Conservation of Value  43
predictions, the stock prices of companies didn’t change when the new ac-
counting rules were implemented, because the market already reflected the 
cost of the options in its valuations of companies.12 One respected analyst told 
us, “I don’t care whether they are recorded as an expense or simply disclosed 
in the footnotes. I know what to do with the information.”
In this case, the conservation of value principle explains why executives 
didn’t need to worry about any effects that changes in stock option account-
ing would have on their share price. The same applies to questions such as 
whether an acquisition creates value simply because reported earnings in-
crease, whether a company should return cash to shareholders through share 
repurchases instead of dividends, or whether financial engineering creates 
value. In every circumstance, executives should focus on increasing cash flows 
rather than finding gimmicks that merely redistribute value among investors 
or make reported results look better. Executives should also be wary of pro-
posals that claim to create value unless they’re clear about how their actions 
will materially increase the size of the pie. If you can’t pinpoint the tangible 
source of value creation, you’re probably looking at an illusion, and you can 
be sure that’s what the market will think, too.
Conserving Value: A Brief History
The value conservation principle is described in the seminal textbook Principles 
of Corporate Finance, by Richard Brealey, Stewart Myers, and Franklin Allen.13 
One of the earliest applications of the principle can be found in the pioneering 
work of Nobel Prize winners Franco Modigliani and Merton Miller, financial 
economists who in the late 1950s and early 1960s questioned whether man-
agers could use changes in capital structure to increase share prices. In 1958, 
they showed that the value of a company shouldn’t be affected by changing 
the structure of the debt and equity ownership unless the overall cash flows 
generated by the company also change.14
Imagine a company that has no debt and generates $100 of cash flow each 
year before paying shareholders. Suppose the company is valued at $1,000. 
Now suppose the company borrows $200 and pays it out to the shareholders. 
Our knowledge of the core valuation principle and the value conservation 
principle tells us that the company would still be worth $1,000, with $200 for 
the creditors and $800 for the shareholders, because its cash flow available to 
pay the shareholders and creditors is still $100.
13 R. Brealey, S. Myers, and F. Allen, Principles of Corporate Finance, 12th ed. (New York: McGraw-Hill/
Irwin, 2017).
12 D. Aboody, M. Barth, and R. Kasznik, “Firms’ Voluntary Recognition of Stock-Based Compensation 
Expense,” Journal of Accounting Research 42, no. 2 (December 2004): 251–275; D. Aboody, M. Barth, and 
R. Kasznik, “SFAS No. 123 Stock-Based Compensation Expense and Equity Market Values,” Account-
ing Review 79, no. 2 (2004): 251–275; M. Semerdzhian, “The Effects of Expensing Stock Options and a New 
Approach to the Valuation Problem” (working paper, May 2004, SSRN).
14 F. Modigliani and M. H. Miller, “The Cost of Capital, Corporation Finance and the Theory of Invest-
ment,” American Economic Review 48, no. 3 (1958): 261–297.