MoF Issue 1 Summer 01

McKinsey on Finance

Mastering revenue growth in M&A 1Merging companies too often neglect revenue growth to focus almost exclusively on cost synergies. What do merger masters do differently?

What happened to the bull market? 6Fundamental analysis can explain why the market went upand why it went down again. It also gives us some pretty good clues about what will happen in the future.

Thriving in discontinuity: An excerpt from Creative Destruction 10To sustain high performance over the long term, authors of the best-selling book explain, executives must learn to run companies more like markets.

Valuing dot-coms after the fall 14Last years fall reminds us that stock prices eventually reflect a companys fundamental economic performance. Here are the key questions to ask.

Shed no tears for poolings demise 17 The US Financial Accounting Standards Board has eliminated pooling accounting for business combinations. How can companies make the most of purchase accounting?

Perspectives on Corporate Finance and Strategy

Number 1, Summer 2001

A note from the Editors

McKinsey & Company is an international management consulting firm serving corporate and governmentinstitutions from 84 offices in 43 countries.

Editorial Board: Marc Goedhart, Bill Javetski, Timothy Koller, Michelle Soudier, Dennis SwinfordEditorial contact: [email protected]

Editor: Dennis Swinford Managing Editor: Michelle Soudier

Design and layout: Kim Bartko

2001 McKinsey & Company. All rights reserved.

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No part of this publication may be copied or redistributed in any form without the prior written consent ofMcKinsey & Company

Welcome to the inaugural issue ofMcKinsey on Finance, a newsletter forcorporate leaders written by experts andpractitioners in McKinsey & CompanysCorporate Finance & Strategy Practice.

Each quarter, McKinsey on Finance will aimto provide insights into strategies that createvalue and ways to translate those strategiesinto stock market performance. Our subjectmatter and scope will be broad. Some articleswill cover creating value through transactions,including mergers, acquisitions, alliances,IPOs, equity carve-outs, and spin-offs. Otherswill address issues such as investor communi-cations, capital structure, risk management,and approaches to managing performance.Periodically we will also provide perspectiveson valuation and stock market events.

The insights you will find in McKinsey onFinance will be grounded in our finance andstrategy consultants direct experienceworking with clients around the world andfrom their ongoing research. We believe thatthis combination produces unique perspectivesthat you will find valuable.

We welcome your input. As a leader of yourorganization, you have an opportunity to helpus shape our research agenda by commentingon our current articles or by suggesting othertopics that would be worthwhile exploring.You can reach us at [email protected].

We are confident that you will find McKinseyon Finance useful and thought-provokingreading.

Mastering revenue growth in M&A | 1

Mastering revenue growth in M&AMergers seldom live up to expectations. Research from a recentMcKinsey study suggests why: companies too often neglect revenuegrowth to focus almost exclusively on cost synergies.

Matthias M. Bekier, Anna J. Bogardus, and Timothy Oldham

Making a merger work is an acid testfor any executive team. Study afterstudy has shown that up to 80 percent ofM&A deals completed during the 1990s failed to justify the equity that funded them.1

Research from a recent McKinsey studysuggests that a key problem is the tendency for integrating companies to pay too littleattention to revenue growth and to focusalmost exclusively on cost synergies. As oneintegration manager put it, the CEO told meto put a knife between my teeth, dive down,slash deep, and not come up until it was done.

And while growth may be a stated objective in three out of four mergers,2 a study of193 transactions between 1990 and 1997worth at least $100 million found that only36 percent even maintained revenue growththrough the first quarter after announce-ment.3 By the third quarter, 89 percent hadsuccumbed to a slowdown, with a medianrevenue decline of 12 percent. Underperfor-mance of target companies with a history ofgrowth rates lower than their industry peersexplained only half the post announcementresult. Unsettled customers and declining staffproductivity explained the rest.

In the end, flat or declining revenues may hurta companys market performance far morethan a failure to nail costs. If balance is to be

restored, the merger approaches of companiesthat maintain or accelerate revenue growthcan be a useful starting point.

Identifying merger masters

To understand the impact of mergers onrevenue growth, McKinsey researchersexamined 160 mergers worth $100 million or more between 1995 and 1996 across11 industry sectors, plus another 25 of the100 biggest mergers between 1995 and 1999.The sample was then screened down to 80companies where it was reasonably possible toisolate the growth attributable to acquisitionsbetween 1995 and 1996. Of these, only sevencompanies were able to accelerate revenuegrowth over the following three years anddeliver strong total returns to shareholders(TRS) (Exhibit 1).

