We Study Billionaires - The Investor’s Podcast Network - TIP725: First Principles of Valuation w/ Tim Koller

Starting point is 00:00:00 You're listening to TIP. On today's episode, I'm joined by Tim Kohler to discuss all things valuation. Tim is the lead author of Valuation, measuring and managing the value of companies, which is the number one bestselling guide on business valuation. This book, now in its eighth edition, has sold more than one million copies, and it's used as a textbook at top business schools such as Wharton and MIT. As a partner at McKinsey and Company, Tim combines broad cross-sector experience with decades of service to clients in value creation, corporate strategy, capital markets issues, and

Starting point is 00:00:35 emanate transactions. During this episode, we cover how companies create shareholder value, the common misconceptions related to creating value, how managers should think about return on invested capital, why it's so common for managers not to take a long-term approach, how return on invested capital impacts a company's valuation, how Tim thinks about the vast differences in returns we've seen in the U.S. relative to Europe, his most commonly used value metrics and much more. Tim delivered a wealth of knowledge and insights related to valuation during this discussion. So with that, I bring you today's episode with Tim Kohler. Since 2014 and through more than 180 million downloads, we've studied the financial markets

Starting point is 00:01:19 and read the books that influence self-made billionaires the most. We keep you informed and prepared for the unexpected. Now for your host, Clay Fink. Welcome to the Investors podcast. I'm your host, Clay Fink, and today I'm happy to be joined by Tim Kohler. Tim, thank you so much for joining me here today. Clay, thanks. I'm happy to be here. So for those in the audience who might not know Tim, he co-authored the well-regarded book

Starting point is 00:01:52 titled Valuation, Measuring and Managing the Value of Companies. And they just released their eighth edition of the book. It's definitely an excellent resource for investors to draw on just so many topics related to valuation. And I thought a good place to start here, Tim, was with a quote from the preface of your book, you write, the book's messages are simple. Companies thrive when they create real economic value for their shareholders. Companies create value by investing capital at rates of return that exceed their cost of capital. These two truths apply across time and geography. Now, I think back to when I first got started investing, if you would have shown me those lines, I would have been like, what in the

Starting point is 00:02:31 world, are you talking about Tim? So how about you just speak to the significance of this and how it ties into what's discussed in the pages that follow in the book? That's a great question. I'll only break it up into two parts. One is sort of how do you create real value for your shareholders, for the company, for the economy? Ultimately, what matters as with any investment is the cash flows that you generate. And the way you generate cash flows is by earning more than your cost of capital. So we focus on the return on capital. And the way companies create value is by investing money and then generating a return on that capital.

Starting point is 00:03:11 And their return is the biggest driver of whether or not that company is going to create a lot of value or not in combination with how much capital they're investing and how fast they're growing their revenues as a result. So the common theme throughout the book is, and this is what I emphasize to whenever I talk to corporate clients is it all boils down to long-term revenue growth and return on capital as the drivers of cash flow and therefore value creation. The other part of your question is about you use the word real value creation. And I think what we're trying to get at there is that you can fool the market for a while.

Starting point is 00:03:57 Okay. So if you are doing things that make your accounting results look good, it may be not transparent to the market, but eventually that will come through. So companies that, so for example, focus only on cost cutting and don't invest in product development or sales and marketing or other types of growth, typically that will come back to hurt them and it will eventually become apparent to their shareholders. So you want to focus on real value creation. Things like share repurchases are return of capital. They're not additional value creation. Choices of accounting methods in the end, they all flesh out in terms of eventually translating into cash flows. So focus on the real. Don't focus on the real. Don't focus.

Starting point is 00:04:54 focus on the short-term share price, although for the most part, we find that the real short-term share price just reflect the economics of the company. So basically focus on real value creation, not accounting things, not gimmicks, and then finally going back to it's all about return our capital and growth that drive cash flow as drivers of real value creation. Now, you're someone who's interacted and worked with countless managers at companies with your work at McKinsey. I'm reminded of some managers are able to buck the institutional imperative, as Buffett would refer to it, as where they aren't looking at what their competitors are doing. They're doing what makes most sense to their company. Are there any common misconceptions

Starting point is 00:05:40 as it relates to value creation in working with all the managers that you've worked with over the years? Yeah, there's a whole bunch of misconceptions. One of the misconceptions is related to to what you were saying is that the market is a monolith, right, and that all investors think the same way. And in our research, what we found and what we encourage our corporate executives to do, the CEO's CFO, is to focus on the investors that matter. And our research suggests that the investors that matter are long-term intrinsic investors. There's a lot of noise out there, a lot of different trading strategies. Some investors are short-term-oriented. They want to know what the next piece of good news is.

