Beyond Earnings

1NEVER FORGET THE GOLDEN RULE: PURSUE STRATEGIES WITH POSITIVE NPV

“Cash flow is a fact, earnings an opinion.”

—written on a subway wall

KEY LEARNING POINTS

• Rational investors prefer more value to less.
• The responsibilities of corporate financial managers are varied but revolve around making decisions that increase economic value.
• Accounting value is what’s been put into a business while economic value is what can be taken out in future cash flows. Don’t confuse earnings and cash flow.
• The golden rule of finance is to pursue strategies and projects with a positive net present value.
• The growing annuity equation is useful for back‐of‐the‐envelope valuations.
• Decision trees help visualize and value the outcomes from decisions and chance events.
• The price of short‐termism can be high. Investors pay for the long term.
• The Law of Conservation of Value specifies that if expected cash flows don’t change, then the intrinsic value shouldn’t change.

INTRODUCTION

If we offered you the chance to buy a crisp $100 bill for $80, you would undoubtedly accept the deal since its immediate profit, or net present value (NPV), is $20 in your favor. You would surely decline an opportunity to purchase a $100 bill for $120. The NPV would be a loss of $20, resulting in an immediate decline in your wealth. Simply stated, rational investors prefer more value to less.

This statement might strike you as blindingly obvious, but there is no shortage of corporate examples where it has been violated. ...