Creation of economic value, alchemy or reality?

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The financing that a company obtains from its investors can come from its own resources (net worth) or from others (debt). Once investment decisions have been made, capital is invested in the assets that the company needs to develop its strategy and achieve its objectives.

These investments will take time, more or less, to generate cash flows. In other words, capital is injected at a given moment but it requires time to start generating revenues.

Risk and opportunity cost

Throughout this period, the investment is exposed to risk (that expectations are not met or that the plan and its schedule do not evolve as expected) while incurring an opportunity cost: that of not having allocated those resources to other companies that generate an alternative profitability.

If everything goes according to plan, at some point the investments will generate profits and cash flows and it will be necessary to make new economic-financial decisions on the profits obtained. That is, whether to return them to investors or reinvest them (all or part of them) to continue growing, gaining market share and building competitive advantages.

Therefore, when investors decide to risk their capital to finance a company, they expect:

  1. An economic award that rewards your entrepreneurial daring.

  2. That the remuneration is sufficient to exceed the opportunity cost of not having invested in other companies with similar risk.

It is this opportunity cost that sets the minimum expected return, which is determined based on risk. When an investment generates a long-term return higher than expected, we say that it has created economic value.

This implies that, to retain the capital in a company, it is not enough that it be profitable but that this return must be higher than that which could be obtained in other investments of similar risk and duration.

In favor of the free market

The opportunity cost is set by the competing companies which, despite not always having the same risk, are taken as a reference and are called comparable companies.

Thus, when the results of a company or the performance of its actions are analyzed, not only is the evolution of the company tracked, but they are also compared with those of its competitor or its direct competitors.

This is why financial analysts specialize in specific sectors. They have to always be up to date with the situation of the market, the sector and the companies that compete in it, in terms of strategies, investment and financing decisions, dividend policy (and a long etcetera).

Taking into account the opportunity cost ensures efficiency in the use of capital and the creation of value. The generation of wealth is, therefore, a social engine that requires a free market. His worst enemies, as Vargas Llosa cites in reference to the work of Adam Smith, are “privileges, subsidies, controls, prohibitions and monopolies.”

The Philosopher’s Stone: Economic Value

When we think of creating value in the economic-business sphere, we see some entrepreneurs as alchemists. They found the philosopher’s stone in their market and managed to rethink and rejuvenate it. Transformed magically its assets are the most valuable in the world due to its extraordinary ability to generate cash flows and maintain them over time.

What formula did Amancio Ortega and Rosalía Mera (Inditex, 1963) develop to, from a sewing workshop in A Coruña, Spain, invent the fast fashion and become one of the companies in the textile sector with the highest turnover in the world?

Until the disruptive emergence of Inditex, the fashion sector produced two seasons a year: spring-summer, winter-autumn. This implied a high risk of obsolescence of the products: if they were not sold during the season they had to be aggressively lowered to be able to sell them.

Inditex changed the rules of the game, keeping its production active throughout the year to adapt, in a continuous process, to what customers demanded in its stores. In this way, it was able to maximize the efficiency in the rotation of its inventories and minimize the impact of the sales. In fact, its production chain and logistics are among the best in the world.

As of November 26, 2021, the market capitalization of Inditex, that is, the market value of the company’s net worth was close to 99,000 million euros. Pure alchemy.

How was Jeff Bezos able to transform a capital of $ 245,000 and a simple business idea (sell books on-line, 1995), in one of the largest companies in market capitalization in history and breaking the rules of the distribution of retail products in more than 100 countries?

As of November 17, 2021, Amazon’s market capitalization exceeded $ 1.82 trillion. Pure alchemy.

Expectations and wealth

The creation of economic value can generate skepticism. Economic value is not a mathematical concept, where 2 + 2 equals 4, since it implies expectations, unexpected changes in the market and approaches to measuring the opportunity cost.

However, over the years tools and metrics have been developed in the field of corporate finance that allow measurements to be made of the value created in the past and to make projections about the value that is expected to be generated in the future to provide an economic foundation. to business decision making.

Measurements and estimates of value are one of the most relevant functions in the field of business finance, since, to paraphrase Peter Drucker, “you cannot manage what you cannot measure”. But we will talk about metrics another time.

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