Starting point is 00:06:27 The analysts, the South Side analysts, some of them are short-term oriented and asked a lot of short-term questions. So there's a lot of noise that CEOs, CFOs, and their boards face coming from the market. And we think it's important to focus on those long-term, sophisticated, intrinsic investors in terms of both the strategies that you're pursuing, what they want. and listening to what they have to say and focusing on learning from them as opposed to trying to please all your investors. You cannot please all your investors.

Starting point is 00:07:02 It's impossible. So, you know, the courageous CEOs focus on doing what's right for the company long term, which in general is consistent with what the intrinsic investors would want them to do. One example I give is, and that's a myth, is the importance of meeting consensus earnings forecasts, right? There's a lot of companies out there that will do whatever they can to meet the consensus. We did a survey of intrinsic investors and found that that wasn't very important to them.

Starting point is 00:07:36 And it's not that you can miss every year, every quarter kind of thing. But if you're above or below, we find it doesn't really matter statistically. And when we asked investors about this, they said, we don't want companies taking artificial actions at the end of a period just to hit their numbers if it is going to be a negative in the longer term. We don't want companies cutting prices at the end of the quarter to sell something additional, right? We don't want companies cutting product development or marketing sales at the end of the quarter just to make the numbers because eventually that will come back. They'll just get pushed the problem forward, and we don't want them to do that. So the misconception is one is about who the investors are that matter. And once you understand those investors, you realize that they're thinking long term about once again generating real cash flow, not concerned about accounting or consensus or the impact of share repurchases on EPS, et cetera.

Starting point is 00:08:40 They're really focused on the cash flows that the company's. going to be able to generate longer term. Now, you just released the eighth edition of your book, and the fundamental principles, of course, largely remain the same. What are some of the important new elements that you felt need to be included in this newer edition? The fundamentals, as you said, do remain the same, and we are constantly updating for things like accounting changes and tax changes and things like that. So there's sort of on the technical side. But what's changed is not so much the fundamentals is applying it in different environments to different sets of issues, right? So for example, you know,

Starting point is 00:09:20 everyone is thinking about digital and Gen AI. And so we talk about, you know, how do you think about that in the context of valuation? And then for example, people think it's something big and mysterious, but for most companies, except for companies that are selling AI products, what matters is how they're using AI to improve the business, right? There's not something separate that happens. So it's all a matter of, does this improve customer retention? Does it help me get new customers? Does it help me become more efficient because I can, you know, manage my costs better, etc.? Those are the kind of things that ultimately matter, right? But then we also point out that when companies adopt new digital technologies,

Starting point is 00:10:14 AI, et cetera, it's likely that their competitors are doing the same thing as well, right? So a lot of times those benefits flow through to ultimately to the consumer and not to the company or its shareholders because everyone is doing the same thing for the most part. And so everyone is cutting costs or competing in a better way for customers. Same thing with sustainability. Once again, it's not sort of proclaiming that you're good at sustainability isn't going to get you anywhere with investors, right? It has to be about the cash flows and the competitive advantage that you generate. So, for example, we talk about how if you want to get into, let's say, renewables, renewable energy, you have to have a competitive advantage.

Starting point is 00:11:01 There's a lot of competition out there. A lot of people who are really good about building out wind and solar. And if you don't have a competitive advantage, you're probably better off returning your cash to shareholders rather than investing it as a also ran or somebody who just has deep pockets. You bring up an interesting point that many of these new technologies, a lot of the benefits can just flow to the consumers. And it's interesting that a lot of industries can provide a lot of value to its customers, but not necessarily to the shareholders.

Starting point is 00:11:36 I look at the airline industry, for example, anyone can fly anywhere in the world thanks to this industry and the auto industry. There's constant innovations that are flowing through into vehicles, but these industries have typically been a tough playing ground for investors. I was curious, how important do you think it is for companies to create economic value in order for society at large to prosper? I think it's very important for companies to create value for society. I mean, we talk a little bit about that in our book, right?

Starting point is 00:12:09 It's the whole element of competition that drives innovation, right? Innovation is why we can live the lifestyles that we lead right now, right? If you look at, you know, we've gone from in the U.S., probably 40 or 50% of the population was involved in agriculture 80 years ago and now it's 2%. If you look at all the innovations and you mention automobiles, right, the autos that we drive right now are so. much safer, they're so much more comfortable, they handle better. It's amazing, even, you know, even economy cars. You can drive them at 85 or 90 miles an hour, not that I'm advocating that. They're very stable, which wouldn't have happened 50 years ago. And yet cars really don't cost more when you adjust for inflation, right? So there's been all this innovation and things that happen because of, or consumer

Starting point is 00:13:07 benefits that occur, just think about how many people now have air conditioning that didn't have air conditioning 50 years ago, right? Most people in the U.S. have access to air conditioning, for example. So we are so much better off because of innovation, and innovation wouldn't happen without companies striving to create economic value. Now, some of the companies, unfortunately, most of that economic value is passed on to the consumer, which is good for the consumer. and some companies are able to capture a bigger share of it, particularly companies like consumer branded companies where people become very brand loyal.

