Tim Koller on the timeless truths of corporate finance

Tim Koller literally wrote the book on corporate finance as coauthor of the best-selling Valuation, now in its seventh edition. He also leads McKinsey on Finance, our journal for finance executives that just published its 20th-anniversary issue. This article combines two episodes of the Inside the Strategy Room podcast in which Koller reflects on the changes in the corporate finance and valuation landscape and the three urgent challenges facing executives today. This is an edited transcript of his conversation with David Schwartz, editor of McKinsey on Finance. For more discussions of the strategy issues that matter, follow the series on your preferred podcast platform.

David Schwartz: You have been writing about value creation for decades. What would you tell the Tim Koller launching McKinsey on Finance in 2002 about value creation?

Tim Koller: The Tim Koller of today would probably say much the same things. After all, Valuation came out in 1990, and the core messages are the same: that value creation comes from revenue growth and return on capital, which drive cash flows. What has changed are my views on more subtle things. For example, we experienced a bit of a bubble in tech stocks in 1999 and 2021, and I’m less confident about the short-term alignment of share prices and economic fundamentals. I also realize now that even if companies develop strategies based on growth and return on capital, they don’t always follow through. I would tell myself back then to spend more time on helping companies translate their strategic plans into action.

David Schwartz: Let’s go back further still. We are in a period of high inflation, low growth, and geopolitical tension—it’s 1972. What would you tell a CFO back then?

Tim Koller: Hopefully, the situation today is different than what we experienced in the 1970s, which was a period of high inflation and unemployment that lasted a decade. While there is a lot of uncertainty, today is very different.

What I would tell CFOs back then is very dependent on the company’s situation. Different sectors respond differently to different forces. For example, innovation-driven sectors, such as technology and pharmaceuticals, continue to grow as long as they innovate, so I would tell a tech or pharma CFO to continue to invest in innovation. If I was talking to a consumer packaged goods company, I would probably say the same thing. People still needed breakfast cereals and laundry detergent, and those companies could raise prices with inflation and maintain fairly good results. To a cyclical manufacturer or an auto company, I would say, “Be more cautious, because demand will be low, so you don’t want to over-expand.”

David Schwartz: We know some things that will shape our future: the net-zero imperative, AI and machine learning, and prominent demographic trends, for example. What would you ask the Tim Koller of 2042 about how things turn out?

Tim Koller: We face an unprecedented macroeconomic situation. We’ve had a very loose monetary policy for more than ten years. The Federal Reserve was buying bonds, forcing down interest rates to very low levels, and that’s not sustainable. That’s why, even before the recent inflation numbers, economists were concerned about inflation, especially with a strong economy. At the same time, we are facing massive supply shocks that are pushing up prices. We also have labor shortages, with people not returning to work despite job availability. So I would ask my future self how these things will interact and how we will get through them.

If the Fed sticks to getting interest rates back to normal and letting the economy fix itself, I think we can get through this period in a year or two without too much difficulty. If the government acts like it did in the 1970s, introducing wage and price controls, gas rationing, and other economic interventions that discouraged investment, we could end up with a longer period of high inflation and a deeper recession.

David Schwartz: Are you still long on equities?

Tim Koller: Yes. I don’t believe you can time the market well, and while I think that parts of the market are overvalued, during almost every 20-year period stocks will outperform any other investments because they are linked to economic growth and profitability. I’m proud that my daughters are diligent about putting money into their 401(k)s and I convinced them to invest all their money in index funds. They are in their 20s and by the time they are 50 or 60, they will have ridden the ups and the downs and will be much better off.

I’m also optimistic because it’s not a coincidence that stocks earn 6.5 to 7 percent real returns over longer periods of time. It’s due to what we just discussed: corporate growth and return on capital. As long as companies grow along with the economy and continue to earn similar returns on capital as they have, we will be able to earn similar returns on stocks.

David Schwartz: Most American households hold stocks directly or through mutual funds, but a sizable segment does not. Are you concerned that the market leaves some people out?

