McKinsey On Finance

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McKinsey onFinancePerspectives on Corporate Finance and StrategyNumber 56, Autumn 20152Are share buybacksjeopardizing future growth?6A better way to understandinternal rate of return19Building a betterpartnership betweenfinance and strategy23How M&A practitionersenable their success13Profiling the modern CFO:A panel discussion

McKinsey on Finance is aquarterly publication written bycorporate-finance expertsand practitioners at McKinsey& Company. This publicationoffers readers insights intovalue-creating strategies andthe translation of thosestrategies into companyperformance.This and archived issues ofMcKinsey on Finance areavailable online at, where selected articlesare also available in audioformat. A series of McKinseyon Finance podcasts isavailable on iTunes.Editorial Contact:McKinsey on Finance@McKinsey.comTo request permission torepublish an article, send anemail to Quarterly Board: DavidCogman, Ryan Davies, MarcGoedhart, Chip Hughes, BillHuyett, Tim Koller, DanLovallo, Werner Rehm, DennisSwinford, Robert UhlanerEditor: Dennis SwinfordArt Direction and Design:Cary ShodaManaging Editors: Michael T.Borruso, Venetia SimcockEditorial Production:Runa Arora, Elizabeth Brown,Heather Byer, Torea Frey,Heather Gross, ShahnazIslam, Katya Petriwsky, JohnC. Sanchez, Dana Sand,Sneha VatsCirculation: Diane BlackExternal Relations:Lisa FedorovichCover photo PM Images/Getty ImagesMcKinsey PracticePublicationsEditor-in-Chief: Lucia RahillyExecutive Editors:Michael T. Borruso, Allan Gold,Bill Javetski, Mark StaplesCopyright 2015 McKinsey &Company. All rights reserved.This publication is not intendedto be used as the basisfor trading in the shares of anycompany or for undertakingany other complex orsignificant financial transactionwithout consulting appropriateprofessional advisers.No part of this publicationmay be copied or redistributedin any form without the priorwritten consent of McKinsey &Company.

Table of contents2Are share buybacksjeopardizing futuregrowth?Fears that US companiesunderinvest by payingtoo much back to shareholders are unfounded.Rather, the rise in buybacksreflects changes inthe economy.19Building a betterpartnership betweenfinance and strategyThe growing strategic role ofCFOs may create tensionwith top strategists. That’sa missed opportunityfor teaming up to improvecompany performance.6A better way tounderstand internal rateof returnInvestments can have thesame internal rate of returnfor different reasons.A breakdown of this metricin private equity showswhy it matters.13Profiling the modern CFO:A panel discussionSeasoned finance chiefsexplore revamping businessmodels and coping withnew competitors, currencyrisks, and changingcapital structures.23How M&A practitionersenable their successCompanies that are best attransactions approachM&A differently—but there’sroom for improvementacross the board.Interested in reading McKinsey onFinance online? Email your name, title,and the name of your company toMcKinsey on,and we’ll notify you as soon as newarticles become available.

PM Images/Getty ImagesAre share buybacks jeopardizingfuture growth?Fears that US companies underinvest by paying too much back to shareholders are unfounded. Rather,the rise in buybacks reflects changes in the economy.Tim KollerReturning cash to shareholders is on the rise forlarge US-based companies. By McKinsey’s calculations, share buybacks alone have increased toabout 47 percent of the market’s income since 2011,from about 23 percent in the early 1990s and lessthan 10 percent in the early 1980s.1 Some investorsand legislators have wondered whether thatincrease is tantamount to underinvestment in assetsand projects that represent future growth.It isn’t. Distributions to shareholders overall,including both buybacks and dividends, arecurrently around 85 percent of income, about thesame as in the early 1990s. Instead, the trendin shareholder distributions reflects a decades-longevolution in the way companies think strategically2McKinsey on Finance Number 56, Autumn 2015about dividends and buybacks—and, morebroadly, mirrors the growing dominance of sectorsthat generate high returns with relatively littlecapital investment.In fact, ever since the US Securities and ExchangeCommission loosened its regulations on buybacks in 1982,2 companies have been changing theway they distribute excess cash to shareholders.So while dividends accounted for more than 90 percent of aggregated distributions to shareholders3before 1982, today they account for less than half—the rest are buybacks (Exhibit 1). The shift makesgood sense. Empirically, the value to shareholdersis the same,4 but buybacks afford companiesmore flexibility. Executives have learned that once

