An enterprise’s Intrinsic Value is equal to what its free cash flows, appropriately discounted, are really going to be.

This might sound basic. If you know the future cash flows and apply an appropriate discount rate, you will know Intrinsic Value.

The overwhelming criteria for making business decisions is (or at least should be) the quest to maximize Intrinsic Value. That is, the singular focus when evaluating a decision should be the cash flows that will really result from the range of choices available.

A mistake often made by businesses is overweighing the need to beat their budget for revenue, EBITDA, or capital. No doubt that missing a budget will have immediate and typically negative ramifications. What if, though, management has opportunity to satisfy budget expectations by making decisions that are sub-optimal to Intrinsic Value?

This choice occurs frequently. Though unspoken, the temptation to overlook Intrinsic Value optimization in favor of achieving budget goals is high. It can be rationalized as well. “We always make our numbers.” A true commitment to Intrinsic Value means that maximizing Intrinsic Value will trump making budget.

Generally speaking, the pace of revenue and EBITDA growth positively influences the value of an enterprise. Growth can be accelerated through decisions that are suboptimal to maximizing Intrinsic Value. Same question as earlier: What if management has opportunity to show higher growth through decisions that are sub-optimal to Intrinsic Value? Will they resist the temptation?

Management rarely approves a business plan that shows a poor IRR or lousy NPV. Does this mean all approved business plans maximize Intrinsic Value? Let’s focus on the words “what free cash flows are really going to be”. The question shifts to whether the business plan is an accurate portrayal of future cash flows. Often, too little scrutiny is placed on the accuracy of the cash flow prediction. A good faith attempt to accurately forecast isn’t sufficient. At the end of the day, Intrinsic Value will reflect the real cash flows, not  the business plan forecast. Competency, in the area of business plan analyses, is tied to the degree of accuracy of cash flow predictions. To what degree does a management team focus on knowing and improving the accuracy of their predictions?

Most industries have rules of thumb for approximating the enterprise values. Telecom often uses EBITDA Multiple. Revenue multiple is used in earlier stage growth industries, and EBIT Multiple is used in more mature industries. Management teams must realize that none of these is an acceptable proxy for Intrinsic Value. Management must maintain its focus on Intrinsic Value, and use its ever-improving understanding of Intrinsic Value to guide thinking around rule of thumb multiples of a simple accounting metric.

Intrinsic Value is a simple concept. It is true worth of an enterprise, and will be revealed as the true free cash flows play out. A management team’s commitment to using maximization of Intrinsic Value as the overwhelming compass for decision-making is paramount. This commitment cannot be compromised even when confronted by conflicting goals such as achieving budgets, growing revenue, or funding interesting projects.

Enterprise Value = Equity Value + Net Indebtedness

Equity Value = Shares Outstanding * Price Per Share

Net Indebtedness = Debt Outstanding less Cash Balance

For a public company, Enterprise Value is tabulated every day.  Enterprise Value can be viewed as the stock market’s then-current estimate of Intrinsic Value.  It represents the consensus opinion of all those who bought and sold the stock a particular day as to what the enterprise’s Intrinsic Value.

Recall, though, that Intrinsic Value is defined not as an estimate of an enterprises’ value.    Instead, Intrinsic Value is the true value of the business, and will reveal itself as the true cash flows over time become known.

The delta between Intrinsic Value and Enterprise Value can be viewed as the inaccuracy of the stock market’s consensus estimate on a particular day.   A long-term investor, such as Warren Buffett, does well if he or she can deduce when a wide delta exists between Intrinsic Value and Enterprise Value.  The wider the delta, the more lucrative it is to either buy or sell.

A management team performs best when they have better knowledge of Intrinsic Value than the stock market.  To understand why, let’s consider the alternatives.