In fact, most sloths remained sloths, while most solid performers slowed down.Overall, acquirers posted organic growth rates 4 percent below their industry peers,with 42 percent of acquirers losing ground.These results were evident across a range ofcircumstances, including some commonlybelieved to enhance the probability of asuccessful merger. Mergers in fast growingsectors were as susceptible as any, smalleracquisitions were not significantly moresuccessful than larger ones, and experienced

2 | McKinsey on Finance Summer 2001

acquirers did not demonstrate better successthan novices.

Maintaining or improving revenue growth in a merger is by no means easy. And whilerevenue growth is not the only factor formerger successsome companies may achievehigh postmerger TRS through such means asasset rationalization or cost reductionitclearly matters. Declining revenues are a redflag to skeptical markets ready to question theprice paid for an acquired company. Moreover,revenue growth is a powerful tool to offsetcost savings shortfalls for the 20 to 40 percentof companies that fail to realize the synergies

they identify premerger. Finally, growthcreates positive dynamics both internally andexternally that can help retain customers and talented staff.

The seven companies that emerged during ourresearch generated impressive revenue growthand created shareholder value following theirmergers. These Merger Masters grewrevenues an average of 40 percent faster peryear than industry peers, driving annualshareholder returns an average of 22 percenthigher than the S&P 500 between 1995 and2000 (Exhibit 2). While these companies camefrom a variety of industries and had very

AEC: Oil and gas

1 Arrow grew revenue 2.4 standard deviations faster than their industry.

Arrow Electronics: Electronic componentsdistribution

HighTechCo: Technology/network components

HealthCo: Health care/medical devices

EnergyCo.: Oil and gas

ClearChannel: Consumer staples/outdoor advertising

Tyco: Capital goods electronics, healthcare, fire safety and flow control

1.9

1.3

Revenue$billions 2000Company and industry

Major mergersNumber19951999

18.9

2.7

5.0

28.9

8.6

Revenue growthPercent annualizedrelative to industry19961999

TRSPercent annualized19952000

3

10

80

8

2

9

4

45

31

34

87

17

63

33

26

56

34

35

48

25

18S&P 500

62

Source: Datastream; Hoovers; Analysts; McKinsey analysis.

2 While Arrows 1995 to 2000 TRS did not exceed the S&P 500, we include it here because during that period

Arrows TRS increased by 6 percent per year while its competitors TRS decreased on average by 2 percent per year.

Exhibit 1. Merger master profiles


different merger experiences, we foundthrough interviews with them that they allmade conscious decisions to ensure futurerevenue growth. Furthermore, they did notcompromise long-term value creation for thesake of short-term cost savings.

While their specific approaches to executingmergers vary, the common pattern amongthese top performers was to naturally empha-size four different priorities in executingpostmerger management.

Planning for growth early in themerger process

Performance following the announcement of a merger can decline quickly, even beforechanges to finalize the integration are made,as the uncertainty that accompanies allmergers damages momentum.

One trait we witnessed in most of themasters was a bias for planning their moveswell in advance. Before a merger announce-ment they systematically analyze all possiblesources of cost and revenue opportunities andrisksincluding the impact of planned costreductions on revenue aspirations. Such fore-casting produces a payback during integrationby easing the difficulty of making decisions onsequencing and providing resources for costand growth initiatives, rather than focusingsolely on cost.

Regulatory constraints do not make such earlyanalyses easy. Some companies do everythingpossible to speed up the process. Several useclean teamstrusted third parties who willnot pass sensitive information if the mergerdoes not proceedto start identifying costsynergies and revenue opportunities as early as possible.

Protecting existing revenues firstThe uncertainty that sweeps in with a mergerannouncement brings risks to revenues. Seniorstaff are distracted, and with good reason: onaverage 50 to 65 percent of target companysenior executives are replaced.4 Substantialfrontline changes can also occur. Headhunterstypically target key employees within 5 days of announcement.5 And customers beginwondering if service levels will decline, oftenseeking alternative suppliers to mitigate supplyrisk. The results can be disastrous. Analystsestimate that US banks lost an average of5 to 10 percent of their customers following1990s mergers.6 But our research turned up several strong performers that made apriority of securing relationships with keycustomers and staff, and by extension, thoseexisting revenues.

