My Book Reviews

This book interviews various CFOs from large companies in order to learn more about some of today's issues regarding corporate finance.

One of the main goals of the book is to review the usefulness of the metrics currently being used to measure a company's efficiency (e.g. return on assets, etc.) and learning how the use of these metrics can help create value. Despite that fact that we now operate in a world where we have all the data we want, we still haven't arrived at the point where we are processing this data in the best way in order to get the most useful "information" that we need. A good example of this from the investing world is the use of "profit margins" (i.e. earnings margins) as the main metric for measuring company returns. Considering that cash flow is the foundation for the ubiquitous "Discounted Cash Flow" models, you would think that margins would be stated in terms of cash flow instead (some people do use "cash flow margins", but not many). The recent popularization of EBIT, EBITDA, and EVA are evidence that there are still ways to improve on the choice of financial metrics being used.

The best part of the book was the interesting discussion that came out of the interviews about the evolving role of finance within corporate America. The book points out that the function of finance is changing from being a score-keeping role, to one that is a partner in the business and is involved in strategic thinking that focuses on the future. As the book points out, the finance department of a company used to just be a referee, but now they are also a player.

Put more simply, finance itself is often where the profits are being made these days - not by selling the actual products. Let's look at Circuit City as an example. Briefly before they went bankrupt, Circuit City was making all of its profits from the extended warranties that they sold with their products. Since extended warranties are insurance contracts, this meant that Circuit City was essentially an insurance company whose profits were wholly derived from finance. There are other, more obvious examples where finance drives most of the profits - like car dealerships. But there are also less obvious examples. When retail companies like Target decide to create an in-house credit card, then they essentially become (partly at least) a bank.

Another example is General Electric, which makes a large portion of its profits from GE Capital. Interestingly, within the book, there is an interview with Dennis Dammerman, the former CFO of General Electric, where he says, "General Electric has done such a phenomenally good job of increasing shareholder value -- people wonder what the secrets are." Although most people have historically pointed to the operational efficiency and managerial leadership of GE as their "secret", many people now (after the financial meltdown) realize that the secret may have simply been over-leveraging. The role of finance as it related to business strategy is a topic that you don't hear much about but has a very understated importance with regard to company performance. Although the book touched on the importance of finance playing a bigger role in a company's strategy, there was no discussion about the side effects and potential dangers of this trend - or whether or not it is even a good thing.

And while we are on the topic, it would be beneficial to think of the role of finance in even greater terms - most notably, the economy as a whole. It is well-known that the financial meltdown was partly due to overspending by consumers. Put another way, the "role" of finance was expanded by consumers. Sticking with the same topic, it is also a well-known that the capitalization of the financial sector as a percent of total stock market capitalization has been rising for at least 40 years. This is a trend that should be analyzed and monitored. To see why, the book refers to a concept called "the marginal utility of sophistication":

There's a point at which sophistication doesn't buy you anything whatsoever. Where that point is - where more sophistication . . . just becomes too much and really gets in the way . . . No one is really sure where that break point is."

After the financial meltdown of 2008, it's now obvious that this idea should have been taken even further - that way too much financial sophistication (CDOs and credit default swaps) can have a negative marginal utility and can even lead to increased systematic risk. The book makes a cultural comparison to Japan, whose smaller ratio of finance staff to total staff helps them focus on the long-term.

On a random note, the book also has a decent 50-page section about start-up financing and venture capital.

The only kind of investors this book may appeal to are the quants who are looking to build their own valuation models. It may also be possible to use the aforementioned financial sector capitalization as a long-term timing market model. It wouldn't be surprising if many of the long-term stock market tops occurred when the financial sector capitalization was at a relative high. The book also quickly touches on some theoretical investment topics, like the possibility that a company may be able to improve it's stock prices if it lowered its earnings volatility simply by using risk management techniques. An example of this principle may be a company like Jack In The Box, which switched from running mainly company owned-restaurants to running a franchised model. The more stable franchise royalties give the company a lowers the volatility of the company's cash flow, which could lead to a higher valuation - even at the same level of earnings.

Although the book brought up some interesting topics, it's subject matter at times was a little too esoteric and scattered. I wish there could have been more philosophical discussion about the role of finance, but that didn't seem to be the mission of this book. Of course, this omission was partially due to the natural bias that everyone has when it comes to their own functional areas - that everyone always looks at their own functional area as the most important one and instinctually wants to expand it. So it's not realistic to expect CFOs to question the role of finance.