1. One alternative is the management team’s best estimate of Intrinsic Value is the stock market’s daily estimate.  We all know the stock market is fickle and their best guess is subject to wild swings.  If the management team’s understanding is linked to the market’s daily consensus, management’s decision-making criteria will also be volatile.
2. The second alternative is the management team’s best estimate is inferior to the stock market.   Perhaps this creates more stable decision-making environment.  However, the basis for decisions is concerning, as it is predicated on management having a lessor understanding of the cash flows that will result from their decisions than the collective view of the stock market.  It is hard to see how anything good can come from this.
3. The third alternative is that management team must rely on an averaging of the stock market’s view over multiple weeks or months.  This normalizes for daily volatility, and hence is better than #1.  And it is certainly better than #2.  Nonetheless, this third alternative doesn’t compare well to a management team that has a superior (relative to the stock market’s) understanding of future cash flows.

Is it a realistic expectation that a management team have a better understanding than the stock market?  The short answer is “absolutely yes”.   I qualify this with a word of caution.  Nearly all management teams believe they have this ability; yet it is unclear how many really do.

Moneyball is an extremely well-written book focused on a young general manager of the Oakland A’s by the name of Billy Beane. In the early 2000s, the small market Oakland A’s achieved surprising success. They did it despite having a payroll that was among the lowest in the league, and a fraction of big market teams such as the New York Yankees and the Boston Red Sox. How did Beane do it? Perhaps this will be a topic of a future post but first I want to discuss Blind Side, which was also authored by Lewis. You might think of Blind Side as the sequel to Moneyball.

Blind Side centered on a kid by the name of Michael Oher. An extraordinarily large kid, Michael was built to be a football player. He had a lot more than size. His speed and strength were off the charts. Making a long story short, Michael had an impoverish upbringing and struggled with grades and discipline in his early teens. He quit football after his freshman year at a Memphis public school, but was discovered by a high school coach and recruited into Briarcrest Christian School. He went to University of Mississippi and became a first round pick in the 2009 NFL draft. His rookie contract for the Baltimore Ravens resulted in him making $13M over a five year contract.

Oher’s story is only a backdrop for Blind Slide. The book was about more about the position that Oher plays—Left Tackle. The offensive line in football had traditionally been the least celebrated positions in the NFL. Offensive linemen don’t throw or catch the ball. They don’t sack the quarterback; nor do they make interceptions. They don’t win games in the last second with a 50-yard field goal. They are big and bulky—and often have a thick layer of fat covering their sizable muscles. Offensive line is the least glorious position in the glorious game of football.

Given all of this, you’d expect that offensive linemen were paid far less than their glorious teammates. Prior to the 2000s, this assumption would have proven accurate. But, in the mid 2000s, the relative compensation of an offensive lineman had changed in an unexpected way. The salaries for one of the offensive lineman positions—the Left Tackle—began to skyrocket. In Blind Side, Michael Lewis explains how the Left Tackle became the 2nd highest paid position in the NFL. Only quarterbacks were paid more. How could this be? And what lessons can we take away and apply to our business?

Quarterbacks are paid a lot of money for a good reason. Quarterbacks are the key to a football team. Franchise players like Tom Brady, Peyton and Eli Manning, Ben Roethlisberger, and Drew Brees win games, fill seats and sell jerseys.

What is the second most important position? Is it running back? Wide receiver? Kicker? Middle linebacker? Defensive end? The answer to all of these is NO.  Surprisingly, the 2nd most important position is the Left Tackle. You know, the big and bulky linemen whose names are called only when a holding penalty is called. And you only notice him when he missed a block and the lucky linebacker delivers a crushing blow to the quarterback.

How do we know the Left Tackle is so valuable? According to Michael Lewis’ book Blind Side, Left Tackles, on average, get paid more than every position other than quarterback. They get paid millions despite being largely invisible to football fans. Owners pay them the big bucks despite gaining no “ego-stroking” value as a side benefit. That is, the owner is far more likely to invite the middle linebacker to the weekend barbecue than the Left Tackle. If the owner is courting a trophy wife, he will introduce her to the wide receiver instead of the Left Tackle.