Starting point is 00:13:45 But in general, the whole approach is essential to progress and to making our lives as consumers more comfortable having access to more things that we wouldn't have access to. Now, return on invested capital is, of course, one of the important metrics when measuring the creation of shareholder values. you've mentioned multiple times just the accounting gimmicks and whatnot and number of times you pull up company reports you see adjusted EBITA growth and all these other metrics companies can come up with. Are there any misconceptions as it relates to return on invested capital that you've seen

Starting point is 00:14:21 with managers? With respect to return on invested capital, I think it's more important to get the numbers directionally correct, then to refine it too much. I see sometimes companies where they are so focused on the extra decimal point that they lose sight of the bigger picture. So we do try to, or we do advocate moving away sometimes from the pure accounting results in calculating return on capital. We want to focus on the things that, you can really drive, and that they're pretty simple to understand, inventories, receivables, payables, fixed assets, et cetera. So focusing on the operating performance is the most important thing. So you don't want to get hung up on things like how is deferred taxes driving your

Starting point is 00:15:18 return on capital, that kind of stuff, right? So you don't want to get hung up on those kind of things. We also do think it's important, though. One of the big questions that companies struggle with sometimes as whether to measure return on capital with or without goodwill and intangibles. We think you need to do both because they tell you different things, right? With goodwill and intangibles, which the number is often a lot lower, and that tells you how good a job you did with your acquisitions. Without it, it tells you're operating performance, and you can compare that relative to your peers, and is that getting better or worse? So there's things you can do, but I generally advocate a pretty simple approach.

Starting point is 00:15:57 And the other thing that's important when it comes to return on capital is not to look at it just, especially for a larger company, not to just look at it at the enterprise level. That really doesn't tell you anything. Some companies include non-operating things in there, which we need to take out. But it's also important and very important to dive down into the units because typically, let's say you've got a company that's earning a 15% of return on capital. When we dive deeper, we find that there are some units earning less than their cost of capital, less than 8%, some that are earning in the low teens and some that are earning in the mid-20s. That tells you something about your strategies. And so it's very important with the return on capital to not worry so much about precision, but worrying about more where are you generating that return on capital? Where's it good? Where's it bad?

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Starting point is 00:20:39 sign up for your $1 per month trial today at Shopify.com slash WSB. Go to Shopify.com slash WSB. That's Shopify.com slash WSB. All right. Back to the show. And oftentimes when a company makes a new investment, it won't see a positive return on that until multiple years into the future, say, newly built retail store might not reach maturity or profitability until, say, year three or four. How should managers consider the timing of cash flows with respect to capital allocation decisions? I mean, we have to be realistic that it does take time, right? And that's something that managers need to be patient about. They need to educate the board of directors about. And there's also often an opportunity to educate investors about that timing. I'll give you an example. There was a company, a retailer a number of years ago before it was purchased that used to publish in their annual report the

Starting point is 00:21:48 return on capital for different age cohorts of the stores. So you can see the stores that had been open for four or more years what their return on capital is, which gives you a sense of really how good the franchise is, right? And they also showed the return on capital of the stores that have been open less than a year, which was obviously much lower, right? And knowing how many stores were in each category, you could get a sense of how good a job are they doing. And as you grow and or as your growth slows, for example, more of your stores will be older and your return on capital will go up. So investors can see a lot by looking at that.

Starting point is 00:22:26 Now, that's a pretty simple example. But there are things I think investors can do or companies can do to educate investors about the timeframes on which things will play out and those investments will pay off. In one of the red flags you shared with me before we hit record was that you want CEOs and the executive team to understand the business at a very granular level and not be afraid to get their hands dirty at times and really understand their business. You look at many companies in the S&P 500. There's just so much complexity in many of these companies. So how about you talk more about kind of sifting through when analyzing a management team, how you really want someone, that deeply understands the business that they're managing. First of all, I would distinguish between complexity and size.

Starting point is 00:23:16 You can have a big company that's not very complex, and you could have a medium-sized company that is very complex. But what we have found is that companies where the CEO and CFO don't manage at a granular level, at the level of, let's say, 30 to 50, maybe even more units, what they tend to do is they tend to use a one-size-fits-all approach to management, right? Okay, this year we're all going to cut costs. And yet, you know, you may have some young business units that are growing very fast that should be focused on revenue growth, right?

Starting point is 00:23:54 And you may have some other units that should be focused on cutting costs and improving the return on capital. So that's why granularity is so important. So you can tailor the strategy and what you want each business unit to, accomplish based on the economics of that unit, right? And if you can't do that, you're likely to suboptimax, right? So if I have a company with 60 business units divided into three divisions, if I'm only looking at the three divisions, I don't understand how the division heads are making decisions. And the division heads may have a different time frame, different objectives than I do as the CEO. They're focused more on their short-term bonus, probably.