The stakes are high. Employees who owncustomer relationships or who are key todelivering the service can take their eye offthe ball. Tyco CEO Dennis Kozlowskiobserves, People are normally productive forabout 5.7 hours in an 8-hour business day . . .

Merger masters

1 Revenue information for 73 companies, TRS information for 48 companies in sample

2 Equal weighted averages

40

1Remainingsample1

Average2 revenue growthPercent annualized relativeto industry 19961999

Average2 TRSPercent annualized19952000

40

2

S&P 50018

Exhibit 2. Merger master performance

any time a change of control [such as amerger] takes place, their productivity falls to less than an hour.7

Customers may also defect if they sense thatthe merger will constrain their bargainingpower, change their security of supply, reduce service levels, or even cause a loss ofkey relationships. We found that to addressthese risks the merger masters start withstrong communication. They create a streamof communications to ensure customers knowexactly how the merger will affect them. Sales representatives for Arrow Electronics,for example, hand-deliver letters to allcustomers outlining the merger process and its eventual benefits.

We found several CEOs who invest consider-able time personally visiting key customers.Others ensure that the target customersreceive tangible benefits immediately after the merger is consummated in order to retainthem. One oil and gas pipeline operator, forexample, ensures that the customers of amerger target are given access to itsproprietary product management software at little or no cost, enabling them to quicklyidentify ways to save money.

Explicitly balancing cost and revenues

In most mergers, quickly cutting costs makessense. Cost savings, which may be necessaryto enable growth, are the easiest opportunitiesto quantify, and their variables are all internal.And markets frequently demand rapid savings.However, cost savings have a habit of neverquite making it to the bottom line. Up to 40 percent of mergers fail to capture theiridentified cost synergies.8 The danger is thatcutting too deeply can depress future earnings:

In the rush to save costs, [one US bank] . . .really hurt revenue growth . . . they didnt justtake out the fat, they took out muscle.9

Paradoxically, revenues actually hit the bottomline harder, since fluctuations in revenue canquickly outweigh planned cost savings.

Understanding the opportunities a mergercreates and deciding where to focus integra-tion team efforts are critical in balancing costand revenue targets. The most effective mergerplayers make careful decisions about whetherto attack revenue or cost synergiesor both.Some even launch separate revenue and costteams. At Arrow, for example, the focusduring integration is on revenue because CEOSteve Kaufman believes you only get onechance at revenue, but you can always haveanother go at cost.

In contrast, Alberta Energy focuses almost entirely on cost, deliberately buyingunderperforming assets where the existingperformance culture cannot be relied on todeliver cost savings. At the same time, thecompany ensures growth by buying only thoseoil and gas production assets that complementtheir existing distribution assets, thus quicklyand inexpensively exposing those newlyacquired assets to a wider distributionnetwork.

Instilling a performance culturegeared for growth

Focusing on growth in a merger can help acompany build a positive internal dynamicthat makes it easier to achieve other mergerobjectives, including cost reductions. Why? A focus on growth is a far more attractiveproposition and more powerful motivator forkey talent on both sides of a merger. The



merger masters we encountered nurture theautonomy of high-performing entrepreneurialteams and set aggressive targets and generousincentives.10 They typically commit to growthtargets early, often during the deal stage. Oneresult: responsibility for achieving growthmoves from the deal team to the integrationteam to the line as soon as possible. Even inmergers where cost reductions are a priority,incentives are structured to require somegrowth or, at a minimum, to prevent managersfrom jeopardizing future growth. ArrowElectronics, for example, found that setting upa competition between the sales force of atarget company and Arrows own reps toclaim top dog honors at a mergers closeboosted sales growth in the first quarter afterthe merger announcement.

Similarly, Tyco business unit managers haveaggressive EBIT targets that require bothacquisition and organic revenue growth. This drives managers to find deals. To obtaincapital approval, managers must commit toadditional specific targets for each deal.Performance bonuses are uncapped forexceeding EBIT targets and are reduced when targets are not met. As a result, ease ofintegration becomes a criterion for evaluatingdeals, those executives leading the integrationeffort are in closer touch with the sources ofvalue from the start, and growth is high onthe merger agenda.

