Going Public  23 This intrinsic value is based on the future cash flows or earnings power of the company. This means, essentially, that investors are paying for the perfor- mance they expect the company to achieve in the future, not what the com- pany has done in the past (and certainly not the cost of the company’s assets). Lily asked us how much their company’s shares would be worth. “Let’s assume,” we said, “that the market’s overall assessment of your company’s future performance is similar to what you think your company will do. The first step is to forecast your company’s performance and discount the future expected cash flows. Based on this analysis, the intrinsic value of your shares is $20 per share.” “That’s interesting,” said Nate, “because the amount of capital we’ve invested is only $7 per share.” We told them that this difference meant the market should be willing to pay their company a premium of $13 over the invested capital for the future economic profit the company would earn. “But,” Lily asked, “if they pay us this premium up front, how will the investors make any money?” “They may not,” we said. “Let’s see what will happen if your company performs exactly as you and the market expect. Let’s value your company five years into the future. If you perform exactly as expected over the next five years and if expectations beyond five years don’t change, your company’s value will be $32 per share. Let’s assume that you have not paid any divi- dends. An investor who bought a share for $20 per share today could sell the share for $32 in five years. The annualized return on the investment would be 10 percent, the same as the discount rate we used to discount your future performance. The interesting thing is that as long as you perform as expected, the return for your shareholders will be just their opportunity cost. But if you do better than expected, your shareholders will earn more than 10 percent. And if you do worse than expected, your shareholders will earn less than 10 percent.” “So,” said Lily, “the return that investors earn is driven not by the perfor- mance of our company, but by its performance relative to expectations.” “Exactly!” we said. Lily paused and reflected on the discussion. “That means we must manage our company’s performance in the real markets and the financial markets at the same time.” We agreed and explained that if they were to create a great deal of value in the real market—say, by earning more than their cost of capital and grow- ing fast—but didn’t do as well as investors expected, the investors would be disappointed. Managers have a dual task: to maximize the intrinsic value of the company and to properly manage the expectations of the financial market. “Managing market expectations is tricky,” we added. “You don’t want in- vestor expectations to be too high or too low. We’ve seen companies convince the market that they will deliver great performance and then not deliver on those promises. Not only does the share price drop when the market realizes 24  Finance in a Nutshell that the company won’t be able to deliver, but regaining credibility may take years. Conversely, if the market’s expectations are too low and you have a low share price relative to the opportunities the company faces, you may be subject to a hostile takeover.” After exploring these issues, Lily and Nate felt prepared to take their com- pany public. They went forward with an initial public offering and raised the capital they needed. Expansion into Related Formats Lily and Nate’s business was successful, growing quickly and regularly beat- ing the expectations of the market, so their share price was a top performer. They were comfortable that their management team would be able to achieve high growth in their Emporium stores, so they decided next to try some new concepts they had been thinking about: Lily’s Furniture and Lily’s Garden Supplies. But they grew concerned about managing the business as it became more and more complex. They had always had a good feel for the business, but as it expanded and they had to delegate more decision making, they were less confident that things would be managed well. They met with us again and told us that their financial people had put in place a planning and control system to closely monitor the revenue growth, ROIC, and economic profit of every store and each division overall. Their team set revenue and economic-profit targets annually for the next three years, mon- itored progress monthly, and tied managers’ compensation to economic profit against these targets. Yet they told us they weren’t sure the company was on track for the long-term performance that they and the market expected. “You need a planning and control system that incorporates forward-look- ing measures besides looking backward at financial measures,” we told them. “Tell us more,” Nate said. “As you’ve pointed out,” we said, “the problem with any financial mea- sure is that it cannot tell you how your managers are doing at building the business for the future. For example, in the short term, managers could im- prove their financial results by cutting back on customer service, such as by reducing the number of employees available in the store to help customers, by cutting into employee training, or by deferring maintenance costs or brand- building expenditures. You need to make sure that you build in measures related to customer satisfaction or brand awareness—measures that let you know what the future will look like, not just what the current performance is.” Lily and Nate both nodded, satisfied. The lessons they so quickly absorbed and applied have placed their company on a solid foundation. The two of them still come to see us from time to time, but only for social visits. Some- times they bring flowers from their garden supplies center.