Starting point is 00:24:35 So they may be in a situation where they're going to underinvest in certain units to meet their short-term numbers, which as a CEO, I wouldn't want them to do. So I need to understand that. And it doesn't mean, you know, making the day-to-day decisions for the division heads or the business unit heads. It's really more about transparency and guiding them and making sure that they have the right priorities, that the businesses, the product lines with growth opportunities, are fully funded and that those businesses which are stagnating, their markets are not growing anymore, that they maybe don't try to grow and that they try to focus on, you know, improving their return on capital. That's what we mean by granularity.

Starting point is 00:25:20 It doesn't have to, it's not day-to-day decision-making. It is getting the strategic direction of each unit, each product line, each geography, correct and getting alignment about what they should be trying to accomplish. We talked about investing in the projects that do produce a return in excess of the cost of capital. And I think of some successful companies that have sort of moonshot bets within their business. Think of like Alphabet and their other bets division where they put a small amount of their capital in these bets that might pay off a thousand X down the line. But they might not be sure what the probability is of that. Perhaps you could talk more about how managers should think about, say, the certainty with which

Starting point is 00:26:03 the return they're expecting to generate. Some shareholders might argue for more capital returns if they're not certain they're going to be getting a return on that investment, whereas maybe some of these more longer-term investors, maybe they want managers to take more risk and even if they're somewhat uncertain of what the payoff is going to end up being. Yeah, I think investors, and we've surveyed them, these sophisticated investors do, you know, companies are in the business of taking risk, right, and making investments and not all of them are going to pay off. And if you're a large company and, you know, you're making 50 bets maybe at a time of different sizes of different risks, you ought to think about it as a portfolio, just as you were

Starting point is 00:26:44 investor thinking about your portfolio of stocks, some of them aren't going to pay off. Doesn't mean you shouldn't invest in those, right? So you do want to be making some, what I'll call risky bets. I think the important thing is, though not whether or not you should do it, but you should only be undertaking those risky bets. One, if you are in it to win, right? So are you going to invest enough to be a winner in, say, some new product area, right? Or are you going to be a dabbler? Because dabblers never win. So if you put a little bit of money into it, you're not going to win. You shouldn't be spending that money, right? Secondly, do you have the right? people in the right people model for those new invests, for those risky investments. If you're

Starting point is 00:27:29 competing with a bunch of startup companies, that creates a challenge for large companies, because oftentimes companies have very rigid pay scales, right? And so if you can't compete and you can attract the best talent, maybe you shouldn't be making that bet. And then another element about making those bets is, do you bring some sort of competitive advantage? Once again, if you're not going to bring a competitive advantage, you're going to be an also ran, then you probably shouldn't be doing it. So if you take companies that or investments where you meet all those three criteria, right, we have a competitive advantage or no one is in that market yet so we can create a competitive advantage. If we've got the right talent and if we're going to be willing to invest

Starting point is 00:28:18 enough to actually win in that market, those are the kind of investments that investors would like to see you do. You commonly hear that a lot of managers don't buck the institutional imperative, just repeating the Buffett line. They fall prey to short-term pressures and whatnot. But you've actually talked with so many of these managers. How common would you say it is for, you know, managers to do things like think long-term, focus on value creation, look at return on capital, and have this deep understanding of capital allocation? Unfortunately, I don't come across as many managers, executive as I would like, who have that long-term view. A lot of companies now have adopted return on capital in my career.

Starting point is 00:29:06 So there is a focus on return on capital, which is a good thing and the importance of having a higher return on capital. That part's good. I do come across more companies than I would be comfortable with. Maybe that's why we're consulting to them. I don't know. that are a bit too short-term oriented, to be honest. I think one of the reasons why you see a lot of companies being split up right now is it's because it's difficult for them sometimes to focus on growth

Starting point is 00:29:35 when they are part of more conglomerates or more diverse businesses, right? And I think what we have seen, for example, when companies get spun out of larger companies, that's often an opportunity to become more long-term oriented as an independent pure play company, for example. So there's unfortunately a lot of companies out there that are still short-term oriented, right, that aren't innovative. Fortunately, we have, as an economy, we have a great ecosystem that generates new businesses, entrepreneurs, etc., and not just in the tech world, but even in consumer products. So even if the bigger companies aren't being long-term oriented, there's a lot of smaller companies that are coming up with innovations that eventually get adopted by the big companies

Starting point is 00:30:27 because they have to be. So we do have a very dynamic economy, which creates a lot of value. Unfortunately, it's not always the large companies that are capturing that value because some of them have become too short-term oriented. All of us are self-interested in some way, shape, or form, and we're likely more biased than we likely believe we are. What do you think the key reason is that just a lot of managers tend to opt for the shorter-term focus, even if it's just, say, they're thinking one to two years out, which might be long-term to a lot of people, but, you know, intrinsic investors are thinking, say, 10-plus years out. What do you think the key reason is? I think the key reasons are, one is listening to the wrong investors, right? They listen a lot to the