Tim Koller: We need to separate direct effects from indirect effects. What you mention are the direct effects, and yes, the immediate returns only accrue to people who can own shares. But what’s more important is the indirect effect, which is that stock market returns encourage people to invest in building new factories, innovation, or medical research. The market enables the creation of wealth for the whole economy. Less than 100 years ago, about 40 percent of the population was involved in feeding the country. Now that number is around 3 percent and others have moved to different jobs, improving the general standard of living. Even those who don’t own stocks typically have air conditioning, iPhones, reliable automobiles, and I don’t think that would have come about without the stock market as a facilitator.

While the market encourages innovation, it also encourages competition. It enables me to raise capital to compete with you. As a result, prices are much lower than they were 50 or 80 years ago in many categories. Prices are highest in areas not subject to competition or much innovation. For example, there has been relatively little innovation in education, and we spend a lot more on education than we used to.

David Schwartz: Markets face increased regulations. Is there a point where companies may find the burdens of being public too onerous and choose to stay or go private?

Tim Koller: Many large companies are too large to go private. Once they get above a certain size, they cannot get sufficient capital without access to public markets. You do see medium-sized companies go private from time to time, but they often go public later because investors need to cash out at some point, creating a cycle. Despite the regulatory burdens, there are many reasons why the bulk of corporate market capitalization is in listed companies. One reason for going public, especially for young companies, is to attract talent.

David Schwartz: Do public companies face greater barriers to innovation or creative destruction than private ones due to the pressure to meet earnings targets?

Tim Koller: We should separate companies’ internal dynamics from external forces. Many perceive the markets as short-term oriented, forcing management to worry only about quarterly earnings. Our research shows that successful companies are typically those with longer-term horizons. There are plenty of investors who have long-term horizons as well, but they generally need to talk to a company only once or twice a year to make their decisions. Short-term investors are noisier. They probably drive the short-term market volatility, but it’s longer-term investors that drive the share price over time.

In a typical large US or European company, long-term institutional and retail investors comprise about 75 percent of the shareholder base. We encourage our clients to spend more time on communicating with and getting to know those investors. And it’s interesting: if we start a conversation with clients on long-termism, we often end up talking about innovation, and if we start on innovation, we end up talking about being long-term-oriented. Those two go hand in hand.

As for the internal dynamics, public companies are often not set up for innovation, partly because their compensation systems tend to be short-term-oriented and because the boards aren’t deeply enough involved in innovation. In a recent survey, more than 60 percent of executives told us their companies are not investing enough in growth and not taking enough risk. We’ve seen a tremendous amount of innovation in the past 20 years, but a lot of it has come from younger, newer companies. Despite all the talent, capital, and customer knowl­edge established corporations have, there do seem to be barriers. My colleagues recently wrote an article about overcoming fears surrounding innovation. You have to put in place mechanisms to encourage people to bring forward ideas that could be risky without fearing that if circumstances outside the company’s control make the projects unsuccessful, their careers will be damaged.

From an economy-wide perspective, it doesn’t matter where innovation comes from, but from a shareholder perspective, you could argue that the shareholders of some larger companies are missing out because of those barriers. Companies respond to self-imposed short-term pressures created by their compensation systems, so I wouldn’t blame it on the stock market.

David Schwartz: You have written a lot about decision making and biases. Why the interest?

Tim Koller: I spent most of my career focusing on the analytic side of things, but ten years ago, when I started learning about cognitive biases in decision making, I realized that companies were not following through on their strategies partly due to those biases. Psychologists have identified more than 60 cognitive biases that affect how people make decisions. We boiled them down into four groups: group think; confirmation bias; loss aversion, which leads us to put more weight on losses than gains; and anchoring or inertia—anchoring decisions in what we did in the past.

I see that last one all the time: companies allocate capital based on last year’s allocation plus or minus a little bit, instead of starting from scratch based on where current opportunities are. They should put resources where the strategy says those resources should go, whether it’s dollars or people. It seems like an enormous opportunity that hasn’t been addressed.

David Schwartz: What are some tactics that companies can use to improve their decisions?

Tim Koller: A lot of it relates to governance. One executive at a company with three divisions told me, “We allocate resources to the three division heads and hope they make the right decisions.” But those division heads have a much shorter-term incentive structure than the enterprise leaders like the CEO and CFO, and resource allocation is one of the most important things a company does. We encourage CEOs and CFOs to play much more formal roles at a granular level. They should be looking at the top ten to 30 strategic initiatives to make sure those are fully funded and translated into concrete initiatives.