they announce dividends, investors tend toexpect that the dividends will continue inperpetuity unless a company falls into financialdistress. By contrast, a company can easilyadd or suspend share buybacks without creatingsuch expectations.Regardless of the proportion of buybacks todividends, there’s little evidence that distributionsto shareholders are what’s holding back theeconomy.In fact, on an absolute basis, US-basedMoF2015companieshave increased their global capitalShare buybacksinvestmentsExhibit1 ofby2 an inflation-adjusted average of3.4 percent annually for the past 25 years5—andtheir US investments by 2.7 percent.6 That exceedsExhibit 1the average 2.4 percent growth of the US GDP.Furthermore, replacement rates have remainedsimilar. Capital spending was 1.7 times depreciation from 2012 to 2014, compared with 1.6 timesfrom 1989 to 1999.7 The only apparent declineis in the level of capital expenditures relative to thecash flows that companies generate, which fellto 57 percent over the past three years, from about75 percent in the 1990s.That’s not surprising, given how much the makeup ofthe US economy has shifted toward intellectualproperty–based businesses. Medical-device, pharmaceutical, and technology companies increased theirshare of corporate profits to 32 percent in 2014,Overall distributions to shareholders have fluctuated cyclically since deregulation inthe mid-1980s, though the ratio of buybacks to dividends has grown.Distributions as % of adjusted net income, 5-year rolling ds10019851990200020101 For US nonfinancial companies with revenues greater than 500 million (adjusted for inflation).Source: Corporate Performance Analysis Tool; McKinsey analysisAre share buybacks jeopardizing future growth?3

from 13 percent in 1989. Since a company’s rate ofgrowth and returns on capital determine how muchit needs to invest, these and other high-returnenterprises can invest less capital and still achievethe same profit growth as companies with lowerreturns. Consider two companies growing at5 percent a year. One earns a 20 percent return oncapital,and the other earns 10 percent. TheMoF2015companyearning a 20 percent return would needSharebuybackstoinvestonlyExhibit 2 of 252 percent of its profits each yearto grow at 5 percent, while the company earning a10 percent return would need to invest 50 percentExhibit 2The composition of the US economyhas shifted away from capitalintensive industries.Share of total profits and capital expendituresfor US-based companies, 1Technology,pharmaceuticals, andmedical devices62Automotive, mining, oil,chemicals, paper,telecommunications,and utilities27Other13252351989264220145633198920141 Other includes capital goods, consumer staples, consumerdiscretionary, media, retail, and transportation.Source: Corporate Performance Analysis Tool; McKinsey analysis4McKinsey on Finance Number 56, Autumn 2015of its profits. So a higher return on capital leads tohigher cash flows available to disburse to shareholders at the same level of growth.That is what’s happened among US businessesas their aggregate return on capital has increased.Intellectual property–based businesses nowaccount for 32 percent of corporate profits but only11 percent of capital expenditures—around15 to 30 percent of their cash flows. At the sametime, businesses with low returns on capital,including automobiles, chemicals, mining, oil andgas, paper, telecommunications, and utilities,have seen their share of corporate profits declineto 26 percent in 2014, from 52 percent in 1989(Exhibit 2). While accounting for only 26 percent ofprofits, these capital-intensive industries accountfor 62 percent of capital expenditures—amountingto 50 to 100 percent or more of their cash flows.Here’s another way to look at this: while capitalspending has outpaced GDP growth by a smallamount, investments in intellectual property—research and development—have increased muchfaster. In inflation-adjusted terms, investmentsin intellectual property have grown at more thandouble the rate of GDP growth, 5.4 percent ayear versus 2.4 percent. In 2014, these investmentsamounted to 690 billion.

Certainly, some individual companies are probablyspending too little on growth—just as others spendtoo much. But in aggregate, it’s hard to make a broadcase for underinvestment or to blame companiesreturning cash to shareholders for jeopardizingfuture growth.5US-based nonfinancial companies with more than 500 millionin revenues. Using the aggregate GDP deflator, capitalexpenditures increased by 2.6 percent, versus 3.4 percentfor the capital-expenditure deflator (as a result of lowerinflation on capital items).6 National Income and Product Accounts Tables, US Departmentof Commerce Bureau of Economic Analysis, accessed August2015, This is lower than it was in the 1970s and 1980s—decadesaffected by high inflation.1For US nonfinancial companies with revenues greater than 500 million (adjusted for inflation). Income is beforeextraordinary items, goodwill write-downs, and amortizationof intangibles associated with acquisitions.2 Rule 10b-18 of the US Securities and Exchange Commission“provides companies with a voluntary ‘safe harbor’ from liabilityfor manipulation under the Securities Exchange Act of 1934.”3 Among nonfinancial companies in the S&P 500.4 Bin Jiang and Tim Koller, “Paying back your shareholders,”McKinsey on Finance, May 2011, share buybacks jeopardizing future growth?The author wishes to thank Darshit Mehta for hiscontributions to this article.Tim Koller (Tim is a principal inMcKinsey’s New York office.Copyright 2015 McKinsey & Company.All rights reserved.5