Starting point is 00:31:17 cell side analysts whose clients are short-term hedge funds usually. If you listen to the typical quarterly call, it's mostly fairly narrow short-term questions, right? But those questions are all being asked by sell-side analysts. They're not being asked by long-term investors. When they talk to long-term investors, they hear different things, but they're sort of struggling to balance these two, right? That's one thing. Another thing that is that the boards of directors oftentimes aren't close enough to the businesses to judge whether or not the recurrent results are a function of poor performance or we made some investments, right? And I think there's an opportunity for boards to get more granular to do a better job of understanding, because the board's,

Starting point is 00:32:06 set the incentives. And we've also come out with a system partly encouraged by the SEC, where the SEC wants more quantitative sort of evaluations of executives, which by nature are short term, right? So a big chunk of compensation while, you know, you think of it as being in stock options, which are longer term, the reality is the amount of options you get. The bonuses are tend to be much more short-term oriented. So there's a lot of fresh, from the board, a lot of pressure from your compensation system, et cetera, for short-term results. I often think that boards actually don't spend enough time really of doing a good job evaluating the performance of the CEO because they tend to rely on sort of short-term numbers,

Starting point is 00:32:54 as opposed to really understanding what investments did they make? How are they paying off? Are they doing a good job of allocating resources? Did they move resources away from older business, to growing businesses and how long is that going to take and rewarding people for more qualitative actions to improve the performance of the business longer term, that doesn't happen very much. And so I think a lot of it is on the board, a lot of it is on the CEOs themselves, though, to listen to the right investors and to have the courage,

Starting point is 00:33:27 like a Warren Buffett, to just ignore the conventional wisdom, right, and do what's right for the longer term. So as we outlined, a company creates value when it earns a return on invested capital that's greater than its cost of capital. How about we talk about the cost of capital side? How do you go about determining the cost of capital for a company? And how does that potentially differ between companies? Yeah, well, the first thing we do is we tell companies that you can't really do much about your cost of capital, right? Your cost of capital is, for the most part, determined by the industry

Starting point is 00:34:04 that you're in. And it is what it is. And don't waste too much time worrying about that. And for most companies, large companies, you know, your cost of capital is somewhere between seven and a half and nine and a half percent. And yet your return on capital varies over a much broader range. So don't get hung up on getting it to the nearest decimal point or changing it a lot, right? I think that's the main thing we want to point out to investors, to companies, for example. In terms of how to calculate the cost of capital, we do use the capital asset pricing model, but what really matters is what's the average or the median cost of capital for a big company, the sum of the risk-free rate and the market risk premium, right?

Starting point is 00:34:50 That's where there's been more debate over the last 15 years or so. And what we observed was that when interest rate, went down, when central banks pushed interest rates down artificially since the financial crisis until recently, equity investors did not reduce the cost of capital. You didn't see PE ratios going up, but you would have seen if the cost of capital had gone down substantially. And also, we and investment banks that we've seen, you know, their analyses, couldn't come up with reasonable valuations using very low costs of equity that you might be. might have, you know, if you had sort of done a knee-jerk reaction and just reduced your cost of

Starting point is 00:35:33 equity as interest rates went down. So basically what our research suggests, and I think a lot of economists would agree that the government bond rate no longer really reflected the risk-free rate, because it wasn't market determined. It was artificially driven down by the central banks. And so our approach has been to look at what the long-term return on government bonds has in real return, and that's two or two and a half percent, add inflation. So we've typically been using a risk-free rate of four, four and a half percent, which is pretty stable. And a market risk premium of about five percent. So we end up with nine, nine and a half percent cost of equity for the typical company. And we've also validated that by reverse engineering,

Starting point is 00:36:21 if you will, the market. So what we do is we look at, take the market as a whole or the median company in the market. We've got to throw out some of the outliers from time to time, right, like the mega seven. We take the way companies are valued and then we create a little economy and say, okay, what is the typical return on equity? What's the typical growth rate of profits? That translates into cash flows. We can then solve for the cost of equity. And we do that, and we've done this consistently for the last 25 years, we find that the real cost of equity, when we reverse engineer share prices, has been about 7%,

Starting point is 00:37:01 pretty very consistently going back 60, or going back to the 1960s. And so if then if you add a 2% inflation or so to that, you end up with a nominal cost of capital and the cost of equity of about 9, 9, 9.5%, which is what we were just talking about. So different ways we get to the same number. So the fact is, for the most part,

Starting point is 00:37:22 most companies, the cost of equity is somewhere in the 9, 9.9% range, maybe a little bit lower, maybe a little bit higher, not that much. And the capital structure will affect that a little bit. Most companies have fairly conservative capital structure, so that's not going to have much of an effect. We do not advocate levering up a company in order to reduce the cost of capital. The benefits of levering up are far outweighed by the additional risks that you take

