Value Maps

John Wiley & Sons

Chapter One

At the conclusion of a valuation engagement, the professional should have value-enhancing insights into the client's business that the client does not have. This is true even in projects in the rapidly growing niche, valuation for financial reporting. If the analyst does not have such insights, then he or she did not do the job right. That is a strong statement, I know. But I am with Dizzy Dean, the supremely self-confident pitcher from the 1930s, who liked to say "If you can do it, it ain't braggin'."

The valuation field is growing fast. The general absence of barriers to entry in our arena, however, invites opportunists, charlatans, incompetents, low-ballers, and rip-off artists to eviscerate pricing and destroy the opportunities that serious practitioners can have to create value for clients. At Beckmill Research, LLC, we are about value creation. That comes from my experience before I became a valuation guy. I had held various jobs as a financial professional, but the game-changer-life-changer, really-was the half-decade I spent as a Ph.D. student in strategic management in the mid-1980s. As the word `strategic' suggests, it is management for the long term as seen from the top of the organization. The focus is on the creation and retention of value. We-my wife, Dorothy, and I-launched our firm in 1991 as a strategy boutique. I "discovered" valuation in 1993. As I dove into the field devouring books and every other piece of information I could find, I was struck by the huge disparity in rates of return among firms of different size in the Ibbotson dataset. Frustrated by the insufficiency of tools from finance and accounting to explain such disparities, I began experimenting, first with tools from strategy. I found that they had considerable utility. I then added other tools from industrial organization and organization theory, two other disciplines I had encountered in my Ph.D. coursework.

At a valuation seminar sponsored by the American Society of Appraisers (ASA) in 1995, one of the instructors introduced Porter's five-forces framework. My jaw dropped, and I almost fell out of my chair. I had the empirical confirmation that I needed that I was on the right track.

Not surprisingly, we see the world differently from most of our colleagues. For starters, we do not believe that valuation has much to do with accounting. Now, before all my accounting colleagues take aim at me, please hold your fire and allow me to explain. For starters, I am a Certified Public Accountant (CPA) and a Certified Management Accountant, as well as a former controller and chief financial officer (CFO). But, if accounting knowledge were essential in this line of work, we would see CPAs on what remains of Wall Street and working for buy-side institutions. Few are there. Labor markets are telling us something.

Don't misunderstand. I'm glad I know, understand, and can do accounting. I'm a better valuation professional because of that knowledge and experience. But I suffer from no delusions that valuation should be seen through the lens of accounting. It shouldn't, and here's why: Valuation is about the future, and accounting is about the past. It's that simple.

Like most who have worked in this emerging field for a while, I didn't start out here. Near the end of cramming four years of undergraduate education into 14, I had 54 on-campus job interviews, got 53 rejection letters (including eight in one day, which surely must be a record), and received one job offer. That lifeline was to become an internal auditor at Union Pacific Corporation (UP).

Next to what I do now, that job was the most fun I ever had professionally. The staff at "Uncle Pete," as we called it, was run in the mid-1970s by former members of the "traveling audit staff" at General Electric. My two years there were a career-changing experience that stands me in good stead to this day.

For one thing, the idea of paying our way was hammered into us. We were obsessed with finding ways to reduce costs, eliminate inefficiencies, and help processes work better in our operational audits of various functions within the far-flung UP empire. The late Charlie Billingsley, then the general auditor for UP, oversaw the staff. It was a preschooler, barely five years old when I joined it. We spent only a quarter of our time on financial audits; that was to keep the fees of the outside auditors down. The other nine months of the year, we did operational auditing, long before such audits became all the rage in U.S. industry.

We had audit programs, of course, but Charlie liked to say: "At the end of the day we have a three-word audit program around here: `Do something smart."' That is because operational audits, like business valuations, are very much about "facts and circumstances."

As I did when I started out in 1975, today I still go where the facts and the circumstances lead me. If that makes the client happy, terrific. If it makes the client unhappy, well, I'm sorry. We want clients to be happy but their happiness is not part of our engagement letter. It doesn't change anything we do. In the inimitable characterization by the late Senator Paul Tsongas, valuation professionals cannot be "pander bears." Those who are-and there are many of them these days-mislead and disrespect clients. In the process, they undermine the hard work and credibility of the rest of us.