Why is the Left Tackle so valuable? The answer is quite simple. Quarterbacks are the most valuable and it is devastating when the quarterback gets hurt.  Quarterbacks are most vulnerable to getting hit on their blind side, particularly if the hit was delivered by Lawrence Taylor in his prime.  Since the vast majority of quarterbacks are right handed, the blind side is to their left. As a quarterback goes to throw, he turns his body so that his back is to the left side of the field. If the 350 lb defensive lineman coming from the left gets around his blocker, the lineman comes crashing into the quarterback. Often, the QB just doesn’t see this coming because he has his back to this charging lineman. Hence, “blind side” was coined.

The Left Tackle’s job is to protect the quarterback’s blind side. A great Left Tackle is much more likely to be successful than an average one. Success helps ensure the franchise quarterback stays healthy throughout the season and playoffs. Failure could mean the QB is out for the year, leaving the team to fall apart. That is why the Left Tackle is the second highest paid position in football. Their job is to protect the highest paid position.

No matter how big of a football fan/expert you are, you’d never figure this out by watching a game. Even those who were the biggest experts—coaches and general managers—were slow to figure it out. In Blind Side, Michael Lewis shows that not until the 2000s did the salaries of Left Tackles skyrocket, reflecting new insight into the importance of their role.

A valuable business lesson can be gleaned from this story. Over time, certain NFL coaches discovered the importance of the Left Tackle position. And they quantified its importance. That is, they quantified the relative value of a great Left Tackle relative to an average Left Tackle. And they used this intelligence advantage to sign the best Left Tackles at salaries well below their value.

Certain coaches discovered this intelligence despite the fact that it was not obvious. In fact, conventional wisdom would have steered them elsewhere. Conventional wisdom was that running backs or receivers were more valuable. Conventional wisdom was that the lean and muscular defensive lineman was far more valuable than the big and bulky offensive lineman.

Conventional wisdom was challenged. Perhaps the ideas originated during coaches’ brainstorming sessions over pizza and beers. Perhaps the ideas were a result of highly analytical college grads looking to discover a new angle. Either way, the key was the pursuit of new ideas that create a competitive edge. What might we do different that might give us an advantage over our rivals?

A second key is perhaps more important. Analytics. Fact based financial analysis. The conviction to act on the idea—and to know how to act—comes from quantifying the “value”. That is, a team must carefully compute the relative value of a great Left Tackle relative to a mediocre one. And, even more difficult, the calculation needs to compare the value of a great wide receiver relative to an average one. Are we better off spending $10M on a great Left Tackle, leaving us only $5M for a middle-of-the-road receiver? Or would we create more value by spending $3M on a mediocre Left Tackle, which would leave us $12M to get a prime-time wide-out?

Developing conviction in the answers requires a strong commitment to data gathering and quantitative analysis. Your average football coach circa 1995 was unlikely to be receptive to such an approach. They were more likely to rely on the gut instincts of a 30-year lifer, who almost certainly never used excel and thought NPV was the Swedish expression “No Puck’en Vay”.

How does this apply to what you do? Are you committed to data gathering? Do you challenge conventional wisdom? Do you rely on quantitative analysis to help discover where value can truly be created for the enterprise? Or are you more like a football coach circa 1995, relying on the time-tested instincts on how to get the job done. If so, you should be worried about who is protecting your Blind Side.

Adam Foote played for the team from 1995 through 2004, and was a key defender on the team when they twice won the Stanley Cup.  Seeing Adam back in a Colorado uniform brought back a fond memory.

Years ago, Adam made a lasting impression on my son Danny. Though Danny met Adam only briefly, I suspect that Adam made a meaningful contribution to Danny’s character. Oh, by the way, Danny is a darn good hockey player and Adam Foote remains his all-time favorite player.

The 51st National League All-Star Game took place on February 4, 2001 at the Pepsi Center in Colorado. The skills competition took place the day before. I brought my son and we had a great time. Anaheim Mighty Ducks’ Paul Kariya won his third straight puck control relay event and Boston Bruins’ Ray Bourgue came in first in the shooting accuracy competition.  My friend Marty and his son Christopher joined us at the event. Though Colorado’s #52 wasn’t in the game, my then 6-year-old son wore his Adam Foote jersey.