Starting point is 00:37:48 and the fact that you may not have the ability to make investments when you want to. So that's why also we de-emphasize, if you will, trying to do. anything about the cost of capital because there's not that much you can do about it. Let's take a quick break and hear from today's sponsors. No, it's not your imagination. Risk and regulation are ramping up, and customers now expect proof of security just to do business. That's why VANTA is a game changer. Vantza automates your compliance process and brings compliance, risk, and customer trust together on one AI-powered platform. So whether you're prepping for a SOC or running an enterprise GRC program,

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Starting point is 00:40:50 in the Fundrise Income Fund in just minutes. The fund's total return in 2025 was 8%, and the average annual total return since inception is 7.8%. Past performance does not guarantee future results, current distribution rate as of 1231, 2025. Carefully consider the investment material before investing, including objectives, risks, charges, and expenses. This and other information can be found in the income fund fund fund's prospectus at fundrise.com slash income. This is a paid advertising. All right, back to the show. So when you look at a number of industries, they seem to be plagued by low returns on invested capital. We talked about the auto industry, for example, and I just looked up Ford, you know, and this is not to pick on Ford, just one of many examples of a company with low return on invested capital.

Starting point is 00:41:41 The numbers I'm seeing is return on invested capital and a return on assets of around 2% for this company. does that imply that if they wanted to create value for shareholders, they shouldn't be reinvesting all that much into their business if they're not going to generate a high return on that capital. And any cash flow as they generate should just be returned back to shareholders through dividends or buybacks. Yeah, the audio industry is a tricky one for right now because you've got this transition going on, right?

Starting point is 00:42:12 So sometimes it's hard to interpret or to draw concordial. conclusions from the current return on capital, right? But there are industries which are where the return on capital, even in normal times that the auto industry has a relatively modest return on capital. And you have seen as a result shrinkage of the market shares of, say, U.S.-based companies over time. First, we had the Japanese coming in with lower cost cars, initially lower quality, but their quality quickly caught up. Then we had the Koreans come up coming in and creating competition. So if you're in that kind of a situation, you do have to rethink and decide whether or not you should be returning cash to the shareholders. So in

Starting point is 00:43:02 industries where that is the case, that is the right thing to do is to return cash to the shareholders rather than investing it. However, it's also worth pointing out that sometimes if the measured return on capital is low, right? And you have a lot of assets that you can't do anything else with. It doesn't mean you should go out of business right away. It just means you should be very cautious about putting new capital into the business. Sometimes people use the word, you should milk the business kind of thing. That's good for some businesses that are going to go away kind of thing. But really, the more important thing is just being very cautious and selective about where you put new capital when you have a low return on capital.

Starting point is 00:43:47 We just recently did an episode on an OTA business, booking holdings, and I was looking at booking, Expedia, and Airbnb. And it's amazing to see the contrast between companies with different growth profiles and different return on capital within the same industry. I found that bookings return on capital was substantially higher than Expedia's. And yet, even with a fairly similar gross booking value within the company, Booking's market capitalization is over seven times larger than Expedia's. And I was just amazed to see just a stark differences. I was curious if you could talk about how return on invested capital plays into how the market determines the value of a company.

Starting point is 00:44:33 So if you have a higher return on capital, the way the math works is that at any level of growth, more of your profits will become cash flows that you can distribute to your shareholders, right? So if you have two fast-growing companies and both of them, let's say they're growing at the same rate, but one of them has a higher return on capital, it won't have to invest as much in order to achieve that revenue growth and that profit growth. And as a result, it'll generate more cash flows and it should be worth a lot more. And that is why you see for example, some slow growing companies like consumer package goods companies that you have fairly high valuations if you look at sort of enterprise value to EBITAs or PEs or whatever,

Starting point is 00:45:22 not because they're growing fast, but because they have high returns on capital. And I think there's a big misconception that a company's valuation multiple PE or enterprise value to EBITA is a function of growth, right? It's clearly a function of both of growth and return on capital. And you can see it in the banking world, for example. Most of the companies are growing relatively modestly, and the differences in valuation all come down to differences in return on capital because it affects their cash flows. So whenever we look at company,

Starting point is 00:45:54 and we look at hundreds of companies a year, and look at them relative to their peers, growth, not just growth, but return on capital is a major effect on the way they are valued by investors. and it makes sense because of the math that return on capital determines how much of your profits gets turned into cash flow. So in your book, you highlighted the difference in the returns between the U.S. and Europe over the past 10 to 15 years.