Companies that pay closer attention torevenues instead of focusing exclusively oncost cutting are likely to boost their chancesof pulling off successful mergers. Practitionersthat grow revenues and deliver on TRS stickto a few basic principles. They plan early forgrowth, protect existing revenues, balancerevenues and costs, and creating a growth

performance culture. Companies that employthese steps can build a reputation that fostersloyalty, tolerance for short-term disruptions,and faith in long-term outcomes among targetemployees, customers, and the financialmarkets.

The authors wish to thank Andrew Sypkes, whose

research contributed to the development of this

article. Acknowledgments also to Randolph P. Beatty,

Hemang Desai, and Steven L. Henning, Southern

Methodist University, Dallas, Texas.

Matthias Bekier ([email protected]) is

a principal in McKinseys Sydney office and Anna

Bogardus ([email protected]) and

Timothy Oldham ([email protected])

are consultants in the Melbourne office. Copyright

2001 McKinsey & Company. All rights reserved.

1 McKinsey & Company, 2000; Ernst & Young, 1999; ATKearney, 1998; Mercer, 1996; Coopers & Lybrand, 1996;Mitchell Maddison, 1996. Failure was defined variously asno net growth or share performance below the industryaverage, and was assessed over time frames between anannouncement window of 3 to 5 days to up to 2 yearspostdeal.

2 The Conference Board, New York, 2000; McKinsey analysis.

3 Randolph P. Beatty, Hemang Desai, and Steven L Henning,The importance of corporate control mechanisms in take-over execution, Southern Methodist University(unpublished), 2000.

4 Randolph P. Beatty, Hemang Desai, and Steven L Henning,The importance of corporate control mechanisms in take-over execution, Southern Methodist University(unpublished), 2000.

5 Ira T. Kay and Mike Shelton, The people problem inmergers, McKinsey Quarterly, 2000, Number 4, pp. 2637.

6 Rodgin, Cohen, Sullivan & Cromwell. US bank mergers: whencutting costs is not enough, Euromoney, November 1999.

7 A CEO roundtable on making mergers succeed, HarvardBusiness Review MayJune 2000, p. 145.

8 Haarman Hammered Management Consultants, Stahl undReisen, 119 Number 8, p. 131.

9 Rodgin, Cohen, Sullivan & Cromwell. US bank mergers: whencutting costs is not enough, Euromoney, November 1999.

10 Ira T. Kay and Mike Shelton, The people problem inmergers, McKinsey Quarterly, 2000, Number 4, pp. 2637.

MoF

By the time the NASDAQ index reachedits peak in the recent bull market, manyfinancial commentators had begun to acceptthe idea that stock market valuations were nolonger driven solely by the traditional economicfactors of earnings growth, inflation, andinterest rates. Instead, they suggested, newfactors like structural changes in the economy,new rules of economics, and the value ofintangible assets justified the lofty stock prices.Today the fundamental question remains: hasthe market changed what it factors into sharevalues? Using a simple model based on changesin earnings, inflation, and interest rates, wefound that these traditional factors aloneexplain most of the medium- and long-termmovement in S&P index of 500 stocks over thelast 40 years. We uncovered scant evidence thatthe market had changed what it consistentlyfactors into stock prices.

Clearly the market can deviate fromfundamental values; a strong case can be made that the performance of Internet andhigh-technology stocks during the second halfof the 1990s added up to a bubble. But suchdeviations tend to be short-lived. The economyand the market are closely connected, makingthe markets long-term aggregate performancequite predictable. Given that connection, we can be confident that real long-term returns from stocks will not exceed about7 percent a year.

The record, clarifiedWhat happened to the bull market? When weexamined the performance of the S&P 500, we discovered that the bulk of the indexs risefrom 1980 through May 2001 resulted fromthe natural and expected growth of themarket; only a small portion could be assignedto the amazing run-up in the Internet and high-tech sectors, which some investors came tobelieve had rewritten classical theories of howmarkets behave. Yet the plunge in the prices ofa few megacapitalization stocks did play amajor role in driving the markets down.

Between January 1, 1980 and December 31,1999, the S&P 500 rose to 1,469 from 108,representing a compound annual growth rateof almost 14 percent (excluding dividends). Inthe 17 months that followed the S&P 500 fellto 1,256.

