48  Fundamental Principles of Value Creation Every corporate leader must know this. So why are we discussing such obvious fallacies? The answer is that companies often do justify acquisitions using this flawed logic. Our alternative approach is simple: if you can’t point to specific sources of increased cash flow, the stock market won’t be fooled. Financial Engineering  Another area where the value conservation principle is important is financial engineering, which unfortunately has no standard definition. For our purposes, we define financial engineering as the use of financial instruments or structures other than straight debt and equity to man- age a company’s capital structure and risk profile. Financial engineering can include the use of derivatives, structured debt, securitization, and off-balance-sheet financing. While some of these activities can create real value, most don’t. Even so, the motivation to engage in non- value-added financial engineering remains strong because of its short-term, illusory impact. Consider that many of the largest hotel companies in the United States don’t own most of the hotels they operate. Instead, the hotels themselves are owned by other companies, often structured as partnerships or real estate in- vestment trusts (REITs). Unlike corporations, partnerships and REITs don’t pay U.S. income taxes; only their owners do. Therefore, an entire layer of taxa- tion is eliminated by placing hotels in partnerships and REITs in the United States. This method of separating ownership and operations lowers total in- come taxes paid to the government, so investors in the ownership and oper- ating companies are better off as a group, because their aggregate cash flows are higher. This is an example of financial engineering that adds real value by increasing cash flows. In contrast, sale-leaseback transactions rarely create value for investment- grade companies.19 In a sale-leaseback transaction, a company sells an asset that it owns but wants to continue to use, such as an office building, to a buyer who then leases it back to the company. Often, the company structures the lease so that it is treated as a sale for accounting purposes, and then removes the asset from the company’s balance sheet. It can also use the sale proceeds to pay down debt. Now it appears that the company has fewer assets and less debt. Rental expense replaces future depreciation and interest expense (though rental expense is typically higher than the sum of depreciation and interest expense). For larger investment-grade companies, the implied interest rate on the lease is often higher than the company’s regular borrowing rate, because the lessor uses the creditworthiness of the lessee to finance its purchase. In ad- dition, the company buying the asset must cover its cost of equity and its operating costs. 19 Both the FASB and IASB changed the lease accounting rules effective for the 2019 calendar year. Under the new rules, all leases greater than one year must be capitalized. The Math of Value Creation  49 If the company intends to use the asset for its remaining life (by renewing the lease as it expires), then it has created no value, even though the company appears to be less capital-intensive and to have lower debt. In fact, it has de- stroyed value because the cost of the lease is higher than the cost of borrow- ing. The company also incurs its own transaction costs and may have to pay taxes on any gain from the sale of the asset. What’s more, other creditors and rating agencies will often treat the lease as a debt equivalent anyway. The transaction may create value if the company wants the ability to stop using the asset before its remaining life expires and wants to eliminate the risk that the value of the asset will be lower when it decides to stop using the asset. Sale-leaseback transactions may also create value if the lessor is better able to use the tax benefits associated with owning the asset, such as accelerated depreciation. This does not violate the conservation of value principle, be- cause the total cash flows to the companies involved have increased—at the expense of the government. The Math of Value Creation Earlier in this chapter, we introduced the value driver formula, a simple equa- tion that captures the essence of valuation. For readers interested in the techni- cal math of valuation, this section will show how we derive the formula. Let’s begin with some terminology that we will use throughout the book (Part Two defines the terms in detail): • Net operating profit after taxes (NOPAT) represents the profits generated from the company’s core operations after subtracting the income taxes related to those core operations. • Invested capital represents the cumulative amount the business has in- vested in its core operations—primarily property, plant, and equipment and working capital. • Net investment is the increase in invested capital from one year to the next: Net Investment Invested Capital Invested Capital = − + t t 1 • Free cash flow (FCF) is the cash flow generated by the core operations of the business after deducting investments in new capital: FCF NOPAT Net Investment = − • Return on invested capital (ROIC) is the return the company earns on each dollar invested in the business: ROIC NOPAT Invested Capital =