Starting point is 00:46:21 So from 2013 to 2024, U.S. stocks have returned over 10%, while European stocks have returned less than 4%. And you attributed the difference in returns to return on invested capital. improving profit margins in the U.S., higher growth rates in the U.S. being home to industry leaders and technology and life sciences. And many investors use this notion of the reversion to the mean, right? Banking on the idea that high returns in the U.S. will eventually revert to lower levels and low returns will, in places like, say, Europe, will eventually rise. Given that the U.S. seems to fundamentally have many better businesses with higher returns on invested capital,

Starting point is 00:47:04 I'd be curious to get your thoughts on how you would see the future returns for the U.S. and Europe over, say, the next 10 years. Yeah, I used to be, you know, when I was young and out of school, I used to be a strong believer in reversion to the mean. Competition would sort of cause that to happen. And I've discovered that it doesn't always happen. Just that's why consumer package goods with great brand names consistently earn high returns on capital. it's very difficult to break into or to convince people to buy a different laundry detergent than they've been buying, right? So the companies can charge a lot of a very high premium, very high return on capital. So reversion to the mean doesn't necessarily happen, whether we're talking U.S. versus Europe or within the U.S., etc.

Starting point is 00:47:50 In terms of the U.S. versus Europe, though, one is, first of all, a large part of it is just a different industry mix, right? as you pointed out. We have all the leading technology companies and a ton of smaller technology companies. We have a lot of life science. The U.S. is still the leader in innovation. And one of my co-authors is based in Amsterdam. And I spent time in Europe as well, five years. And there isn't sort of that entrepreneurial ecosystem that generates entrepreneurship, that generates the kind of new companies, new growth that we have in the U.S. So that's one of the things I don't see changing. I know European companies, countries have talked for years about how do we do this.

Starting point is 00:48:47 You know, they set up incubators. They set up all kinds of things to encourage innovation. it hasn't made that much of a dent yet in terms of new companies, new industries, being really the leaders in big chunks of the economy. So that I don't see changing in the near future. In addition to that, there is just a little bit of a different mindset there that hasn't changed, that doesn't put as much emphasis on earning a high return on capital. And as a result of that, I don't see sort of a a reversion to the mean where the U.S. and Europe equalize anywhere in the next 10 or 15 years. Maybe it happens after that.

Starting point is 00:49:29 But it's a big opportunity, lots of people in Europe trying to figure out how to make it happen. That said, there are companies in Europe that are leaders in their fields that have higher returns on capital. You know, we're talking about averages or medians here, right? If you look at a particular industry, you will find that oftentimes, even if the median return of a European company is lower, you'll find that the better European companies are much better than the median U.S. company in a particular industry. So we don't want to overstate and sort of make it seem like every European company faces this issue, right? It's just the averages are brought down. But if you look at a distribution of returns, you'll find that there is a big overlap. It's just that the U.S. one is shifted over, okay, compared to the European one.

Starting point is 00:50:27 So it's not an indictment, if you will, of all European companies, right? It's just that the laggards bring down the averages. So in a way, I would say that Europe has a lot more laggards than the U.S. Yeah, that definitely makes sense. And yeah, I've also seen that, you know, even if a certain economy isn't a great overall market to invest in, there's certainly great businesses underneath the surface if you look hard enough. And managers are always facing an uncertain future.

Starting point is 00:50:57 And after the recent tariff announcements by the Trump administration, the prediction markets are pricing in a 60% chance of a recession. Should poor consumer sentiment or higher macro uncertainty impact how we think about valuation regarding different periods of economic uncertainty. And certainty does make valuation much more difficult, which is why I think, you know, you have to sort of focus on the longer term, right? What are the long term fundamentals likely to be for a company or for an industry? Because what's happening today, we just don't know.

Starting point is 00:51:37 And so, for example, I was talking to a grocery retailer in the, It takes them two or three years to build a new store. Typical recession doesn't last that long. You know, so if you say, how long is this uncertainty going to last? You might say, okay, the typical investment cycle is longer than the uncertainty, so I shouldn't, I should still want companies to invest, right? And also, I think one of the things that you want as an investor to be looking at is, is the company freezing because they, uh, the uncertainty or are they being very thoughtful and about how that uncertainty affects their specific business? Every business is affected differently by different types of macro uncertainty.

Starting point is 00:52:28 And not all parts of their business are the same. Like if you take the grocery retailing where I live in Colorado, there are neighborhoods that are springing up all over the place, tremendous amount of growth, they need grocery stores, regardless of what's happening to the economy. So there are still investment opportunities here for grocery stores. So you really have to think about that uncertainty at, you know, how it affects a specific company and whether it's going to affect the long-term economics of the business. That said, in terms of today's valuations, it's really hard to say what there are probably opportunities out there for companies where the market has

Starting point is 00:53:05 gotten too conservative, and there are probably places to avoid because the market hasn't taken enough into consideration. But that's what you want to thinking about is sort of what's the company going to look like five years down the road. And your book also discusses valuation multiples and how those can be impacted based on different types of businesses you're looking at. There's all sorts of multiples. Investors can analyze. You have PE, EV to EBIT, EV to EBIT. perhaps you could discuss the merits of some of these measures and which you find to be most useful for you when looking at companies. So we tend to focus on enterprise value divided by no-pat, net operating profits after taxes.

