Michael Mauboussin - Sharpening Investor & Executive Toolkits

Key Takeaways:

• The idea of the "value stick" framework for understanding value creation and market power was introduced by Brandenburger and Stuart in the mid-1990s, and more recently discussed in a book by Felix Oberholzer-Gee called "Better, Simpler Strategy."
• The value stick framework consists of four elements: willingness to pay, price, cost, and willingness to sell. Willingness to pay represents the most someone is willing to pay for a good or service, and the difference between pricing and willingness to pay is consumer surplus. The difference between price and cost for the company is value creation. Willingness to sell represents the price at which suppliers are willing to sell their goods or services to the company.
• The aggregate value creation is the difference between willingness to pay and willingness to sell, and includes consumer surplus, supplier surplus and the company's value creation.
• Oberholzer-Gee suggests that companies should focus on increasing willingness to pay rather than raising prices, as it increases consumer surplus. He also suggests specific techniques for lowering willingness to sell and making employees and suppliers feel happy to sell to the company at lower prices than they might otherwise.
• Market share on its own is not important, and should be balanced with the idea of value creation. Total addressable market should be defined as the number of units that can be sold while creating value, rather than just revenue or units sold.
• The concept of market power, and frameworks like "7 Powers" have become popular among entrepreneurs, who now often focus on generating power and competitive advantage rather than just creating a good or service and charging fairly for it.
• Market power can be measured by the difference between marginal cost and price, which is known as a markup. In classic economics, equilibrium is reached when the price of a good or service equals the marginal cost, and when the price is above that level, it reveals market power. When a company has market power, they are able to price their good or service above the marginal cost, which leads to a decrease in consumer surplus, but an increase in economic profit for the company.
• Return on invested capital (ROIC) is a key metric for investors to evaluate a company's ability to generate returns on the investments they make. It is calculated by dividing net operating profit after taxes (NOPAT) by invested capital. NOPAT represents the cash earnings of the business without any leverage or excess cash, and invested capital represents the cumulative amount of investments made in the business.
• Companies to have a ROIC that is higher than the cost to capital (the opportunity cost of the invested capital) to create value for investors.
• Michael mentions that there is recent work on ROIC with and without intangibles, which can make the picture of how good a company is earning returns on their investments appear cloudy. This could be due to the difficulty in accurately valuing intangibles such as brand value, patents, or goodwill.
• Michael explains that when calculating return on invested capital (ROIC), certain expenses can be considered investments and thus can be capitalized.
• An example is given of how this calculation affected the ROIC of company Snowflake, which went from a -416% to a more consistent 3% for a company in its early life cycle.
• Capital allocation becomes increasingly important for companies as they mature and produce more cash. The fact that most capital is internally generated can be both good and bad, as it reduces friction but also means that there is no capital market check to prevent companies from making poor investment decisions.
• There's an optimal level of how much companies move their capital around, but 98% of companies are below the optimal level, indicating that companies tend to be conservative and have a lot of inertia in their decision-making.
• Zero-based resource allocation is important, meaning starting with a clean sheet of paper and asking what resources are needed to maximize the potential of a business every year.
• Thinking about strategies versus projects is important, as a good project within a bad strategy can lead to poor capital allocation.

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