Another way to improve decisions is separating debate from decision making. Social science suggests that rigorous debate leads to better decisions, so when you are evaluating initiatives, you should include everyone who has a stake in the outcome in the debate, even going so far as to appoint someone to take a contrarian point of view. But you can’t have 15 people making decisions through consensus because you end up with the lowest common denominator. You need to have a rigorous debate in one forum, then the top leaders separately make the hard decisions.

David Schwartz: Are employees dissenting less today than they used to?

Tim Koller: Younger companies typically have strong debate cultures, but some companies get so big that debate and dissent become difficult. Early in my career, I would have knock-down, drag-out debates with the senior partners, and they loved it. Likewise, when someone new to the firm disagrees with me and gives me reasons, I love it, because I learn something, they learn something, and we come up with a better answer.

David Schwartz: In an essay in the 20th-anniversary issue of McKinsey on Finance, you lay out three big challenges facing corporations in the coming years. One is innovation, which we discussed. The second is taking good ideas too far, which has been behind many of the systemic failures we saw through the decades. What can we do to prevent that?

Tim Koller: When good ideas are taken too far, they lead to misallocation of resources in the economy, which eventually has to be corrected. Since, fortunately, the global economy and most national economies are not centrally directed, there’s not much we can do to stop that misallocation broadly. At the company level, what matters is having an independent perspective. In the wake of the financial crisis, some banks emerged stronger than others, and those were often the ones that went against the grain. They had done their own analysis, decided the housing market was overheated, and were cautious about their exposure. One of the big challenges for companies and investors is avoiding going along with the herd.

David Schwartz: The other challenge is the impact of climate change. How do you think companies should respond?

Tim Koller: I’ve been impressed by how much capital is available for investments in the energy transition—from venture capitalists, pension funds, and other sources. As a result, capital is not at all a competitive advantage. So, what would differentiate a company? Just because I have cash flows coming in doesn’t mean I should be investing them into the energy transition if I can’t create value. I’m better off letting people who have not just capital but the right skills do that. Building a wind farm, for example, requires skills like identifying appropriate sites and negotiating with landowners, local governments, and utilities. The skill set is very different from what most large companies have. Business leaders need to figure out what their companies can offer that’s unique and better than someone else. That’s not just best for shareholders but for the economy as a whole.

David Schwartz: Do you think companies have an obligation to invest in sustainability and green growth, and be willing to have their legacy businesses disappear?

Tim Koller: Well, the transition for an automobile company from manufacturing cars with internal combustion engines to making electric vehicles is a much different challenge than what an oil and gas business faces. Automakers have many advantages over start-ups in the electric-vehicle space and may perform better in the long run because they have dealer networks and know how to manufacture with high quality. The transition will be difficult, but their core business likely won’t go away, or at least not for a long time.

On the other hand, if we eliminate our reliance on oil—and, to a lesser extent, gas—oil production and refining will go away. Companies will need to figure out how to manage the decline, but from an economy-wide perspective, we don’t want everyone to shut down oil production tomorrow because that would be disastrous. So what should you do with the cash flows as you wind down that industry? You can either invest them in new areas or you can return them to shareholders.

The answer, I think, is simple. If you can figure out a way to create value—if you have skills, for example, in building platforms in the deep waters of the North Sea—you could potentially apply those skills to building wind farms. If you don’t have the capabilities to create value, then you would be better off returning that cash to shareholders. It’s not like that money will not get invested in the green economy; it will just be invested by a business that may do a better job.

David Schwartz: Over 20 years of leading McKinsey on Finance, we have been telling CFOs about ever more things they should be doing. How should they manage these expanding responsibilities?

Tim Koller: CFOs need to develop strong teams behind them that can handle more tactical, less strategic tasks. In today’s environment, CFOs play a key role in strategy, educating the rest of the management team, and making the hard decisions, serving as CEOs’ right hands on these matters. To do that, they need controllers, tax people, and other specialists they trust who can operate pretty independently.

David Schwartz: Over those 20 years, is there an article you wish we had not published?

Tim Koller: When we created the 20th-anniversary issue, we looked back and I didn’t come across any that I would say, “I would take that back.” The world doesn’t change that quickly in finance—the principles don’t change.