Saving Capitalism by Rappaoprt is an interesting book describing a key source for whay we are where we are now. There are always different sides of the equation but this specific side has substantial value.
People often do what you have asked them to do, so if you do not like the result examine what you asked for. That in a nutshell is the message of Rappaport and his book Saving Capitalism. The principle he rejects is the short term goals set for management and by which they produce their results, oftentimes at odds with what he sees as true value creation.
For Rappaport, value creation is based upon a discounted cash flow value looking forward ( see Valuation: Measuring and Managing the Value of Companies, 5th Edition by Koller et al). The audience for this work is the more general public and the arguments he makes add to the overall discussion the nation is having regarding changes we must make to our thinking of business, finance, and the economy. In general his arguments are compelling and build on the already recognized deficiencies of short term profit maximization.
One can conclude from the Rappaport model that if the investment bankers had to rely upon the performance of their deals, rather than obtain instant gratification, and if the banks had to live with their loans, rather than hand them off to the Government with no risk, then decisions would have been different. Rappaport clearly demonstrates that people are all too often great optimizers of the rules, and if the rules are wrong, they may very well not pay any attention until it is way too late.
For Rappaport value creation is determined via the discounted cash flow produced by the entity on a going forward basis. Value for Rappaport is not created by short term optimization. Let me give an example of how this had actually applied in the small. When I took over as COO of the cellular company at what was then NYNEX, now Verizon, the churn, or loss of customers, was about 8% per month. That meant we spent 26-28 days of sales just to remain where we were the last month. Why the churn? Simple, the goal was to get new customers, so the sales force got a commission for every new customer, as did the competition’s sales force!
The company thought that just motivating customer growth was the desired result because we wanted more customers. However, customers would sign up, receive a sign up. bonus themselves, and then in a few months switch to the competition. The sales forces on both sides benefitted, the customers benefitted, but the company, and in turn the shareholders paid a tremendous price. Simple solution, as Rappaport states, think long term and think cash flow. Pay the sales force a percent of the revenue from the customer over a reasonable lifetime, not all at once. Churn dropped to 2% and even lower and cash flow increased. That is Rappaport in the small.
Rappaport spends a good deal of time defining and discussing what he calls “short termism”, namely the principle of living quarter by quarter. He spends Chapters 1 through 4 demonstrating how this thinking precipitated the financial crisis and how infects the way business is conducted in both the corporate and financial world. Broadly speaking, it is this short term viewpoint which Rappaport argues drives the decisions which lead to what we see today in business and finance.
Taking actions to meet the quarter’s number is and has in many ways been the bane of managers for the past few decades. Accounting gimmicks and tricks have been applied to maximize returns. The second part of the book by Rappaport suggests ways to remedy the short term view, namely by using discounted cash flow metrics and managing on a truly forward looking basis. Rappaport spends a great deal of time on these topics in various business segments.
Value creation is the cornerstone of Rappaort’s view as it is introduced on p. xviii. By value he means, as one later learns, is the discounted cash flow, DCF, of the business on a going forward basis. In principle, he is correct, in practice this may be a bit more difficult to achieve.
Chapter 1 allows Rappaport to frame some of his discussion as the evolution from self invested entrepreneur to what he calls agency capitalism, the management of the large capital markets by a few who in turn are compensated on short term gains with no dependency on long term performance. There are some misconceptions in his footnotes however. On p. 17 he states that the dot.com bubble was somewhat debt independent.
In fact, as one who survived that bubble by not having debt, debt was key to that bubble as well. Telecom suppliers provided 125% to 150% financing of equipment, and the amount of high yield debt was explosive with no reasonable prospect of paying it off. The dot.com bubble lost almost $5 trillion in debt and equity value in less than a year. It was the same culprits then who came back in 2007-2008 with housing rather than fiber and Internet facades. In both cases, I believe identical cases, the bankers made their killing. In both cases trillions were lost.
Chapter 2 is a discussion of the recent collapse as per his view. He states on p. 34 that some independent directors had little if any knowledge of the financial concerns. Indeed if one knows some of the principals they were at best “fishing, drinking and smoking” buddies of the management. The problem all too often is that Boards are composed of controllable and socially acceptable and well paid members. Rappaport hits a very key point here. Boards are ultimately responsible, but all too often that are clueless and just along for the ride and to ensure the management gets compensated.
In Chapter 3 on p. 46 Rappaport finally describes his value as discounted cash flow. For the sophisticated reader they may have already jumped on it but for the general reader it may have been lost. But DCF is a truly valuable method except it suffers from three critical potential faults. First it assumes we can project future cash flows. That means revenue, expenses, capital plant, taxes and the like. Risky to do this well. Second it assumes we have a discounting factor, cost of capital. This also depends on capital structure, exogenous factors such as the risk free rate, perhaps no longer a Treasury rate. Third it depends on a terminal value. That factor often dominates the total value. Rappaport makes length and positive arguments on DCF shareholder value throughout Chapter 3 and his discussion is compelling and I believe correct. The short term view he decries is truly the basis of what got us where we are now.
In Chapter 4 Rappaport discusses the finance issues of his concerns. On p. 74 he makes the point of projecting cash flows. I believe he is right. Accounting is history, it just records what has happened. Finance is to some degree looking forward. As most entrepreneurs know who have investors, they always ask how one did last week, and how it compared to plan. It is the plan that they are looking towards, since it was the projections that management gave and it is the ability to meet the projections that are most important.
All too often as Rappaport decries we just look at accounting measures of how things were and not how they are supposed to be. On p. 79 he discusses the capital asset pricing model, CAPM, which incorporates an efficient market hypothesis, EMH. The problem here is that reality and perception may never real mash. There is the concept of the Rowe conjecture that looks at the alignment of the probability of the EMH actually being in play and the probability that people believe that the EMH is a reality. One sees as Rappaport describes that perhaps all the information is really NOT out there and that the EMH does not apply but that people believe it does, or vice versa.
Chapter 5 is an excellent discussion of what should be in the world of executive compensation. The same of course would apply to those in the financial sector. People should be compensated on the long term performance not on the short term.
In Chapter 6 Rappaport lays out several rules he sees as critical for long term management. There are 12 simple rules and each is worthy of a read by themselves. I believe that this Chapter will stimulate much productive discussion. The remaining two chapters bring his argument to completion.
Rappaport argues that Boards should take the long term view, the value creation perspective. However I feel that all too often that such a process is a bit too difficult, albeit worthy of great consideration. The Boards rely on management, and certain Boards are often nothing more than Management’s friends, so collusive behavior is rampant. Furthermore the creation of reliable DCF models requires substantial knowledge and understanding. They are not the simple acts of the accountant. They certainly go well beyond the ken of most Board members, especially those from the public or non-profit sector or academia.
DCF models require a true understanding of the business, in depth. Rappaport has done an excellent job on raising the issues but it is necessary to show how and by whom they can be carried out. Clearly the compensation consultants are generally clueless on this issue, which also goes to the heart of many of the problems facing Boards.
In summary, Rappaport has presented a very worthwhile contribution to a discussion on what should be done next. The recommendations are based upon a clear understanding and analysis of the crises we have just gone through, s crisis of short termism to use his phrase.
DISCLOSURE: The reviewer received a copy of the book from the publisher and was asked to review it for Amazon. There was no compensation provided nor any guidance regarding the review. These are the opinions solely of the author regarding this book based upon a reading of the book.
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