Peter Dazeley/Getty ImagesA better way to understandinternal rate of returnInvestments can have the same internal rate of return for different reasons. A breakdown of this metric inprivate equity shows why it matters.Marc Goedhart, Cindy Levy, and Paul Morgan6Executives, analysts, and investors often rely oninternal-rate-of-return (IRR) calculations asone measure of a project’s yield. Private-equityfirms and oil and gas companies, among others,commonly use it as a shorthand benchmarkto compare the relative attractiveness of diverseinvestments. Projects with the highest IRRsare considered the most attractive and are givena higher priority.a project’s strategic positioning, its businessperformance, and its level of debt and leverage—also contribute to its IRR. As a result, multipleprojects can have the same IRRs for very differentreasons. Disaggregating what actually propelsthem can help managers better assess a project’sgenuine value in light of its risk as well as itsreturns—and shape more realistic expectationsamong investors.But not all IRRs are created equal. They’re acomplex mix of components that can affect both aproject’s value and its comparability to otherprojects. In addition to the portion of the metricthat reflects momentum in the markets or thestrength of the economy, other factors—includingSince the headline performance of private equity,for example, is typically measured by the IRRof different funds, it’s instructive to examine thosefunds’ performance. What sometimes escapesscrutiny is how much of their performance is due toeach of the factors that contribute to IRR above aMcKinsey on Finance Number 56, Autumn 2015

baseline of what a business would generate withoutany improvements—including business performanceand strategic repositioning but also debt andleveraging. Armed with those insights, investorsare better able to compare funds more meaningfully than by merely looking at the bottom line.Insights from disaggregating the IRRAlthough IRR is the single most important performance benchmark for private-equityinvestments, disaggregating it and examiningthe factors above can provide an additionallevel of insight into the sources of performance.This can give investors in private-equityfunds a deeper understanding when makinggeneral-partner investment decisions.Baseline return. Part of an investment’s IRR comesfrom the cash flow that the business was expectedto generate without any improvements after acquisition. To ensure accurate allocation of the otherdrivers of IRR, it is necessary to calculate and reportthe contribution from this baseline of cash flows.Consider a hypothetical investment in a businessacquired at an equity value of 55 and divestedtwo years later at a value of 100 (Exhibit 1). Thebusiness’s operating cash flow in the year beforeacquisition was 10. At unchanged performance,the investment’s cash return in year two,compounded at the unlevered IRR, would havebeen 23.30. In other words, the return frombuying and holding the investment without furtherchanges contributed ten percentage points ofthe 58 percent IRR. Strong performance on thismeasure could be an indicator of skill in acquiring companies at attractive terms.Improvements to business performance. The bestprivate-equity managers create value by rigorouslyimproving business performance: growing thebusiness, improving its margins, and/or increasingits capital efficiency.1A better way to understand internal rate of returnIn the hypothetical investment, revenue growthand margin improvement generated additionalearnings in years one and two, amounting to a compounded cash-flow return of 3.30. In addition,earnings improvement in year two translated intoa capital gain of 20, bringing the cash returnfor business-performance improvements to 23.30 and its IRR contribution to ten percentagepoints. This is an important measure of a privateequity firm’s capacity to not only choose attractiveinvestments but also add to their value duringthe ownership period.Strategic repositioning. Repositioning aninvestment strategically also offers an importantsource of value creation for private-equitymanagers. Increasing the opportunities for futuregrowth and returns through, for example,investments in innovation, new-product launches,and market entries can be a powerful boost tothe value of a business.Consider, for example, the impact of the change inthe ratio of enterprise value (EV) to earnings beforeinterest, taxes, depreciation, and amortization(EBITDA) for our hypothetical investment. Thebusiness was acquired at an EV/EBITDA multiple of 10 and divested at a multiple of 12.5—whichgenerated a cash return of 30. This translatesinto 13 percentage points of the project’s 58 percentIRR. This measure could indicate a firm’s abilityto transform a portfolio company’s strategy to capture future growth and return opportunities.Effect of leverage. Private-equity investments typically rely on high amounts of debt funding—much higher than for otherwise comparable publiccompanies. Understanding what part of aninvestment’s IRR is driven by leverage is importantas an element of assessing risk-adjusted returns.In our hypothetical example, the acquisition waspartly funded with debt—and debt also increased7

