46  Fundamental Principles of Value Creation
share price of the company doesn’t reflect its underlying potential, so it buys 
back shares today. One year later, the market price adjusts to reflect manage-
ment’s expectations. Has value been created? Once again, the answer is no, 
value has not been created; it has only been shifted from one set of sharehold-
ers (those who sold) to the shareholders who did not sell. So while the hold-
ing shareholders may have benefited, the shareholders as a whole were not 
affected. Buying back shares when they are undervalued may be good for the 
shareholders who don’t sell, but studies of share repurchases have shown that 
companies aren’t very good at timing share repurchases, often buying when 
their share prices are high, not low.18
Executives as a rule need to exercise caution when presented with trans-
actions like share repurchases that appear to create value by boosting EPS. 
Always ask, “Where is the source of the value creation?” Some research and 
development (R&D)–intensive companies, for example, have searched for 
ways to capitalize R&D spending through complex joint ventures, hoping 
to lower expenses that reduce EPS. But does the joint venture create value 
by increasing short-term EPS? No, and in fact it may destroy value because 
the company now transfers upside potential—and risk, of course—to its 
partners.
Acquisitions  Chapter 31 covers acquisitions in more detail, but for now we 
can say that acquisitions create value only when the combined cash flows 
of the two companies increase due to cost reductions, accelerated revenue 
growth, or better use of fixed and working capital.
To give you a sense of how a good transaction might work, we’ll use the 
example of United Rentals’ purchase of RSC (another equipment rental com-
pany) for $1.9 billion in 2011. Within several years, they had achieved more 
than $250 million of annual cost savings. We conservatively estimated that the 
cost savings were worth over $1.5 billion in present value. That’s equivalent to 
about 80 percent of the purchase price.
A revenue acceleration example comes from Johnson & Johnson, which 
in 1994 acquired Neutrogena, a maker of skin-care products, for $924 million. 
Over the next eight years, management introduced 20 new products within 
existing product categories and launched an entire line of men’s care products. 
It also accelerated the brand’s presence outside the United States. As a result, 
J&J increased Neutrogena’s sales from $281 million to $778 million by 2002.
18 B. Jiang and T. Koller, “The Savvy Executive’s Guide to Buying Back Shares,” McKinsey on Finance, no. 
41 (Autumn 2011): 14–17. The results here are counter to academic studies that were based on earlier 
samples and included many small companies. Our study included only companies in the S&P 500. 
When share buybacks were rare, announcements were made with great fanfare and often provided 
strong signals of management’s concern for capital discipline. Most of the fanfare has faded, as compa-
nies regularly repurchase shares, so announcements aren’t a surprise to the market anymore.