No business has an inherent value in and of itself; it has a different value to different owners or potential owners—a value based on how they manage it and what strategy they pursue.

Companies often want to make decisions based on "the number," or a precise estimate of a project's financial potential. When companies only consider a single scenario, they almost always feel as if they have to be conservative, leading them to prioritize "sure things" in known markets over risky ventures in new markets.

While that approach might be reasonable when a company is launching a modest line extension into a known market, a new-to-the-world solution could unfold in infinite ways. It might be worth investing in a project that appears to have negative NPV, on average, if a modest investment can highlight whether outsize returns are possible. Further, if you don't invest in the long term, you increase the odds that you will fall behind existing and emerging competitors in the next economic cycle. A company that ranks all of the projects in its innovation portfolio by NPV might unintentionally stop working on projects with the greatest long-term growth potential.

Use a combination of three measures — revenue growth, economic profit, and free cash flow — to set business targets, track strategy execution, and evaluate management performance. These three measures capture virtually all the high-level financial information that is important for an operating unit. As long as internal management reporting processes are designed to report these measures accurately, they provide excellent feedback on whether the value creation expectations of a particular strategy are being met. Moreover, they are good indicators of which questions to ask and where to look for answers when performance is off track.

After 40 years of preaching, we have convinced everybody that cash flow is more important than profit. (Everybody except Wall Street, and Wall Street will never learn that lesson. There are no slower learners than securities analysts. I can testify to that; I was one. So they and the companies they promote still run into credit crunches, which kill about four of every 10 new businesses and cripple most of the rest.)

The economist Hyman Minsky has reminded us, “Each state nurtures forces that lead to its own destruction.” All of history testifies to the truth of this observation. Greater liquidity leads firms to borrow more than before. But higher levels of debt mean increasing vulnerability to adversity and negative shocks in an ever-changing world. For these reasons, as Minsky put it, stability leads inevitably to instability.

In concluding that only systematic risk matters, finance theory assumes that frictions in capital markets are negligible. The absence of frictions implies that all market participants become as costlessly and equally informed as everyone else — that is, no individual is more informed than others or, to use a technical term, there is no information asymmetry. This assumption, combined with several other assumptions, implies that news events have an instantaneous impact on prices. That is, prices reach a new level immediately upon the news event, thus fully reflecting the news content in price at all times.

Such abstraction from reality helps our understanding of how share prices behave and the role of, and demand for, capital market institutions. This, in turn, contributes to our understanding of the regulatory and standard-setting implications. However, the abstraction comes at a cost. It ignores the extensive role of information intermediaries, the nature of trading, and the transaction costs of trading shares. Recent research has discovered much about the importance of frictions.

The field of statistics is based on something called the law of large numbers: as you increase your sample size, no single observation is going to hurt you. Sometimes that works. But the rules are based on classes of distribution that don’t always hold in our world.

All statistics come from games. But our world doesn’t resemble games. We don’t have dice that can deliver. Instead of dice with one through six, the real world can have one through five—and then a trillion. The real world can do that.

That’s why portfolio theory simply doesn’t work. It uses metrics like variance to describe risk, while most real risk comes from a single observation, so variance is a volatility that doesn’t really describe the risk. It’s very foolish to use variance.

The option valuation recognizes the value of learning. This is important, because strategic decisions are rarely one-time events, particularly in investment-intensive industrial sectors. NPV, which does not properly recognize the value of learning more before a full commitment is made, is for that reason often inadequate. In fact, its inadequacy can be stated in the precise terms of the real-options model. Of the six variables in that model, NPV analysis recognizes only two: the present value of expected cash flows and the present value of fixed costs. The greater comprehensiveness of option valuation can therefore be summed up in this way: it captures NPV plus flexibility value - effectively, the expected value of the change in NPV over the option's life.