Valuation as Craft

We often hear colleagues bantering back and forth over the question, "Is valuation an art or a science?" Some claim to know the answer. Others take an unambiguous position straddling the fence, muttering that it is some of each. We believe that, like adherents to traditional microeconomics, what they are debating is about the pinhead-dancing of angels.

Valuation is craft. It is not science because it lacks precision and certainty. It is not art because it has utility and economic dimensions. The word "craft" summons images of objects made by hand-by masons, carpenters, weavers, silversmiths, sculptors, and potters. But such one-off work products also come from surgeons, writers, dentists, basic researchers-and valuation professionals. In a craft, neophytes serve apprenticeships under the supervision of a journeyman (or journeywoman). She or he is experienced in the craft and is older, wiser, and more knowledgeable. In a craft, experience dominates because only through experience can one acquire the necessary knowledge of nuance and technique that enables the delivery of a top-flight product.

When craftspeople talk with clients, we speak as weavers, masons, silversmiths, carpenters ... or analysts. When we speak to one another, however, we speak as craftspeople. We understand the use of every tool in our toolbox. That understanding, combined with our experience, gives dignity to our work product.

Each craftsman creates a body of work that grows, evolves, and improves with experience. Each creation is unique. Each is personal. Each is a standalone statement by and about the craftswoman. Improvement comes only from repeated ventures into the craft, pushing the envelope, extending knowledge, expanding reach, and explaining meaning. Craft that does not explain has not meaning and is not craft.

None of these aesthetics, sensory experiences, or nuances afflict charlatans masquerading as craftsmen. They think only of power, prestige, and money. We think only of preserving and enhancing our craft. If we do right by our craft, money and the rest of it takes care of itself.

Done right, every valuation-like every surgery, every piece of handmade furniture, every rock wall, and every silver-and-turquoise belt buckle-is different, not at the margin but in substance. There is a process, of course, and we must respect and follow it wherever it leads us, regardless of how the client feels; if she feels strongly enough, she can fire us. So be it. But, that is why "facts and circumstances" are so important in our craft. It is also why one-size-fits-all doesn't work any better in valuation than it does in haberdashery.

The State of Our Craft

Academic scholars are craftspeople, too. Every paper, whether published or not, gives them new knowledge, new understanding, and insights that they didn't have before. Some business professionals disparage the primacy, at least at larger institutions, of research. Before I spent five years in a doctoral program, I did, too. I learned there, though, that research keeps professors, especially the tenured ones, current in their knowledge. I have seen faculty members at colleges without a research emphasis, and what they know-and what they teach, of course-is often out of date. But 19-year-olds will never know until it's too late.

Besides keeping professors' knowledge current, I believe there is an even stronger argument for a research component: Those in the business of disseminating knowledge should also be about the business of creating some. Similarly, those of us in the business of assessing value should be about the business of knowing how to create it. And if we know how to create it, then opportunities present themselves to do great work helping clients increase the value of their life's work.

The literature of business valuation today is resoundingly mute on the issue of value creation. The major reference books-by Shannon Pratt; George Hawkins and Michael Paschall; Chris Mercer; McKinsey's Tim Koller and his colleagues; and by those who contributed chapters to Jim Hitchner's edited volume-all come from serious professionals with financial backgrounds. Such backgrounds can be limiting; I know because I started out that way. In none of these books, for instance, is there any discussion about value-creating mechanisms, their durability, and the ability of current or would-be competitors to replicate or imitate them. There is nothing about how to analyze and assess such mechanisms. Most important, they are silent on the issue of how to create value.

I'm reminded of the famous words of Supreme Court Justice Potter Stewart in a 1964 pornography case:

I shall not today attempt further to define the kinds of material I understand to be embraced within that shorthand description [of pornography]; and perhaps I could never succeed in intelligibly doing so. But I know it when I see it.

Business valuation is more than numbers. It is about cause-and-effect relationships and how or if a firm creates value. We need an approach to valuation and a framework that enables us to identify causal relationships and that takes us to how value is created, how to assess the durability of value-creating mechanisms, and how to make replication and imitation by competitors more difficult and impossible if possible. This book advances such an approach and such a framework.

Cause and Effect: What and Why

The data archives and ratio analysis tell us what. The published research tells us where. But neither tells us why. The view taken here is that why matters. In our experience, it is all too common in a valuation report to read a paragraph like this:

The Company's inventory turnover, which is Cost of Goods Sold divided by average inventory, is 1/2 the industry average. That means that the Company is not selling what it has on hand as fast as the rest of the industry is. Days' sales outstanding is....

