The Value Equation: A Business Guide to Wealth Creation for Entrepreneurs, Leaders & Investors

The Value Equation

The Value Equation A Business Guide to Wealth Creation for Entrepreneurs, Leaders & Investors

by

Christopher H. Volk

Copyright © 2022 by John Wiley & Sons, Inc. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.

Published simultaneously in Canada.

No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 750-4470, or on the web at www.copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748-6011, fax (201) 748-6008, or online at http://www.wiley.com/go/permission.

Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitable for your situation. You should consult with a professional where appropriate. Further, readers should be aware that websites listed in this work may have changed or disappeared between when this work was written and when it is read. Neither the publisher nor authors shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages.

For general information on our other products and services or for technical support, please contact our Customer Care Department within the United States at (800) 762-2974, outside the United States at (317) 572-3993 or fax (317) 572-4002.

Wiley also publishes its books in a variety of electronic formats. Some content that appears in print may not be available in electronic formats. For more information about Wiley products, visit our website at www.wiley.com.

Library of Congress Cataloging-in-Publication Data:

Names: Volk, Christopher H., author.

Title: The value equation : a business guide to wealth creation for entrepreneurs, leaders & investors / Christopher H. Volk.

Description: Hoboken, NJ : Wiley, [2022] | Includes index.

Identifiers: LCCN 2022002736 (print) | LCCN 2022002737 (ebook) | ISBN 9781119875642 (cloth) | ISBN 9781119875666 (adobe pdf) | ISBN 9781119875659 (epub)

Subjects: LCSH: Corporations—Valuation. | Business planning. | Wealth.

Classification: LCC HG4028.V3 V64 2022 (print) | LCC HG4028.V3 (ebook) | DDC 658.15—dc23/eng/20220301

LC record available at https://lccn.loc.gov/2022002736

LC ebook record available at https://lccn.loc.gov/2022002737

Cover Design and Image: © Classic Sky LLC

For my wife,

the love of my life,

who makes so much possible.

Preface

I did not initially set out to be an entrepreneur. I graduated from college in the middle of a major economic recession with a mediocre grade point average, having avoided taking a single business class. It was then that something fortunate happened to me that would guide my future choices: My applications for employment were declined by more than 300 companies.

Getting rejected by so many businesses was an accomplishment in 1979. Each letter I sent went by regular mail and was hand typed. So were the replies. For years, I kept the rejection letters as a reminder of the privilege of employment. Those letters also provided me with added motivation to succeed. With my mounting rejections, I would likely have taken any reasonable offer of employment at just about any location. Fortunately, the rejections deprived me of that opportunity and gave me time to think.

I committed to a course of action, narrowing my focus. I decided to convince a commercial bank to hire me. The idea was to maintain my career options while finding a job that would give me valuable knowledge about business and finance. I also attended night school, eventually earning an MBA. My brief banking career led me to finance and eventually to the opportunity to take three companies public on the New York Stock Exchange, two of which I co-founded. All the while, I have been a student and observer of business.

This book has been years in the making. It began with many published articles written throughout my career that eventually provided the material for an award-winning video series on business. In turn, the video series was inspired by an educational program called Schoolhouse Rock! When I was in high school, it was brilliantly conceived to make many complex subjects simple. I wanted to do something like that for business, using math you learned in middle school.

This book ultimately emerged from that effort.

Corporate business models cannot be conceived or evaluated without math. Over my career, I have found that most businesspeople are taught to look at absolute numbers. The approach within this book is intended to be broadly accessible and is centered instead on universal relative numeric relationships, beginning with investor rates of return. In taking this approach, which I have used throughout my career, complex business models can be hugely simplified. For you, the result is that a wide range of business financial fundamentals can be addressed using a single integrated approach and then condensed into a few pages.

When you are done reading this book, you should have more than just a basic understanding of how businesses create wealth. You can expect to have a good idea how companies are assembled and valued. And you will also gain insight into how business leaders work to improve corporate business models in ways that generate personal and collective wealth. These fundamentals rest at the heart of the creation of most of the largest personal fortunes ever assembled.

Businesses lie in the middle of the great river of global commerce. They are the engine of our global economy and are ultimately responsible for our collective prosperity. I have spent a career in the middle of the river and am happy to be able to share my observations with you. This book contains many illustrations of businesses, including STORE Capital, the most recent publicly traded company I co-founded.

The business case study illustrations within the book generally stop at 2019. The reasoning should be intuitive. The global pandemic that began in early 2020 created major global disruptions that resulted in near-term business performance and business model distortions. Given the timeless nature of the concepts in this book, this does not matter.

I have been fortunate to work in a time characterized by a high level of business formation and creativity, which has helped me and many others start large businesses from scratch. To my knowledge, business formation has never been more accessible. It is my hope that this book serves to inspire readers to harness the wealth creation potential of business as they contribute to, create, and run businesses that benefit us all.