MoF 2015IRRExhibit 1 of 3Exhibit 1Disaggregating returns reveals how much of the internal rate of return is attributableto different sources.YearInvestment financialsEarnings before interest, taxes,depreciation, and amortization (EBITDA)01210.011.012.0Enterprise value (EV)100.0150.0Acquisition per end of year 0Net debt(45.0)(50.0)Without interestEquity value55.0100.0EV/EBITDA10.012.5Levered and unlevered internalrate of return (IRR)Year0Operating cash flow1211.012.0Cash flow on exit/acquisition(100.0)Unlevered cash flow(100.0)11.0162.0Cash flow from debt45.05.0(50.0)Levered cash flow55.016.0112.0Decomposition of IRR from:0IRR150.0Year1233%58%Presentvalue (PV)of year 21FractionContributionto IRR210%BaselineCash flow10. performanceCash flow1. gain320.020.00.26Capital gain430.030.00.3913% repositioningUnlevered return11.010%Leverage525%Levered return58%1 Cash flows compounded at unlevered IRR to year 2.2 Calculated as each lever’s PV (year 2)/total PV (year 2) unlevered IRR.3 Calculated as [EBITDA (entry) – EBITDA (exit)] EV multiple (entry).4 Calculated as [EV multiple (exit) – EV multiple (entry)] EBITDA (exit).5 Calculated as residual between unlevered and levered return.8Constant revenues, no taxes, no capital expendituresMcKinsey on Finance Number 56, Autumn 2015

over the next two years. In that time frame,earnings increased by 20 percent and the company’sEV-to-EBITDA ratio rose by more than two percentage points. The IRR of the acquisition, derivedfrom the investment’s cash flows, would be58 percent.or large capital investments, further disaggregation could separate the cash flows relatedto those activities from the cash flows due tobusiness-performance improvements—as well asstrategic repositioning.How much does the company’s debt affect itsIRR? Adding back the cash flows for debt financingand interest payments allows us to estimate thecompany’s cash flows as if the business had beenacquired with equity and no debt. That resultsin an unlevered IRR of 33 percent—which meansleverage from debt financing contributed 25 percentage points, about half of the investment’s totallevered IRR. Whether these returns representvalue creation for investors on a risk-adjusted basisis questionable, since leverage also adds risk.The example above illustrates the basic principlesof disaggregating IRR, which ideally should be donebefore any comparison of different investments.Consider, for example, two investments by a largeprivate-equity fund, both of them businesseswith more than 100 million in annual revenues(Exhibit 2). Each had generated healthy bottomline returns for investors of 20 percent or more onan annualized basis. But the sources of thereturns and the extent to which these representtrue value creation differed widely betweenthe businesses.Comparing projects beyond the bottom lineThe disaggregation shown in Exhibit 1 can beexpanded to include additional subcomponents ofperformance or to accommodate more complex funding and transaction structures.2 Managersmay, for example, find it useful to further disaggregate business performance to break out theeffects of operating-cash-flow changes fromrevenue growth, margin expansion, and improvements in capital efficiency. They could alsoseparate the effects of sector-wide changes in valuation from the portion of IRR attributed to strategicrepositioning. Moreover, if our hypotheticalinvestment had involved mergers, acquisitions,The investment in a retail-chain company hadgenerated a towering 71 percent IRR, with morethan three-quarters the result of a very aggressive debt structure—which also carried higher risk.On an unlevered basis and excluding sector andbaseline contributions, the risk-adjusted return toinvestors was a much lower but still impressive21 percent. By improving margins and the capitalefficiency of the individual retail locations, management had contributed around 5 percent a year toIRR from business performance. A successful strategic transformation of the company formed theUnderstanding the true sources of internal ratesof return provides insight not onl

finance and strategy 23 How M&A practitioners enable their success Perspectives on Corporate Finance and Strategy Number 56, Autumn 2015 Finance McKinsey on. McKinsey on Finance. is a quarterly publication written by corporate-finance experts and practitioners at McKinsey & Company. This publication offers readers insights into value-creating .

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