We have only one question: Why is inventory turn half the industry average? The expanding literature of valuation teems with "tools of the what," especially ratio analysis. Unfortunately, it offers few tools that help us get at "the why." Yet if a valuation professional cannot explain why a certain metric is notably above or notably below where competitors' performance is, then the probability is overwhelming that the analyst does not understand the business that she or he purports to value. And without that understanding, the valuation will be on point only by chance.

To be sure, a blind hog can find an acorn every now and then. But it is not something I'd want to bet the farm on every day of the week.

Explaining why not only enhances the quality of the analysis, it also increases the credibility of the analyst. Put yourself in the role of a judge and ask yourself who you would think is more credible: a professional who can explain why or one who cannot. It never ceases to amaze us that so few valuation reports really explain the why. They don't explain why because their authors don't know why, yet understanding why is the key to sound valuation practice as well as to unlocking business wealth.

Multidisciplinary Tools for Analyzing Value Creation

Many of our valuation colleagues-hardworking, honest, well-intended people, all-have one "deep" specialty. It might be accounting or finance. Or it could be expertise in a domain-for example, healthcare. We believe that valuation, especially of closely held companies for whose securities there are no active markets, is difficult and complicated. It is also multifaceted. Therefore, we cannot get by with knowing a little about a lot or a lot about a little. To serve clients and do right by our profession, we must know a lot ... about a lot.

As a craft, our work is multifaceted. The absence of active securities markets requires us to be able to look at a situation from different angles, with different perspectives, and through different lenses. In our shop, we have an arsenal of tools that we use in almost every valuation. These tools-mental, but no less cutting edge than a surgeon's scalpel-come from a panoply of disciplines that we have learned to use over the years.

First and foremost is strategic management. Before "discovering" business valuation in 1993, I spent a half-decade as a Ph.D. student in strategy. Almost from the beginning of my valuation journey, I saw overlap in the basic questions underpinning these two fields:

Strategy. Why do some companies perform much better than others for long periods of time?

Valuation. Why is this company worth what I say it is worth?

It is all about why. I knew that finance and accounting knowledge was not going to be enough. I also saw that some key ideas from strategic management could be deployed in valuation. Strategy-based notions such as distinctive advantage, strategic intent, and generic competitive strategies had roles to play in business valuation. We elaborate at length on these in Chapter 2.

The second field on which we rely for understanding and explaining value creation is a branch of economics, industrial organization (IO). IO itself has two subfields: antitrust and industry studies. We focus on the tools of industry studies. In IO, the unit of analysis (i.e., what the analyst examines) is not the individual company. It is the domain: the group of firms in the valuation entity's competitive arena. The 1974 Ph.D. of strategy guru Michael Porter was in IO. It was thus no accident that he rose to prominence through his "five-forces framework" (which we have expanded to six). Chapter 3 is about IO's applications to valuation.

The third field from which we draw our perspective about creating value is organization theory (OT). OT deals with the multidimensional relationship between organizational structure and company performance. It also considers external influences (macroenvironment and domain) on the available choices for structuring and designing an organization. Phrases such as "span of control," "boundary scanning," and "policies and procedures" are prominent in the OT lexicon. Prominent OT scholars include Barney and Ouchi, Daft, and Galbraith. We devote Chapter 4 to a discussion of the use of OT tools in business valuation.

The fourth piece of our multidisciplinary puzzle is evolutionary economics. The connection between evolution and economics originated with UCLA's Armen Alchian. Building on Alchian and on the behavioral theory of firms, An Evolutionary Theory of Economic Change brought evolutionary economics to the fore. The gist of this book is the importance of "routines" in determining firms' behaviors and decision making, the economic analog of genes embedded in firms' behaviors, the effects of technological innovation on economic growth, and the selection processes by which firms grow and survive ... or don't grow and don't survive.

Somewhat parallel to the work of Alchian was Edith Penrose's seminal contribution, A Theory of the Growth of the Firm. Penrose was the first to identify the constraints imposed by managerial knowledge and a firm's resources on its ability to grow. Her work laid the foundation for what became, 25 years later, the resource-based view of the firm (RBV).

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Excerpted from Value Mapsby Warren D. Miller Copyright © 2009 by John Wiley & Sons, Ltd. Excerpted by permission.
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