We identified three factors responsible foralmost all of the change in the index. The first two, growth in earnings and changes ininterest rates and inflation, are precisely thefactors that would traditionally have beenexpected to drive share prices. The third is thetemporary and somewhat irrational emergenceof megacapitalization stocks.1 Together, thesethree factors account for over 80 percent ofthe run-up in stocks from 1980 to 1999(Exhibit 1). The retreat in the values of mega-cap stocks accounts for 50 percent of the

What happened to the bull market?Fundamental analysis can explain why the market went upand why itwent down again. It also gives us some pretty good clues about what willhappen in the future.

Timothy M. Koller and Zane D. Williams


What happened to the bull market? | 7

decline in the market from January 2000through May 2001.

Earnings growth per share for the S&P 500rose from $15 in 1980 to $56 in 1999. If theforward price-to-earnings ratio2 had remainedconstant, earnings growth alone would haveboosted the index by 302 points. This annualgrowth in earnings of 6.9 percent (3.2 percentin real terms) is not exceptional, since thenominal US gross domestic product grew by6.6 percent over the same period. As a result,corporate profits remained a relativelyconstant share of overall GDP.

Simultaneously, US interest rates were fallingdramatically, as was inflation. Long-term US government bond yields peaked at nearly15 percent in 1981 and then fell, more or lesssteadily, to 5.7 percent by 1999. Fallinginterest rates reduced the cost of capital forcorporations, enabling them to earn a largerpremium for their shareholders.

To quantify the impact on valuations offalling interest rates and expected inflation, we built a simple model shaped by currentearnings, inflation, interest rates, long-termearnings growth, and returns on equity. Themodel showed that falling interest rates andinflation accounted for an increase in theS&Ps forward P/E ratio of nearly 8 points,corresponding to a 440-point increase in theindex. Combined, the increase in earnings andthe decline in inflation and interest ratesaccounted for 742 points (or 55 percent) ofthe increase in the S&P 500.3

The megacapitalization boost and bust

Much of the remaining increase can beexplained by the uneven distribution of value

within the index .4 Between 1997 and 1999,5 ahandful of companies, including Cisco, EMC,and GE, attained huge market capitalizationsas well as very high P/E ratios. By 1999, theP/E of the 30 largest companies was doublethat of the other 470 (Exhibit 2). Such adivergence was new: in 1980 and 1990 theaverage P/E ratio of the largest 30 stocks inthe index (measured by market capitalization)was close to that of the other 470 companiesand of the index as a whole. In fact, theoutsized gains of the largest stocks from 1997to 1999 had no precedent in the previous 40years. The forward P/E ratio increase resultingfrom the emergence of this gap accounted foran additional 376 points of the increase in theS&P 500 from 1980 to 1999.

Taken together, earnings growth, inflation andinterest rates, and the megacapitalizationphenomenon explain more than 80 percent of

S&P 500(Dec. 31,

1979)

S&P 500(Dec. 31,

1999)

Increasein earnings

Decrease in interestrates andinflation

Other

108

Growth inmegacapstocks1

302

440

376

243

1,469

82% ofincrease

1 Measured as change in spread between average and median.

Exhibit 1. Back to basics: Fundamental forces spur bullmarket

Change in S&P 500 index, Dec. 19791999

the 1,361-point increase in the S&P 500 from1980 to 1999. The rest of the change reflects acombination of other factors, such as theimpact of the bubble on the index as a whole,the simplicity of our model, and the impreci-sion with which variables such as earnings aremeasured. Whatever the source of this residual,it largely vanished between 1999 and 2001.

The same factors explain the drop in the S&Psince the end of 1999 (Exhibit 3). While anincrease of more than $1 in earnings per shareboosted the index level by 34 points, otherfactors produced a net decline.6 The impact ofa small increase in long-term interest rates andinflation was minor. However, the closing ofthe gap between megacap stocks and the restof the index caused the index as a whole tolose 106 points.

Fundamental economic forces driveshare prices

Our conclusions about market behavior,derived from analysis extending the periodfrom 1962 to the present, apply to intervals asshort as 3 to 5 years and as long as 40 years.Whatever the duration, the primary factors

driving the aggregate market are earnings,inflation, and interest rates, just as economictheory suggests. (Notwithstanding economictheory, the market isnt driven by returns oncapital, since in aggregate they are remarkablystable.) It is reassuring that the marketactually works the way theory predicts it will.

