Tuesday, December 14, 2010

Value Creators, Value Destroyers

In a recent Economist article they discuss the issue of the gross over compensation of those in banking. It used to be that a trader if great could get a great paycheck, say $500,000, after a fantastic year. Now we see explosive compensation, at levels that distort society, especially in a time when others are suffering.

The Economist states:

I've long had the sense that folks in finance are getting spectacularly rich by somehow gaming the system, but the nature of the system is too inscrutable for me to formulate a sufficiently informed hypothesis on my own. But it's not so inscrutable to Mr Cowen. He offers what sounds to me a quite plausible story about the way the financial-regulatory-political system has been, and continues to be exploited and destabilized. "It’s as if the major banks have tapped a hole in the social till and they are drinking from it with a straw," Mr Cowen writes. His account of the way strategies of "going short on volatility" both increase inequality and threaten the stability of our entire market system is too detailed to summarise here, but merits close attention. I strongly sense that some story like this one largely explains the top 1%'s dramatic separation from the rest of the income distribution. Here's Mr Cowen's bottom line:
For the time being, we need to accept the possibility that the financial sector has learned how to game the American (and UK-based) system of state capitalism. It's no longer obvious that the system is stable at a macro level, and extreme income inequality at the top has been one result of that imbalance. Income inequality is a symptom, however, rather than a cause of the real problem. The root cause of income inequality, viewed in the most general terms, is extreme human ingenuity, albeit of a perverse kind. That is why it is so hard to control.
Surely there is some kind of structural injustice here.

In the 1970s a Harvard Business School professor wrote an interesting book called Financial Strategy (Fruhan). From time to time I come back to it because it presented a paradigm worth considering in different venues. It was one which classified entities as Value Creators, Value Transferors, and Value Destroyers. In the time of the book, he called GE a creator, the computer leasing industry a Transferor, and A&P, the grocery chain, which just declared Chapter 11 again, a Destroyer.

Suppose we look at some companies today. We can ask what characteristics are typical of each class. We would like to look at some firms and see how they fit in the value proposition. First, we must define value. Fruhan looked a positive cash flow, and perhaps an economic measure is best. We could easily use market value. We could use cash flow. Let us assume some metric which is financial. Any other would be problematic. Further we would have to normalize the metric somewhat as well.

Suppose we use the following two metrics, one external to the entity and one internal:

Creates Value Added To Others Along the Chain:
This means that others upward on the value chain or downwards will see a value benefit from the existence of the output of the specific player. Look at Google. Anyone upstream from Google can obtain information or data or contacts that substantially add to the value of their product. Google is a high value adder to others. Now look at Facebook. Entertaining, yes to some, but the value is minimal, to negative. In fact the time spent wasted on a Facebook could be considered value destruction.

Compensated for Value Created Adjusted for Risk Taken:
Now we look at the dimension of compensation. Look at Google again. They create substantial external value, and when they started it was at substantial risk, and thus they were and are compensated in a potentially highly competitive market. Almost all employees or entrepreneurs are compensated at market value. Government employees have no risk, they are compensated at extortionary rates and thus are value destroyers at this level. Now look at bankers. They play with other people’s money, they have guaranteed Government backing, and they are compensated at extortionary rates. They are clearly value destroyers on this scale. They do create value to others but destroy value internally.

We show a few examples below, and we can quantify them a bit more but perhaps one can get the point:

These selections are a bit arbitrary but are descriptive. Banking does add value but is negative relative to internal metrics. Worth some more thought I believe.