Christopher Volk

Paradise Valley, Arizona

March 18, 2022

Introduction

There are many ways to get rich. Strategies for personal wealth creation often center on personal habits that encourage controlled spending, the avoidance of debt, and the accumulation of investment assets designed to make your money work for you. But there is far less written about how businesses create wealth. I went through two years of graduate business school and emerged without taking a single class on the subject. Nor have I noticed any significant change in the understanding of business students in the intervening years since.

Corporate wealth creation stands at the center of our national economic prosperity. Most of us work for businesses. And it turns out, the richest among us did more than simply control spending, avoid debt, and accumulate investment assets. The very wealthiest Americans either made their money by owning a business or by inheriting money from family members who did. The investment assets they accumulated were centered in their own business endeavors.

Any discussion of business is incomplete without a discussion of wealth creation. The two go hand in hand, like peanut butter and jelly. Most growing business enterprises need independent investor capital, and a prerequisite for attracting investors is the company's potential for wealth creation. If a business is unlikely to be worth more than it cost to create—either now or in the near future—it is equally unlikely to attract the independent investor capital it needs.

And therein is the definition of business wealth creation: Making a business worth more than it cost to create.

To make something become worth more than it cost to create involves being an active investor. Investing in public stocks or bonds can deliver returns that can make you rich over time, but those returns are generally part of the fabric of overall corporate costs of capital. Businesses are supposed to reward you for making an investment in their stocks or bonds. Every now and again, investments in public stocks are rewarded with outsized returns as some of the business wealth created by leadership is sprinkled onto shareholders. Every now and again, investments in public stocks will be rewarded with outsized returns as investors pan for gold, seeking undervalued companies having solid, but misunderstood, business models. But corporate wealth creation tends to fall disproportionately on the corporate founders and early investors who took the risk. They are the first to be rewarded for making the company worth more than the cost of its parts.

Businesses have many stakeholders, including their investors. Those many stakeholders include owners, employees, creditors, suppliers, and communities. Today, one can be overwhelmed by the flood of published books and articles that debate which stakeholders are owed the highest degree of loyalty. To analyze the relative importance of stakeholder constituencies is easiest with established businesses, especially if they have grown to be large and powerful. But no large business I can think of got to be that way without first having created massive amounts of wealth for its founding owners. Without the strong potential for wealth creation, such companies would never have existed.

People who put their money into a start-up business typically have other investment choices. Those choices generally come with investment return expectations. In turn, such expectations effectively create a hurdle rate to attract investor capital to a new business. If you can meet or exceed that hurdle rate, then you have a chance to accomplish more than simply earning and saving money. You can create wealth from thin air by making your business worth more than it cost to put in place.

Here is a simple illustration: Since it was first created in 1926, investors in the S&P 500 stock index have earned, on average, 10% annually. That might make 10% the institutional investor benchmark hurdle rate, though I would note that I have generally seen more aggressive investor targets for newly minted companies. The hurdle rate, in this case 10%, is the starting point for wealth creation. Should your business produce a total investor rate of return of 10%, then your company will be simply worth what it cost to create. Raise that delivered return to 20% and your investment doubles in value. In business, it is the excess return, and not the appreciation of underlying business assets, which creates value from thin air. Likewise, a business can easily be worth less than what it cost to create. In this case, should your company's total rate of return be a mere 5%, then your investment value would stand to fall in half.

People commonly confuse investment returns with wealth creation. They are not the same. Think of it: A company could provide its shareholders with a meaty annual rate of return of 10%, yet still have created no value above what it cost to create. In turn, if you accumulate enough investable assets capable of delivering 10% annual rates of return over time, you can personally become rich. But keep in mind that without the potential to deliver annual returns greater than 10%, the company in our example would likely never have been able to attract sophisticated outside investor capital. The independent investors would likely have elected to invest their money elsewhere, possibly into the S&P 500 Index, which is backed by a portfolio of the nation's largest seasoned companies having far greater investment liquidity and far less execution risk.

Most established businesses realize rates of return that are not attractive for outside investors and yet still allow their owners to make a decent living and save some money. But wealth that is created out of thin air can only be achieved in business by producing annual rates of return above applicable return benchmarks. If you can achieve this, then you and your leadership team have realized an enormous accomplishment. If you can achieve this while also satisfying your many other stakeholders, then you can say you have attained a truly rare level of business success.

Shareholder wealth creation is the single most important corporate financial performance metric. It's not that hard to figure out. Just calculate what a company cost to create, then subtract what it owes to creditors, and you get a number equal to what owners have invested at cost. Now, compare that owner investment to its current valuation—this is obviously easiest with a public company—and you arrive at the amount of shareholder wealth creation. This number is called equity market value added, or EMVA, which is simply the amount by which a company's shareholder equity is worth more than it cost to create.

Once you know the amount of value creation, you can compute the annual compound growth rate of your EMVA. Key to this computation is knowing the weighted average age of company equity at cost, which will almost always be younger than a company's chronological age. That is because most companies reinvest some or all their free cash flows back into the business, rather than distribute that free cash flow to shareholders. The result is that the cost basis of a company's equity rises each year as company management reinvests shareholder cash flows into the business. In the case of the companies I have helped lead, we have also raised new shareholder capital annually, which has served to further reduce the effective age of our business. Financially speaking, the higher the annual compound EMVA growth you can realize, the better you are.