Afterwards, we went to the Denver Chop House for dinner. About an hour later, a buzz went through the place that several sports players were hanging out in the bar area. Larry Walker was among them. So was Adam Foote.

I am not the type of guy to bother people in the public eye. However, my buddy Marty is. So Marty took Danny up to Adam Foote to see about getting an autograph.   As my son walked up, Adam smiled ear-to-ear. Adam was already an NHL veteran and was very popular in Colorado. Nonetheless, you would have thought it was the first time he noticed anyone other than himself wearing an Adam Foote jersey.

“You’ve got my jersey on. How cool. I have to bring you to my wife.” He brought Danny over to his wife and they talked for a short while. He then signed Danny’s jersey–and we cherish it to this day.

What happened next was what made the day so memorable.  An hour or so passed and it was time to go. The restaurant was crowded, especially around the bar where the athletes were hanging out. Marty, his son, Danny and I were leaving. As we walked out of the main door, I turned around. No Danny. Marty, Christopher and I looked at each other and, perhaps overreacting a bit, I rushed back in. I looked around frantically and then spotted him in the very crowded bar area.

Again, he was only six years old, so he was hard for anyone to notice him.

I caught him just as he pushed against Larry Walker’s leg, nudging the Colorado Rockies all star out of his way. He stood in the circle of Walker and 3 or 4 others, including Colorado’s #52. He looked up at Foote and waved goodbye. Though I couldn’t hear Foote, he let out a good belly laugh as he caught Danny moving Walker aside. He picked up Danny and wished him well.

Danny, now 16, is a solid defenseman in competitive hockey.  He is always the one that goes out of the way to tap the shin guard of his goalie, just like he saw Adam Foote do oh so many times.  Thank you Adam Foote. You made a difference in two peoples’ lives that day.

2. Be clear, open and honest in communications with investors.

a) Whether the news is good, neutral, or bad, management is responsible for making it easy for investors to understand what is happening in the business.

b) Financial performance should be tracked and reported in a clear and unbiased way.

c) Management should understand and clearly articulate the risk profile inherent in the businesses decisions being made.

Yesterday, we covered how the Meatloaf song “Two out of Three Ain’t Bad” doesn’t apply to Principle #2. An executive must be Clear, Open AND Honest. Two out of Three Ain’t Good Enough.

Today, let’s discuss 2a.

Warren Buffet writes “Elsewhere, triumphs are trumpeted, but dumb decisions either get no follow-up or are rationalized.” The Omaha Oracle points out the unhealthy bias that exists in many companies—emphasize the positive news; sidestep the negative.

As members of Zayo’s team know, following 2a is hard when it counts the most. Especially when the bad news is the result of management missteps. Twice in Zayo’s brief history we had painful events that fit in this category. Both required that I disclose information to our board that, frankly, I would have rather not have shared. I labored over the communication, reminding myself of my responsibility. I suspected the board would appreciate the clear, open and honest part—but, let’s face it, the content of the messages was that the management team screwed up. Just because the board might appreciate the clear, open and honest messaging, the fact that we screwed up wasn’t going to be overlooked. If, as a result, the investors want to make changes, you’ve made it very easy for them to justify.

Let’s pause for a second and re-read 2a. “Whether the news is good, neutral, or bad…” Note that it is balance that is being emphasized. Only harping on the bad news is not much better than only emphasizing the positive. Balanced communication is the key. Management should make it easy for investors to understand what is happening in the business. Investors should feel like they will get the skinny whether it is positive, negative, or just plain neutral. Develop this capability and your investors will forever be grateful.

2.   Be clear, open and honest in communications with investors.

Clear.

Open.

Honest.

Remember the Meatloaf song from the 1980s: “Two out of Three Ain’t Bad.”     Well, when it comes to my Management Ethics Principle #2, Two out of Three Ain’t Good Enough.

Being Clear and Open, but not Honest is obviously a major problem.

