The Power Of ‘What If …?’

fdu’s guest blogger, David Tilston is a Chartered Accountant, a Fellow of The Association of Corporate Treasurers and a member of The Institute for Turnaround. He has held CFO roles in both listed PLC and PE-backed companies and has significant experience of managing turnaround situations.

A number of unrelated experiences have caused me to think about how NEDs address strategy and long term value creation, particularly at a point where we are still working through short term priorities such as the pandemic and lockdowns. I share some thoughts below.

Anticipating Disruption

I recently read a short and interesting book called Anticipating Disruption by Roger Parry. In it Roger talks about his practical experiences as a Chairman of a number of well known listed PLCs. In particular, he contrasts his roles as Chairman of Johnson Press and Future, two UK-based publishing companies, during the 2000s and this comparison is fascinating. These companies have experienced notably divergent performance in a radically changed environment as they grappled with the emerging commercial dynamics arising from the internet.

Johnson Press was originally founded by the Johnson family in the 1700s, ran highly profitable local newspapers and grew rapidly by buying more titles. It made its money from classified advertising, and each paper was essentially a local monopoly. As Roger explains, if you wanted to sell a house in Falkirk you placed an advert in the Falkirk Herald. If you wanted to buy a house in Falkirk you purchased a copy of the Falkirk Herald. In 2004 its papers reached 6 million people weekly. Over time the Board did not foresee, until too late, the implications of the internet age and the rise of Rightmove, Monster (an online recruitment business) and Google who ultimately ate into its advertising revenues. They also did not appreciate the weakness of their customer relationships as relatively few customers had subscriptions and most bought the papers for cash (and hence Johnson Press did not have any information to contact them directly).

Future trod a different path. It had been founded by a San Francisco-based journalist in 1985 who struck gold by launching Business 2.0 which, in 1998, became THE in-house magazine of the growing dot.com boom and sold significant advertising. Future was floated by its private equity owner in London capitalising on the hysteria surrounding the internet economy but its value plummeted post the dot.com crash as advertising revenues dried up. The business stabilised as a publisher of niche titles but recognised that traditional print and retail distribution was one route to market, and one that was in rapid decline. Future consequently experimented with pure online media which appealed to the emerging ranks of digital natives and ended the decade with numerous early stage digital investments.

Johnson Press went into administration in 2018. Future plc now has a market capitalisation of over £2 billion. Both were UK publishing businesses, but they responded to the emergence of the internet in differing ways.

they responded to the emergence of the internet in differing ways

A view of the Future

I also attended a recent webinar led by Howard Covington, Chair of the Alan Turing Institute, who made some fascinating comments around the speed of technology development.

He explained that the concept of having computer programmes structured in a way that could mimic the human brain had been around for many years and had first been posited by Alan Turing in the 1950s. In theory these programmes might be good at pattern recognition, but after an initial burst of optimism such ideas had languished for many years.

In 2010 a competition was run to see how good machine learning algorithms were at recognising pictures (which effectively represented patterns of data). The results were disappointing with a 25% error rate at that time, meaning such programmes were of no great use. The results from a similar exercise in 2012 made data scientists sit up, as the error rate dropped to 15%. By 2015 the error rate was down to 5%, similar to human standards. The conclusion to take from this was that the AI revolution came very slowly, but when it hit an inflexion point AI development was extremely rapid. We should see ongoing rapid development over the next 10 years.

the AI revolution came very slowly, but when it hit an inflexion point AI development was extremely rapid

If one also factors in the impact of Moore’s Law, the observation that the number of transistors on a microchip doubles every two years but with a fall in cost, one can envisage that the trend of more powerful and cheaper processing power being available to drive AI applications is set to continue. Consequently AI algorithms which may not be technically efficient at the moment could be flourishing in two years time given greater processing power.

Shareholder value and timeframes

One way of assessing the value of a business is to discount its projected cashflows. This weights near term cashflows more heavily than those in the distant future which intuitively feels right given the inherent uncertainties involved in long term forecasts.

As a reminder to myself I took a very simplified example of a business and assumed it generated annual post tax cashflows at the end of each year of £1m forever and operated with a post tax cost of capital of 10%. Economic theory suggests the value of this business would be £10m.

Timing aspects inherent within this discounted valuation are however worth noting. Some £0.91m of the value arises in year 1 (ie £1m discounted back by 10% for a year), and £0.83m arises in year 2. The discounted cashflows in the first 5 years of this simplified example account for £3.8m (ie 38% of the overall £10m value) and the cashflows for years 6-10 account for a further £2.4m. Consequently only 62% of the value is derived from cashflows in the first 10 years.

This simplified example of steady cashflow does not represent normal business reality where volatility, growth and contraction may be seen. Most businesses would struggle to confidently forecast out over a period of five years, and the discounted cashflows over that period are unlikely to represent over 50% of the value of the business. We cannot get away from the reality that the value of any business is anchored in its long term cashflow sustainability and hence the Board is forced to take much longer strategic timeframes and variables into its deliberations.

the value of any business is anchored in its long term cashflow sustainability

Conclusion

We have seen above how two publishing companies approached an emerging threat (the power of the internet) with differing results. The speed of technology development and the impact of inflexion points has been illustrated with AI. This article started by explaining that long term sustainable cashflows are important in underpinning business valuations.

NEDs should spend more of their time asking “What if ….?”

Many Boards focus a significant element of their time on operational performance, corporate governance matters and asking the question “Why …?”. As Roger Parry notes in his book, the real challenge is anticipating what might happen in the future and NEDs should spend more of their time asking “What if ….?”