Spend enough time in the business world and you will hear the words “value added” or “value creation” thrown around. Everyone tells you they can “add value” or that they want to “create value.” But what is value? How is value created?
At Penn, my derivatives professor taught us that any and all financial products, from the simplest bond or stock to the most complex CDO or CMBS you can imagine, could be broken down into simple blocks/units consisting of some combination of a long position, short position, put, or a call. Let us take this simplification approach and apply it across any business operating in any industry. Real estate. Technology. Manufacturing. Advertising. Medical practices. You name it. They all break down the same way:
- Company A makes product X or provides service X.
- Product X or service X has a total cost of Y.
- Client B wishes to procure product X or service X from Company A.
- Client B provides to Company A goods/capital/services of value Z in exchange for product X or service X.
- If Z > Y, Company A earns a profit. If Z < Y, Company A loses money.
- That’s it.
When is value created? When Z > Y. When is value destroyed? When Z < Y. A company that only loses money and destroys value will eventually run out of money.
But why then do some companies focus only on growth and not profits?
For a high growth company, profits are traded off for growth and market share. But this trade off still occurs with an eye towards the future when at some point value creation will kick in. As Mark Suster says, “This is the trade-off between profits & growth. You can drive profits up by not investing today’s dollars in tomorrow’s growth.”
And why then are there companies that get acquired for their teams or their technology or other “strategic” purposes and not for their profits? In these cases, the acquiring company expects to acquire resources which will add value to their own organization (some companies are better than others at acquiring other companies.)
Real value creation is not easy. The world is overall fairly efficient at pricing goods and services. Competition in most places/industries is high. In the end, you must take input resources (i.e. labor, capital, goods, services) and produce an output with a total cost that is lower than the price which you receive in exchange for providing the output to others. That said, there are always opportunities, inefficiencies, and ways to create value.