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Featured Events | Sep 19, 2019 |

Mihir Desai Demystifyies the World of Finance

Mihir Desai, the Mizuho Financial Group Professor of Finance at Harvard Business School and a Professor at Harvard Law School, has long inspired his students by demystifying the complex world of finance by blending his business acumen with a sense of wonder. Two years ago, when he spoke at a Gabelli Center event during his first visit to Fordham, Desai regaled his audience with a presentation of his book The Wisdom of Finance.

On September 9, Desai was at McNally Amphitheater to present his latest book to the Gabelli School community.
How Finance Works: The HBR Guide to Thinking Smart About the Numbers uses case studies and storytelling to explore how companies are creating value and explains the relevance of cash flow over accounting profit. He engaged his audience in an interactive session that gave everyone a chance to appreciate how finance helps a corporation to create value in society.

So, why is finance so complicated? The answer, Desai explained, is the same as the answer to why life is so complicated – unequal distribution of information.

This information asymmetry, in turn, leads to agency conflicts. For example, principals (such as shareholders) have to hire agents (such as managers) but cannot guarantee complete compliance because of information asymmetry.

The finance industry is filled with agents of many kinds who are providing a service – analysts, newspapers, rating agencies, and many others who gather, process, and analyze information. This hierarchy of agency relationships creates a complex web of incomplete information.

Desai emphasized how finance differs from accounting. First, finance deals with market values and accounting with historical book values. Also, finance focuses on free-cash-flow, and not on accrual-based accounting income. He traced the evolution of how we describe business, from looking strictly at revenue, then shifting to net income, operating cash flow and finally free cash flow.
“The way we talk about what economic returns are has changed in the last 50 years because finance has become so dominant, and the idea of cash is now really essential,” he said.

The biggest contribution of finance is its link to the corporate strategy question of how to create value. Finance has a simple, yet far-reaching, formula: The return on invested capital must exceed the cost of capital. This simple approach is a cornerstone of value investing, and indeed all investing. It is also a fundamental tenet of capital allocation within a corporation.

Desai started his talk with a question that Bill Ackman asked about GE: Is GE doing a good job of allocating its capital, especially its retained earnings? General Electric can, in fact, be a very efficient company in its operations, but it may lose market value if it is not allocating its surplus cash-flow efficiently.

Although capital allocation remains the dominant frame in business, Desai said that the resulting information that trickles down from decision-makers to individual investors often provides an asymmetrical – and sometimes misleading – view of business strategy.

Desai showed a set of three unlabeled charts reflecting the net income, operating income, and free cash flow of three companies: Amazon, Tesla, and Netflix. He then asked audience members to identify and match the companies with the charts. Interestingly, while net income was rising dramatically in one chart, free-cash-flow for the company was stagnant and dipping. What signals are sent by these data?

Talking through the correct answer, guessed by a sharp business student, Desai elaborated on the business strategies of these three companies. An analysis of the successes and challenges of their recent years revealed that the market has ignored signs of trouble at Netflix and Tesla and failed to understand the improving cash flow generation at Amazon.

“The ideas in the books are really straightforward – the one big one is that we don’t trust accounting; we only believe in cash. The second big one is that value arises because of very specific things. The third one is about how and why financial markets gather information and disseminate it.”

Desai hopes that the next generation of business leaders understands that capital allocation is not the be-all-and-end-all of business strategy. Instead, a multi-dimensional view of business strategy can let us switch between competing narratives and make informed financial decisions.

“Finance is not about money,” he said. “It’s about the deep information and incentive faults in a capitalist economy, at a scale we’ve never seen before. Solving that problem is what finance is all about.”

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