Valuation of business

Long-term value creating strategies in small companies

How a correct valuation could prevent the next financial crisis

Short-termism is a phrase used to describe the behavior of focusing excessively on short-term results, at the expense of long-term interests and value creation. History has shown us several examples of what happens when you only aim for short-term results. In 2008, with inexhaustible faith in the market and the continuous rise of house prices, banks lent money to people at tempting rates. Since the belief was that the house market rates would only continue to increase, the banks thought their loans were secure. But by tying in high-risk debt with long-term securities and selling them to investors who in turn purchased them with borrowed money, a long-term risk was created for the initial moneylender – the bank. When people who had purchased a home then started to fail their payments, the U.S. real estate market crashed. Loans became worthless since the values of the homes dropped below the value of the loan. See what a lack of an accurate valuation did here?

History repeats itself…

Still, history has a habit of repeating itself. This lesson of short-termism should have been learned during the late -90’s, or even at the very beginning of the new millennium. The dot-com bubble was also a result of short-termism. Banks and investors forgot the crucial principle of value creation. A key ratio that was abandoned was return on invested capital (ROIC) and what drove this ratio. ROIC aims to conclude how much a company earns on the capital invested in its core business. The heavy investments in Internet-based companies during the second half of the 1990’s created a sense of “winner takes all”, making investors make even riskier and more speculative moves. Investors wanted to be in on all the fast-growing new tech companies so badly, that little-to-no research or proper valuation was made. It eventually became obvious that these Internet companies didn’t have the sensational competitive advantage that the market assigned them. The companies were struggling to earn even a modest ROIC, and the result was the dot-com bubble.

… and repeats itself

Other examples of when short-termism has completely failed an entire market are the East-Asian debt crisis in the mid-1990s and the U.S. savings and loan catastrophe in the 1980s. Both were a result of high-risk investments, aiming to turn a profit in a short-term perspective. Short-termism can be destructive for a market, as history has shown several times. When the focus on short-term results gets in the way of long-term value creating actions, the balance is tipped. The consequences will eventually undermine the market’s credibility, leading to fewer investments, and, worst-case-scenario – another financial crash.

Long-termism is a winner

Researchers disagree on why short-termism occurs. Some call upon our human nature for instant gratification, others assign the blame to greed. Whatever the reason, most analysts agree that short-termism is irrational and expensive for the economy. The rules of economics will always prevail, which is why a sound and accurate valuation will prevent you from getting too caught up in market trends and group thinking. Long-term value creating strategies will end up serving both your company and the market! You need to create generate cash and profits to create value. Growth first with hopes of generating cash and profits is much more risky than the other way round. You have to envision the long-term in a credible way.