So is it a problem to be Clear and Honest, but not Open. This implies a lot of important parts of the story might be skipped over. It is very easy to be Honest and Clear if much of the most relevant information is simply not addressed. You can’t be held accountable for something you didn’t disclose. In the post Sarbanes-Oxley era, many public companies simply keep to a minimum the information they share with investors. In private companies, this is often the case as well. If investors ask for information, the management team will provide. Other information—including maybe the answers to questions the investors should have asked—is kept close to the vest. This puts a huge burden on investors to figure out what information needs to be extracted from the company.

What about Open and Honest, but not Clear? This often manifests itself when an executive uses complexity to make it hard for the audience to follow what is going on. Investors get frustrated, as it is hard for them to get their heads around what they are being told. The executive goes through the charade of that he or she is trying to be helpful, but complexity is a tool to keep investors in the dark about what is really going on. Time is usually an ally of this type of executive—as he or she knows time is a constraint of most investors. Those executives who are good at this strategy—where “good” equals “most dangerous”—leave their investors thinking how lucky they are to have an executive who understands such a complex business. At times, the result is that investors believe they are highly dependent on the executive. Perhaps they even believe that part of the company’s competitive advantages is that their executive is one of the only people who truly understands the business.

Don’t get me wrong—telecom is an extremely complex business—more so thaN most businesses. Though difficult, it is management’s job to find ways to communicate to their investors so that they can understand the business.  As a side note, I read books on theoretical physics–if an author can explain quantum teleportation in a way I can understand, a telecom executive can explain their business to an investor.

There you have it. Two out of Three Ain’t Good Enough. By the way, there have been a few storied situations—such as Enron and Worldcom—where honesty was at the core of the problem. However, it is the other two combinations that I suspect are more common and, perhaps, harder to detect.

For context, the first principle is:

1. Treat shareholders as long term business partners; and view management as managing partners.

a. An enterprise must be managed with the perspective that investors (not management) own the assets contained within the company.

b. It is management’s responsibility to ensure all executive compensation and perks are clearly understood and approved by its investors.

The second principle is:

2. Be clear, open and honest in communications with investors.

a)  Whether the news is good, neutral, or bad, management is responsible for making it easy for investors to understand what is happening in the business.

b) Financial performance should be tracked and reported in a clear and unbiased way.

c) Management should understand and clearly articulate the risk profile inherent in the businesses decisions being made.

The events of the past two years are scary illustrations of how the principle is often pushed aside by management teams.

As I’ve mentioned often, Warren Buffet is my inspiration for both the content of the principles and for taking the time of sharing them with whomever cares to pay attention. He shares his wisdom via the Berkshire Hathaway annual reports and, specifically, via his Owner’s Manual.  The Omaha Oracle has been publishing this Owner’s Manual for many years. Read it. Print it out. Book mark it. I have found that reviewing it many times has helped my thinking about business get to a higher level.

Tomorrow I will begin to dissect Principle #2.

1. Treat shareholders as long term business partners; and view management as managing partners.

a. An enterprise must be managed with the perspective that investors (not management) own the assets contained within the company.

b. It is management’s responsibility to ensure all executive compensation and perks are clearly understood and approved by its investors.

Yesterday, I listed several ways that executives could game the system. I opined that the vast majority of recent executive pay debacles involved one or more of the outlined situations. I want to close the discussion of the Management Ethics #1 series by making three points.

First, let’s return to the Mike Hampton series. Like professional athletes, executives should get paid all they are entitled to. It is not government’s business to restrict this, any more than it is government’s charter to not allow Tiger Woods to have made $1B dollars so far in his career. Moreover, it is not the government’s business to “help” investors do a better job of managing executive pay. That is, the market needs to sort out how to do a better job of determining executive pay packages so as to not repeat the recent debacles. [This statement isn’t true in the extreme—as the government must play certain roles—but it should be a guiding principle. I don’t want to expound on this now but perhaps will later.]

Second, I am a director of three companies and am a member of certain compensation committees. Like the other directors, I am limited in the amount of time I can spend in these duties. As such, I know first-hand that there is a strong dependency on management when it comes to structuring and understanding executive compensation packages. The director’s role is not easy to perform. Hiring objective and qualified experts is often prohibitively expensive. Thus, the dependency on conflicted executives remains a very-real aspect of the executive compensation process.