Many companies believe that they incur no incremental costs when they add just one more feature to a product or one more term or condition to a contract. Yet these seemingly minor changes accumulate over time into significant financial costs; IBM research has found that they can account for 15 percent to 20 percent of total business costs. The rule of thumb across industries is that the cost of complexity increases by 20 percent to 35 percent for every doubling of complexity. Furthermore, we've found that 30 percent to 50 percent of the difference in cost structure between high-achieving suppliers and average suppliers of the same product comes from differences in design or in the complexity of the companies' product line. Operational inefficiencies account for another 30 percent -- and they're largely a result of overcomplexity.

But relationships that seem causal and permanent in one market era often vanish in the next, taking many "superior investment strategies" down with them. Today's markets are also annoyingly efficient. The more studies that demonstrate that socially responsible stocks do better than regular stocks, the more investors will rush to buy them (and not just for "the greater good"). The resulting torrent of money flowing into the stocks will drive up their prices, and the higher prices will pave the way for subpar future returns.

...One implication of this argument-invest sustainably, and you'll make a killing-is just dreaming. Even if the markets do soon "place a much higher value" on responsible companies, this won't provide superior returns over the long term; rather, it will provide a pleasant short-term bump. Once stock prices have adjusted, the opportunity will evaporate. Investment decisions, moreover, will still be only one factor in changing corporate behavior. Regulatory practices and consumer buying choices will always play the most direct role in persuading companies to behave responsibly.

The best measure for performance is to look at the discounted cash flow model of a company. The comparison of the economic profits relative to the expectations of economic profit is a one period measure, while the discounted cash flows attempt to look at the performance of the company over many time periods into the future. I have found that when I correlate the discounted cash flow estimates of the value of a company with the actual market value of that company I get correlations of 80% and above.

if you use earnings per share or the gross earnings per share you completely ignore any information about balance sheet management. Consequently, companies that focus on earnings are relatively inefficient in the way that they manage their balance sheet. It actually does make a difference whether you generate one dollar of earnings with one dollar of capital or generate the same dollar of earnings with 50 cents of capital. Other companies use return on invested capital or return on assets employed or return on net assets; there are many definitions of the same thing. What I have found is that those measures are better because the income statement information is the numerator and invested capital is the denominator. This is balance sheet information so it represents an improvement over earnings, but unfortunately if you try to maximise the return on invested capital you tend to harvest your business. The easiest thing to do is to let your invested capital base depreciate in order to increase your return on invested capital and after a while you find that you are not competitive. So that is not a particularly good measure either. In my opinion, the best value based management systems have three levels of measurement. At the corporate level and at the business unit level where you have forecasts of income statements and balance sheet, discounted cash flow is a very good tool. For one period performance measurement the difference between actual and economic profit and expected economic profit is probably the best measure. At the plant level where you don't have income statements and balance sheets, value drivers are probably the best way of measuring performance. These value drivers include things like defect rates or on-time delivery or the product mix or, in banking, the creditworthiness of the ledgers.

Real options are an emerging field of financial engineering that in my opinion will completely replace net present value in the next 10 years. The reason is that net present value is a flawed model for evaluating projects. The problem is that managers who experience these decisions know that that approach is full of implied assumptions that are rigid or even wrong. For example, if you start a project and it turns out to be going badly, it will not last ten years but will be either abandoned or scaled down. Furthermore, if it is a successful project its life will either be extended or it will be scaled up. Finally, no one says that the initial investment has to take place right now, it could take place next year or the year after, which is a deferral option. All managers know that there are abandonment options, extension options, contraction options, expansion options and deferral options in every project. Experienced managers have all been in situations where they have taken the net present value numbers and basically thrown them away, because their intuition told them that flexibility will add value to the project. If you frame the issue in that way you therefore begin to realise that net present value is very limited.