Even so, the market does sometimes deviatefrom fundamental values; the behavior ofInternet and high-tech stocks over the pastseveral years makes it hard to argue otherwise.A strong case can be made these stocks did gothrough an upward deviation, or bubble.Academic researchers continue to identify suchdeviations, though we cannot yet predict whenthey will begin or endor even know withcertainty when we are in the middle of one.Fortunately, in the United States thesedeviations have tended to be concentrated in a small number of stocks. By contrast, the


1 As measured by market capitalization.

30 largestcompanies

1980 1990 1999

Remainingcompanies

S&P 500overall

9

9

9

15

14

15

46

23

30

Exhibit 2. The megacap gap

Average price-to-earnings ratios of S&P 500 companies by size1

1 Measured as change in spread between average and median.

S&P 500(Dec. 31,

1999)

S&P 500(May 31,

2001)

Increasein earnings

Increasein interestrates andinflation

OtherDecline of gap between

megacapstocks and

rest of index1

1,469 34 24106

117 1,256

~50% ofdecrease

Exhibit 3. The gap closes

Change in S&P 500 index, Dec. 1999May 2001

What happened to the bull market? | 9

behavior of the typical, or median, company isremarkably true to theory.

Predicting the future, broadly

If the past can be explained relatively easily,forecasting the future shouldnt be extremelydifficultat least within broad bands.Although our analysis says nothing aboutshort-term fluctuations, it can explain longer-term movements.

In light of past performance, the most onemight expect from investing in stocks is areturn of about 7 percent a year in real terms.Why? In the aggregate, future returns fromstocks will be driven by earnings growth,changes in P/E ratios, and dividends. We haveobserved that US corporate profits haveremained a relatively constant 5.5 percent ofUS GDP over the past 50 years. Assuming thataggregate earnings increase along with GDP,history suggests that real corporate earningswill grow at a rate of 3 to 4 percent a year.

If long-term interest rates dont drop further,aggregate P/E ratios are about as high as theycan be. Currently, expected inflation andinterest rates are quite low; in fact, long-termrates havent been so low since the late 1960s,when, not coincidentally, P/E ratios wereabout the same as they are today. Assuming,optimistically, that P/E ratios remain constantand that earnings grow by 3 to 4 percent ayear in real terms, stock prices alone shouldalso increase by 3 to 4 percent per year.

The current dividend yield of roughly1.5 percent and annual share repurchases of 1.5 percent7 of outstanding shares generatean additional 3 percent of the return onstocks, for a total expected real return of 6 to7 percent. Once again, this finding is in line

with history. Jeremy Siegel, of the Universityof Pennsylvanias Wharton School of Finance,has shown that the long-term real return onstocks during the past 200 years has averagedabout 6.7 percent a year.

Stocks could exceed a real return of about7 percent only if the GDP were to growsignificantly faster than it has in the past or ifthe real cost of capital for companies were todecline. McKinsey research has found that thereal cost of capital has been stable over thepast 40 years. Real GDP growth has averaged3.5 percent over the past 70 years or so andhas been nearly 3.3 percent for the past 20. If economic growth slows significantly or ifinflation and interest rates rise, returns fromstocks could trend lower.

Tim Koller ([email protected]) is a principal

and Zane Williams (Zane_Williams @McKinsey.com)

is a consultant in McKinseys New York office.

Copyright 2001 McKinsey & Company. All rights

reserved.

1 The impact of the return on capital was not included. Returnson capital are remarkably stable and have little impact onaggregate performance.

2 The current share price divided by the forecast earnings pershare for the following 12 months.

3 The impact of falling inflation and interest rates alreadyreflects the multiplier effect of combining them. The impactof lower interest expenses was excluded, because the impactis not material.

4 Because the S&P 500 is a value-weighted index, the largestcompanies have a disproportionate impact.

5 To estimate the impact, we multiplied the indexs earningsper share by the spread between the indexs value-weightedP/E and the P/E of the median company.

6 The size of the other category reflects the fact that ourapproach works best over longer time spans.

7 See G. Grullon and R. Michaely, Dividends, sharerepurchases, and the substitution hypothesis, atwww.ssrn.com.

MoF

In 1917, B. C. Forbes formed his first listof the one hundred largest Americancompaniesranked by assets, since sales datawere not accurately compiled in those days. In1987, Forbes republished its original Forbes100 list and compared it to its 1917 list oftop companies. Of the original group, 61 hadceased to exist.