Starting point is 00:53:53 Let me start with the traditional PE ratio. The traditional PE ratio is just so many things going on, so many non-operating items in there, one-time items, other things like that. We don't see too many sophisticated investors or bankers using the simple PE ratios. And when you talk to, like, some of the analysts who publish, they say they published and talk about PE ratios because they think their audience can't understand something more sophisticated than that, okay? Which I think is underestimating the audience, right? But for the most part, when you look at M&A transactions and when, when you're Companies are trying to understand their share price and they hire a banker or us to try to

Starting point is 00:54:37 understand the share price. We're usually using an enterprise multiple. And then the question is, what's the right denominator? Most people now have focused on enterprise value divided by EBITDA, earnings before interest, depreciation, taxes, and amortization. The reason for that, it's a pretty clean measure, right? EBITDA is sort of almost akin to cash flow. The reason that we want to take it a little bit further, though, is that we don't ignore

Starting point is 00:55:12 the depreciation part. We don't want to add back the depreciation. The reason for that is that when you're comparing two companies, they may have different asset profiles. Let's say you have two companies. One company outsources its manufacturing and the other does it in-house. So the company that does the manufacturing in-house is going to have a lot of depreciation on its books.

Starting point is 00:55:34 A company that outsources, the depreciation doesn't show up as depreciation. It shows up as purchases, right? And yet, they're really using the same amount of equipment and factories. It's just, it's under someone else's name. So if you ignore depreciation, when there are companies that have different, let's say, asset intensities by choice, you'll, you'll miss some reasons for that. And then the other thing that we do is we want to take into consideration taxes because if you have companies, let's say, in different countries or with different mix of country businesses, that may have different tax rates. So that's why we go down to enterprise value over NOPAT as the preferred measure because it takes into consideration differences in taxes and differences in depreciation profiles.

Starting point is 00:56:27 That said, if we look at a set of companies and they all have the same. same asset profile and they all are operating in the same geography and have roughly the same tax profile, then we'll use enterprise value over EBITA just for simplicity, right? So it's only when there are differences that cause distortions that we would use these other measures typically. Wonderful. Tim, I really appreciate you joining me here. Really enjoy checking out your book and recommend the listeners check it out as well. For those in the audience that would like to learn more about you in the book, please let them know where you can appoint him so. You can go to mackenzie.com and click on valuation and you'll see more about the book

Starting point is 00:57:11 and you can see more about our strategy and corporate finance practice. And then my email is Tim underscore coller at mackenzie.com. And the book is officially available on May 20th, according to the publisher. And that's when Amazon says that they'll have it. But it is available for pre-order. But if you want to learn about the practice, go to McKinsey, look for valuation or look for strategy in corporate finance, and you'll find plenty of information there. We write a lot of articles on various topics who can see them all there. There's also publication called McKinsey on Finance, which is also there, which comes out quarterly and has a lot of articles that would be relevant to investors and others. Great. Well, thank you

Starting point is 00:57:55 so much, Tim. Thank you, Clay. All right, everybody, thank you for tuning in to today's episode with Tim Kohler. I wanted to take a minute to share some details on a new event that TIP will be hosting from September 24th through the 28th, 2025 in Big Sky, Montana. The event is called The Investors Podcast Summit. We'll be gathering around 25 listeners of the show to bring together like-minded people and enjoy great company with a beautiful mountain view. We're looking to attract thoughtful listeners of the show who are passionate about value investing and are interested in building meaningful connections and relationships with like-minded people. Many of our attendees will likely be entrepreneurs, private investors, or portfolio managers.

Starting point is 00:58:38 I'm thrilled to be hosting this special event for our listeners and can't wait to hopefully see you there. On our website, we have the pricing, frequently asked questions, and the link to apply to join us. So if this sounds interesting to you, you can check it out at theinvestorspodcast.com slash summit. That's theinvestorspodcast.com slash summit. We only have room for around 25 members of the audience, so be sure to apply soon if you'd like to join us. With that, thank you for your time and attention today, and I hope you enjoy today's conversation.

Starting point is 00:59:10 Thank you for listening to TIP. Make sure to follow We Study Billionaires on your favorite podcast app and never miss out on episodes. To access our show notes, transcripts or courses, go to theinvestorspodcast.com. This show is for entertainment purposes only, before making an individual. decision consultant professional. This show is copyrighted by the Investors Podcast Network. Written permission must be granted before syndication or rebroadcasting.

We Study Billionaires - The Investor’s Podcast Network - TIP725: First Principles of Valuation w/ Tim Koller

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