THE STORY
Sudoku is a wildly popular number game throughout the world. It is based on a 9x9 grid. This grid is further sub-divided into 9 3x3 grids. The idea is to fill all 81 squares in the grid with a number from 1 to 9 such that:
a) Every row will have exactly one occurrence of each number from 1 to 9.
b) Every column will have exactly one occurrence of each number from 1 to 9.
c) Each 3x3 grid will have exactly one occurrence of each number from 1 to 9.
Although the origins of the game go back to the 18th century, its recent popularity began back in 1986, when the Nikoli company in Japan started publishing books of the puzzles (they were the first to label the puzzles “Sudoku").
However, the global popularity didn’t begin until Wayne Gould, a retired Hong Kong judge, developed a software program making it easy to develop new Sudoku puzzles. This software started to be used in 2004. Nearly all Sudoku puzzles today are made with Gould’s software.
It is estimated that the size of the global Sudoku business is in the many hundreds of millions of dollars annually. However, neither Nikoli nor Gould see much of that money. Nikoli never bothered to trademark Sudoku outside of Japan, so they only get Japanese royalties. And Gould decided to let others use his software royalty-free (all they had to pay for was the software). It is estimated that of the hundreds and hundreds of millions made on Sudoku, Nikoli only sees about $25 million and Gould only earns about $1 million.
THE ANALOGY
Although Sudoku is a very popular number game, it has not financially benefitted Wayne Gould to anywhere near the extent of its popularity.
In strategic planning, we have a different number game which is also very popular (at least with strategists). It is the discounted cash flow analysis. The object of the game is to estimate future cash flows and then discount them back into today’s value by taking out the annual cost of capital requirements. When you solve this number puzzle, you will supposedly know how much a particular business or strategy is worth in today’s currency.
Companies spend a lot of time and money playing these discounted cash flow number games. However, I am afraid that many of the businesses using this game are like Wayne Gould. They are not reaping rewards anywhere near the size that one would expect.
In fact, I would argue that much of the claimed benefits of discounted cash flow analyses are no longer there. Much of the effort put behind them is wasted effort. You might be just as well ahead if you let your financial analysts play Sudoku as to have them play Discounted Cash Flow.
THE PRINCIPLE
The principle here is that merely solving a discounted cash flow puzzle is not the same thing as developing a sound strategy. And often, solving a discounted cash flow puzzle does not lead to as much insight as one might think. Therefore, you may want to reallocate your resources to solving fewer of these puzzles and more to deeper strategic thinking.
Is Cash Flow As Important As We Think?
Discounted Cash Flow puzzles are based on the assumption that cash flow is the most important determinant of value. And the proponents of using this game can point to historical evidence showing that cash flow has one of the strongest correlations to value. However, I believe that in the future that correlation will significantly weaken. Here is why I think so.
Cash flows measure how a business earns profits through operations. The underlying assumption is that the value of the business is based on how profitable its operations are. In other words, if you assume that business operations are the way money is taken out of a business, then modeling the cash flows of those operations will give you a good idea of what the business is worth to you.
However, it appears more and more that the primary way companies in the future will extract value out of a business will have little to do with operations. Instead, nearly all of the value will be created at the time ownership transfers.
For example, take a look at a lot of the recent activity in the digital space. Companies like You Tube, Alibaba, Webex, Google and Doubleclick created nearly all their value at the time they either sold out or went public. The value created at that instant was far in excess of any type of cash flow profits that they had created in their past or could be expected in their near future. In fact, it is hard to envision how any sort of cash flow could reasonable get to the evaluations firms such as these created at the moment of ownership change.
I think this will get even more distorted when firms like Facebook, Groupon, Zynga, Twitter and others do their change in ownership. You’re already starting to see it with the ownership money already flowing into these firms. The valuations are incredibly high.
If you put these values into a discounted cash flow model and solve for future cash flow, you get numbers which boggle the mind. Sure, I can mathematically make the models work. The models will solve for cash flow. But just because the model can determine what cash flow is needed to make the model work does not mean that those future cash flows are likely to occur.
Flip that Business
In the new reality, if value is made by ownership transfer rather than through operations, perhaps operational cash flow is the wrong place to be looking when trying to determine value.
Keep this in mind. If I know that I am running a business to create value through ownership change rather than through operations, how do you think I am going to run that business? Obviously, I am not going to fixate on operations, but rather fixate on that which influences the transfer of ownership. My definition of customers is no longer the people buying or using my product. No, my customers are now the people I am going to transfer the ownership to.
Think of the people who flip houses. These people find a distressed house, fix it up, and quickly flip it to someone else at a profit. These people have no intention of ever living in these houses. These people to not make investments which are in the best long-term interests of the house. Instead, they focus on superficial cosmetics (how nice the lawn looks—curb appeal) which make the house more appealing to the next buyer. Let the buyer beware!
Many of the businesses of the future will be operated the same way as house flippers. The original owners have no intention of sticking around long term. They are not incented to do what is best for the company long term. Instead, effort will be placed on the superficial cosmetics which increase the appeal to the next owner. Things like how many visits there are to the site (which may be adding no value but be appealing to future owners) will be focused on rather than building a viable long-term business model (the source of cash flows). Let the buyer beware!
Now you might think that future owners would still be fixated on cash flows. They may say so, and they probably should be, but that is not necessarily reality. With all of the well-financed hedge funds and deep-pocket companies out there right now, there is too much money chasing too few great opportunities. As a result, the rules of supply and demand overtake the rules of cash flow. Businesses get bid up beyond appropriate cash flow values due to supply and demand.
In addition, keep in mind that the next owner may not be a final owner, either. They may be purchasing the business in order to quickly flip it to a third buyer. Look how many businesses are taken private (new owner) just so that it can be flipped back public again a few years later (third owner). Therefore, the new owner may be just as disinterested in everyday operations as the old owner.
So What Should We Do?
If this is the case, then what should we do? If you are the owner wanting to flip the business, look for places where supply (companies) and demand (potential new owners) are in your favor. Focus on things which impact desirability at time of sale rather than fixating on cash flows.
If you are the buyer of businesses, spend more time looking beyond the hype to understand the fundamentals. Warren Buffett always puts more value on business fundamentals than on the magic of pushing around numbers in a spreadsheet. If the basic fundamentals of the business are solid and the business model is solid, then good things usually happen (regardless of the numbers).
Unfortunately, the reverse is often not true. You can make a pretty model with nice numbers, but end up with a disaster because the assumptions are not based on solid fundamentals. Without a solid underpinning, a completed cash flow model may not be any more valuable than a completed Sudoku puzzle.
This is not to say that cash flow puzzles should be abandoned. They are still a valuable tool. Think of them as like the speedometer on an automobile. If you glance at them every once in a while, they can be very useful. But if you stare at them constantly (and fail to look out the window), you will end up in a crash. Rather than agonizing over them to the utmost detail, just use them to check for broad reasonableness.
SUMMARY
As value creation shifts more towards ownership transfer and less towards operational cash flows, the value of cash flow tools also diminish a bit. More thought must be given to supplementing such analysis with deeper looks at either the fundamentals of the business model (if a buyer) or the tricks to increasing appeal to a buyer (if a seller).
FINAL THOUGHTS
Sudoku is played by a narrow set of rigid rules. This makes it easy to know if you have won. By contrast, strategy is played using a wide set of vague rules. As a result, in strategy you can solve the puzzle, yet still lose the game. Don’t assume that strategy is a simple as filling out a few spreadsheets.
