head sea, which tossed us about,
to the great detriment of our culinary apparatus. We again anchored
and passed the night at Small Point. We proceeded the next day, by
a difficult and somewhat dangerous channel, between ledges and
islands as far as Haskell’s Island, and anchored in the cove.
Continuing our course the next day, we stopped at Portland, saw our
friends of the Water Lily, and proceeded as far as Winter harbor,
where we arrived at twelve o’clock at night. We continued here a day
to take advantage of the fine shooting, and had very good luck. We
went as far the next day as York, where we anchored, cooked our
birds, and, with the help of good appetites, made a glorious supper.
“Leaving the town of Old York, we rowed slowly out of the small
river which forms its harbor, accompanied by numerous fishing-
boats, which came in the evening previous. It was a dead calm, and
continued so about two hours. The time passed however without the
usual tedium attendant upon the want of wind, it being employed in
the preparation and discussion of a hearty breakfast. The wind came
at last, a light breeze and ahead, and we soon exchanged the
swinging and rolling motion of the glassy ground-swell for the regular
rise and fall and cheerful dash of the ripple against the bow, and the
music of the breaking bubbles as they whirled away in the wake.
With all our canvass set, we stretched slowly along the narrow coast
of New Hampshire.
“Passing the harbor of Portsmouth, with its lighthouse built upon a
ledge so low that the tide sweeps over its foundation, as is the case
with the famous Eddystone, at nightfall we were off the mouth of
Merrimac river, yet some fifteen or twenty miles from our destined
port. A few clouds that had collected about dark now dispersed, and
the stars shone clear and beautiful from the heavens, while the
beacon lights blazed in rival brightness from the shore. About two in
the morning we approached the entrance of our port, which is
situated near the mouth of a small river which intersects Cape Ann,
and which, like most rivers, has a bar at its mouth. After passing the
lighthouse, being within half a mile of our anchorage, the wind fell
suddenly, and the rapid current swept us aground upon the highest
part of the bar, where the receding tide soon left us high and dry
upon the sand. Being stopped thus abruptly, we gazed about in
search of some means to ‘define our position,’ which measure was
presently vetoed by the rolling in of so thick a fog that in ten minutes
everything in sight could have been touched with a boat-hook.
Finding sight unavailing at this juncture, we resorted to sound, and
commenced firing signal guns, which were heard and answered from
the shore, and in a short time assistance arrived in the person of the
keeper of the lighthouse, who informed us that we should not float
again for six hours. Day broke upon us in this position, and having
plenty of time, we despatched two ashore for provisions in the pilot’s
skiff, and in a short time the sand-bar presented a singular
appearance, our baggage of all kinds being strewed about upon the
sand, and in close fellowship with cooking utensils, loose sails, spare
baskets, boxes, rigging, &c. &c.; for we had entirely unladed the
boat, for the purpose of washing and cleansing the inside from the
effects of an unlucky basket of charcoal, which had been upset in the
confusion consequent upon our endeavors to get into deeper water.
Upon the return of our purveyors all hands displayed great activity in
providing and eating breakfast. The fog still encompassed us, so that
we enjoyed all the uproar and fun of the meal in our own way, as our
apparent horizon was hardly more extensive than a common room. It
was a memorable breakfast, that seemed much like a day’s eating
condensed into a single meal, the whole being much enlivened by
the cheerfulness and local anecdotes of our old friend from the
lighthouse, to whom we were indebted for sundry excellent hints
touching the best method of extricating vessels in difficult and