EMVA growth is a far better long-term business evaluation metric than compound earnings growth. Between 2015 and 2019, Walmart, amongst the most valuable publicly traded companies and the single largest retailer and corporate employer in the US, threw off close to $30 billion annually in free cash flow from operations. The company paid out only about 20% of that in shareholder dividends, which means that about 80% of annual shareholder cash flows were available for reinvestment into the company each year. Assuming Walmart reinvested the money profitably into its business, how could earnings per share fail to go up? Really, the company could have lit on fire half of its annual retained cash flow, reinvested the other half into earnings-producing investments, and net income per share would be expected to rise.

The reinvestment of cash flows is the main reason that broad stock market indices rise over the long term. They have to. Yet, for shareholders, the paramount issue should be whether companies are able to retain and reinvest their free cash flows without losing any of the value of that reinvested cash. And while not losing any wealth would be great, creating added EMVA would be even better.

Regrettably, too few Americans understand the power and dynamics of business wealth creation. Many of us believe that wealth is beyond our reach and that our market economy is somehow rigged to favor an elite few. I have never believed this. At its heart, America aspires to be a meritocracy. If you are fortunate enough to live in America, your potential should be limited only by your imagination, dedication, and discipline.

My experience is that good ideas, solid business models, and qualified leadership teams are scarcer than the investor capital needed to support and sponsor them. In my career, this has become increasingly true. If you are considering an idea having the potential for wealth creation, America is as good a place as I can think of to execute it. For one, the US, with approximately 4% of the world's population, has more small- and middle-market companies than any other country in the world. According to the US Small Business Administration and the US Census Bureau, as of 2018, there were approximately 26 million small businesses having no paid employees other than the owner, and more than 6 million small businesses with fewer than 500 paid employees. Those small businesses collectively employed nearly half of all working Americans.

The growth of capital availability to fund business ideas is equally impressive. When I graduated from college in 1979, there were scarcely any private equity investment companies. Forty years on, there are no fewer than 10,000 private equity and venture capital firms investing in every kind of company imaginable. Add them all together and you have an abundance of capital unheard of in American history. With a highly open economy and a strong legal framework, both of which are essential to encourage business formation, the US has a veritable conga line of lenders and equity investors in search of solid ideas having wealth creation potential. I learned this personally—access to investment capital enabled me to co-found companies in 2003 and 2011 that would both go on to be listed on the New York Stock Exchange.

Among the greatest gifts my parents gave me were an education and an example. In 1980, with nothing but a college degree in history and French, $500, and a box of hundreds of rejection letters from prospective employers, I loaded up my 1970 Volkswagen in New York and drove to Atlanta, Georgia. I landed a job selling clothing, and then started attending night school to learn about business. A few months later, I was hired by a regional bank—my goal was to work for a bank—where I would spend the next six years. For most of those years, I was engaged analyzing businesses and evaluating their ability to repay loans. I also spent many of my evenings in night school, earning my MBA. Along the way, I learned something that seems obvious: Not all businesses are created equal. Some businesses simply have superior business models that enable greater wealth creation.

Once a year since 1982, Forbes magazine has published its list of the 400 richest Americans. With few exceptions, members of this elite listing owe their fortunes to the wealth creation engines of some of the world's finest businesses. The fortunate self-made members of the list followed personal interests, often had luck shine on them, and found themselves owning stakes in groundbreaking businesses they helped create that became worth billions of dollars. In turn, the businesses they created were endowed with some of the finest business models capable of producing gargantuan rates of return that so exceeded any rational investor return expectation that they literally created geysers of wealth from thin air. Often, the wealth created was so abundant that it's common to see multiple members of the Forbes 400 who owe their vast collective net worth to the same singular corporate successes. Importantly, the geysers of created wealth often rained down broadly on employees and investors.

After I started to work at the bank, I became interested in business models. From my earliest days in banking, I began to model out businesses and create projections, which helped me to develop an expertise in business model evaluation. I cut my teeth on Visicalc (the first spreadsheet software for personal computers), graduated to Lotus 123, and later moved on to Excel, which is the prevalent spreadsheet software in use today. My earliest financial models can be described as long and weighty.

The thing about most business models and projections is that they are bound to be wrong. In fact, I commonly saw companies put together base case, best case, and worst case financial model scenarios, which simply gave the model authors the opportunity to be wrong three times. In truth, with just one or two variable changes, business model outcomes can vary by great degrees. Given this high level of variability, I became wedded to sensitivity tables (or data tables in Excel), which allowed me to see potential outcomes given a range of values for any two key model inputs. If you created many sensitivity tables, you could incorporate numerous variables, which provided better insight into key model variables and margins for error. The best business models tend to have ample room to make mistakes and yet still create