3

The Conservation of Value

Recall that the first cornerstone is that value is created when a company generates higher cash flows through high revenue growth or high return on capital, or some combination thereof. The second cornerstone, the conservation of value, is a corollary of the first principle: anything that doesn't increase cash flows doesn't create value.

Value is conserved, or unchanged, when a company shifts the ownership of claims to its cash flows, but doesn't change the total available cash flows (such as when substituting debt for equity or issuing debt to repurchase shares). Similarly, changing the appearance of the cash flows without actually changing the cash flows, say by changing accounting techniques, doesn't change the value of a company.1

Although this principle may seem obvious, we make it explicit because executives, investors, and pundits often fall for the allure of the elusive free lunch, hoping, for example, that one accounting treatment will lead to a higher value than another or that some fancy financial structure will turn a mediocre deal into a winner.

The battle over how companies should account for executive stock options illustrates the extent to which executives continue to believe that the stock market is uninformed. Companies issue executive stock options in lieu of cash compensation, creating incentives for employees to act in the interests of the companies and to conserve cash (especially important for young start-up companies).

Even though ...

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