Four quadrants, one decision factory – with David Holland

The career politician is often criticised for lacking ‘real-world experience’ and yet, argues our most recent guest on The Value Perspective podcast, the idea business leaders can move easily from running a company to running a government had little going for it even before Donald Trump took a shot in 2016. “It is a complete misconception,” says company valuation expert, academic and author David Holland.

“Running a business is far easier than running a government because, with a business, your objective is pretty clear – to maximise your net present value or NPV. Make decisions with that in mind and it is going to lead to value creation. Everyone gets paid, everyone is happy. Yes – you also need to avoid making decisions that are going to blow up the company but that is all you have to do.

“I am not saying it is easy – of course, you have to run a tight operation – but it is pretty clear what the objective is. With a government, however, what is the objective? Is it maximising NPV? Not really. I mean, you want to create wealth for the country but you also need to create opportunity for people. Do you have healthcare or not? What about education? The multiple objectives make decision-making that much harder.

“When there are clear economic reasons for a decision, a government can follow a wealth maximisation strategy and really think seriously about the economics – but that is not always clearly the case. For governments, all the objectives are far more intangible and harder to model and take into account – not impossible, but a lot more difficult. In that sense, I have some sympathy with government officials.”

Four quadrants

Nevertheless, Holland continues, it can still be helpful to think of any organisation – be it a government, a company or anything else – as “a decision factory”. “As I say, it is easier for companies because you are basically trying to maximise your NPV,” he says. “But then, if you think about a business as a decision factory, you can break the decisions into four quadrants.

“The first quadrant is strategy. What can we do about clarifying the objectives? What are the opportunities and alternatives? Those opportunities and alternatives are what you need to run through a decision model, using a high-quality decision process – and that is because it is so much better to get the decisions right upfront than to try to fix bad decisions later on.

“I love financial performance metrics and doing valuations, of course – much of my career has been dedicated to those areas – but by the time you have got there, it is a bit too late. So, for the second quadrant, you need to make capital allocation decisions as best you can, using the expected NPV and understanding the risks – risk being the distribution of outcomes. What is the probability the NPV could be negative?

“All those things should be quantified and, once you do that, you should be identifying the most valuable strategies and the most valuable portfolio. Should you use decision models? Absolutely – yet this is where companies make mistakes. Often they do not have robust decision models – particularly when they are making these decisions by their gut or intuition, say, as opposed to a rational process they can score.”

Cash generation

After capital investments, the next quadrant is cash generation. “That is really where the performance analysis comes in,” Holland explains. “Are my returns on capital beating the cost of capital? Am I able to maintain those returns by applying discounted cashflow valuations to my various divisions, so I have the most valuable portfolio? Are key performance indicators and other factors all aligned with value creation?

“Now, this is not something they really teach you in corporate finance. If you think about a valuation as the invested capital plus the present value of all your future economic profit streams, well, the sum of all your NPVs now and in projects you have not even undertaken is equal to the sum of the present value of all those economic profit streams.

“So if you are making decisions that are optimising your expected NPV, then that should manifest itself in growing economic profit streams going forward – which is potentially going to make you rich as an investor spotting those companies. The last quadrant is the capital distribution aspect, which is really going to be capital structure, dividend policy, buying back shares and remuneration metrics. Governance is crucial here.

“Am I paying executives based on earnings? If so, that is foolish, because then I can grow my earnings by making expensive acquisitions – I get paid but I just destroyed value for the company. So decisions are fundamental to every single stage of this process. A company is a decision factory – in fact, decisions are the only thing managers can control. If you approach it like that, the pieces fit together and it all makes sense.”