Corporate Valuation,

Value-Based Management,

and Corporate Governance

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If you had invested $1,000 in the NYSE Composite Index at the beginning of the

1990s, your investment would have grown to $3,010, resulting in an 11 percent annual

rate of return. Had you put the $1,000 in Berkshire Hathaway, you would now have

$9,551, which is a 17.8 percent annual return. And if you had been really smart (or

lucky) and invested in Dell, you would now have $497,510, which translates into a

whopping 76.6 percent annual return!

Berkshire Hathaway and Dell compete in very different industries and have very

different strategies, yet both beat the market by sharing an operating philosophy:

They created value for shareholders by focusing on the free cash flows of their under-

lying businesses. When this focus is applied systematically throughout a company, it is

called value-based management, which is the central theme of this chapter.

Berkshire Hathaway’s primary strategy has been to grow through acquisitions.

Warren Buffett, Berkshire’s CEO, wrote in a recent letter to shareholders that he seeks

to own “businesses that generate cash and consistently earn above-average returns

on their capital.” When evaluating a potential acquisition, Buffett says he compares its

purchase price with its “intrinsic value,” which he defines as “the discounted value of

the cash that can be taken out of a business during its remaining life.” Thus, Buffett’s

growth strategy is governed by the principles of value-based management.

Instead of growing primarily through acquisitions, Dell has chosen to grow “or-

ganically” by expanding its existing businesses and developing new products and

markets. For most companies, rapid growth in sales requires rapid growth in operat-

ing capital, which reduces free cash flow. But Dell is relentless in minimizing the

amount of operating capital required to support sales. During the last five years, Dell’s

sales grew by 43 percent per year. However, Dell actually reduced its operating capi-

tal, largely because of reductions in inventory as a result of its produce-to-order strat-

egy and increases in its accounts payable. Dell also increased its net operating profit

after taxes (NOPAT) faster than sales, 47 percent for NOPAT versus 43 percent per

year for sales. Thus, Dell has excelled at improving three primary drivers of value-

based management: (1) Its sales growth rate was a huge 43 percent. (2) Its profit mar-

gin rose from a good NOPAT-to-sales ratio of 5.1 percent to an excellent ratio of 5.8

percent. (3) Its capital requirements were held in check as a result of lowering the

capital-to-sales ratio from 11.4 percent to virtually nothing.

Sources:Various annual reports of Berkshire Hathaway Inc. and Dell Computers.

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