If you have only one product and sell to only one or two large customers, you don't need much of a cost system to learn where you are making and losing money. But companies typically have hundreds of different products or product variations and hundreds or thousands of customers. In this situation, traditional cost systems will not accurately trace a company's expense base to each product and customer, leading to a highly distorted view of the company's economic model. Even a simple time-driven ABC model will fundamentally change the way the company manages its process improvements, its product variety, and its individual customer relationships.

When I look at stock options, I am more and more convinced that in a basic sense, the trouble is not whether you expense or not - stock options are just a bad instrument. They're so subject to abuse, you want to get rid of them. There ought to be better ways of compensating people. There are better ways. Because the results are so capricious, so fortuitous, depending upon what the overall market is doing.

Going by the numbers alone can be misleading, meaningless or downright hazardous -there are banana skins galore in financial statements "tidied up" for earnings season. One-time charges, for instance, while properly used to take nonrecurring expenses that do not materially affect company value off the balance sheet, can hide unfavorable expenses, bad debt or poor investments. Easy to calculate, the venerable valuation standard P/E ratio-market value per share divided by EPS-reflects the market's collective opinion regarding the company's growth prospects. The rub, though, is that accounting-based EPS has more malleability than Play-Doh, and factors such as inflation can bend the truth of the P/E ratio. Then there is private equity's darling, EBITDA, fine for comparing profitability between companies and industries but blind to all-important operating cash flow and changes in working capital.

An important and often overlooked aspect of operational excellence is regularly comparing actual costs to budget assumptions - not just the numbers in the plan. Understanding assumption deviations will help improve the accuracy of future forecasting.

They say the four words "This time is different" are the four most dangerous words in finance because usually this time is not different. History does often repeat itself.

Profit is an incomplete measure that ignores capital and is inappropriate for making the many business decisions that trade off between income statement and balance sheet. Tied to incentive compensation, this can lead to dysfunctional behaviour among managers.

We often find that improper costing of fixed costs and capital, such as the cost of capacity, creates misleading signals of performance and value in a business's portfolio. First, traditional costing systems today ignore the cost of capital. Second, the treatment of excess capacity is often incorrectly treated as a unit cost, instead of the period expense that it truly is.

Indirect overhead costs are often capitalized and recorded as inventory, rather than expensed as period costs. The capitalization of overhead costs where there is no cost for capital actually makes these costs "free," and creates a great short-term incentive to overproduce to inventory rather than make to demand. This characteristically leads to month-, quarter- and year-end production spurts, production-planning problems, excess inventory, trade loading, and stale, discounted product pushed onto the customer.

Strategically, intrinsic value is not maximized solely by the maximization of Current Operations Value (COV), but by the simultaneous maximization of the sum of its two components--COV and Future Growth Value (FGV), including the value of real options. Ultimately, this requires business leaders to address, in the context of value-based strategy, both the renewal of future growth value through investments in intangibles and the future, as well as the conversion of opportunities into performance, via execution or operational excellence. The implications for business strategy, financial policy, financial management and compensation are far-reaching.

Traditionally, most companies allocate IT funds based on net present value (NPV) or ROI. The problem with this approach is it naturally favors projects that deliver productivity benefits, even when other projects with less tangible value may be more important to the overall business strategy. Projects with the highest NPV or ROI don't necessarily create the most value. What really matters is whether an investment supports critical business processes and affects key value drivers.

Return on capital measures the productivity of capital investments. How useful is this measure for businesses in which capital investments tend to be small and returns of more than 50 percent are common? For people-intensive businesses, it is more important to know about employee productivity than capital productivity.

The notion that the Federal Reserve and the movement in interest rates will motivate or demotivate the economy is one of the fantasies of economic life...It may have a little effect on the housing industry, but its larger economic effect is one of the great hoaxes and errors of the time. And it only shows how little the financial community has to think about, that they rush recurrently to the interest rate as something that will be important.

ABC/M can't tell you in which direction to point your company, but it can show you where waste exists and where more resources are required. Those facts are the basis for developing strategic plans.