Third is the answer to logical questions. Why does my Management Ethics principle #1 include both 1a and 1b? Why not make them two separate principles, as they both are extremely important? It is because they are so inter-related. A management team is more likely to satisfy their responsibilities under 1 b if it fully embraces that (a) their shareholders as long term business partners and (b) the enterprise must be managed with the perspective that investors (not management) own the assets contained within the company.

By the way, the extreme importance of executive compensation—and the inherent conflicts of interest—are why it is covered as part of the FIRST management ethics principle.

Zayo and Envysion employees: I’d like all of our folks to read this bearonbusiness series. Please encourage your co-workers to follow these posts.

1. Treat shareholders as long term business partners; and view management as managing partners.

a. An enterprise must be managed with the perspective that investors (not management) own the assets contained within the company.

b. It is management’s responsibility to ensure all executive compensation and perks are clearly understood and approved by its investors.

It is management’s responsibility to ensure executive compensation and perks:

• are clearly understood

• are approved by its investors

Both aspects to this must be satisfied. Unlike a professional athlete, a CEO/executive team has more of an opportunity to game the compensation dynamic. The fact that this opportunity exists does not entitle managers to exploit it.

How does management game the system? Here is how:

• Allowing employment contract language to be unnecessarily complex, thereby making it difficult for investor representatives (e.g., compensation committee) to evaluate

• Providing summaries that, although perhaps accurate, are incomplete or misleading

• Providing supporting analysis that fails to identify relevant scenarios—like when an executive makes millions while the company is crumbling

• Failing to identify flaws in the plan—for example, if the plan encourages management to pursue inappropriately risky investments which conflict with the overall Management Ethics #1 principle

• Manipulating accounting results to benefit management compensation without the intended benefit to the owners

• Using professional services experts—such as human resource or financial analyst consultants—who are inappropriately influenced by management

• Having the investors’ representatives (e.g., comp committee members) having inappropriately cozy relationships with management

I will not blame only management for all the recent debacles on executive pay. Certainly, investors/directors shoulder some of the responsibility. However, the vast majority of debacles involved one or more of the situations above.

More tomorrow…

Zayo and Envysion employees: I’d like all of our folks to read this bearonbusiness series. Please encourage your co-workers to follow these posts.

1. Treat shareholders as long term business partners; and view management as managing partners.

a. An enterprise must be managed with the perspective that investors (not management) own the assets contained within the company.

b. It is management’s responsibility to ensure all executive compensation and perks are clearly understood and approved by its investors.

I wrote a long series on salaries in baseball. I know I haven’t completed the series—and I will return to it at some point. However, this post provides a clue on my beliefs.

A major league baseball players’ job is to do whatever it takes—within the rules of the game—to help his team win. Managements’ job is to do whatever it takes—while abiding by the law AND appropriate ethics—to maximize value for its stakeholders.

However, our society is not socialistic. Core to our capitalistic system is that employees are entitled to get paid what they are worth. Baseball players want to help their team win—but at contract time, they want to get as lucrative a contract as possible. Good management wants to maximize return for their shareholders—but they too want to get paid as much as possible. Here is the difference.

Professional sports athletes do not have an opportunity to game the system. That is, their contacts are the result of intense negotiations with management. Whether the contract works out well (e.g., Peyton Manning) or poorly (e.g., Mike Hampton), management cannot blame the player for manipulating the circumstances. It is a balanced and transparent negotiation. The team’s “front office” will take the blame if, in hindsight, the contract was ill-advised. Team manager and/or general manager might get fired.

When it comes to executive pay packages, the dynamic could be different. A CEO/executive team has more of an opportunity to game the situation. The point of Management Ethics 1(b) is to clearly state management’s responsibility to not game the system. Instead, it is management’s responsibility to ensure executive compensation and perks are:

• clearly understood

• approved by its investors

Both aspects to this must be satisfied. More on this tomorrow.

Zayo and Envysion employees: I’d like all of our folks to read this bearonbusiness series. Please encourage your co-workers to follow these posts.