Of the remaining 39, 18 had managed to stayin the top one hundred. These 18 companiesincluding Kodak, DuPont, General Electric,Ford, General Motors, Procter & Gamble, and a dozen othershad clearly earned thenations respect. Skilled in the art of survival,these enterprises had weathered the GreatDepression, World War II, the Korean conflict,the roaring 60s, the oil and inflation shocksof the 70s, and unprecedented technologicalchange in the chemicals, pharmaceuticals,computers, software, radio and television, and global telecommunications industries.

They survived. But they did not perform.Collectively, these great companies earned along-term return for their investors during the

1917 to 1987 period 20 percent less than thatof the overall market. Only one, GeneralElectric, performed better than the averages.

An examination of the Standard & Poors 500index supports the same conclusion. Of the500 companies in the original index in 1957,only 74 remained through 1997. If todaysS&P 500 were made up of only those 74companies, the overall performance of theindex would have been about 20 percent lessper year than it actually has been. Of those74, only 12 outperformed the S&P 500 itselfover the 1957 to 1998 period.

For decades we have celebrated the big cor-porate survivors, praising their excellenceand their ability to last. These bedrockcompanies of the American economy are theones that patient investors pour money into,investments that would certainly reward richlyat the end of a lifetime. But our findingsbased on the 38 years of data compiled in theMcKinsey Corporate Performance Databasehave shown that they do not perform as wemight suspect. Investors patiently investing

Thriving in discontinuity: An excerpt fromCreative DestructionWhy, with the sole exception of General Electric, have even the best-runand most widely admired companies been unable to sustain their market-beating performance over the long term? Drawing on McKinsey analysis ofthe performance of more than 1,000 corporations in 15 industries over a36-year period, the authors of the best-selling book explore the imperativethat to survive, executives must learn to run companies more like markets.Excerpted from Creative Destruction, Doubleday, April 2001.

Richard N. Foster and Sarah Kaplan


Thriving in discontinuity: An excerpt from Creative Destruction | 11

money in these survivors will do substantiallyless well than an investor who merely investsin market index funds.

The gales of creative destruction

Managing for survival, even among the bestand most revered corporations, does notguarantee strong long-term performance forshareholders. In fact, just the opposite is true.In the long run, markets always win.

How could stock market indexes like the Dow Jones industrials or the S&P 500which, unlike companies, lack skilledmanagers, boards of experienced directors,carefully crafted organizational structures, the most advanced management methods,privileged assets, and special relationshipswith anyone of their choosingperformbetter over the long haul than all but one ofForbess strongest survivors? Are the capitalmarkets, as represented by the stock marketaverages, wiser than managers who thinkabout performance all the time?

The answer is that the capital markets and the indexes that reflect them encouragethe creation of corporations, permit theirefficient operations (as long as they remaincompetitive), and then rapidly andremorselessly remove them when they nolonger perform. Capital markets are built onthe assumption of discontinuity; their focus ison creation and destruction. The marketencourages rapid and extensive creation, andhence greater wealth building. It is lesstolerant than corporations of long-termunderperformance.

In contrast, corporations operate withmanagement philosophies based on theassumption of continuity and a focus on

operations and are unable to change at thepace and scale of the markets. As a result, inthe long term, they do not create value at thepace and scale of the markets. Outstandingcorporations do win the right to survive, butnot the ability to earn above-average or evenaverage shareholder returns over the longterm. Corporations that lose their ability tomeet investor expectations (no matter howunreasonable these expectations might be)consume the wealth of the economy. Thecapital markets remove these weakerperformers at a greater rate than even thebest-performing companies.

Joseph Alois Schumpeter, the great Austrian-American economist of the 1930s and 40s,called this process of creation and removalthe gales of creative destruction. Theessential difference between corporations and capital markets is in the way they enable,manage, and control the processes of creativedestruction.

Origins of modern managerial philosophy

The distinction between corporations andcapital markets is not an artifact of our timesor an outgrowth of the dot-com generation.The market turmoil we see today is a logicalextension of trends that go back centuries.The origins of modern managerial philosophycan be traced to the 18th century, when Adam Smith argued for specialization of tasksand division of labor in order to cut waste. By the late 19th century, these ideas hadculminated in an age of American trusts,European holding companies, and Japanesezaibatsus. These complex giants were designed to convert natural resources intofood, energy, clothing, and shelter in the most asset-efficient way.

By the 1920s, Smiths ideas had enabled hugecorporations to flourish, exploiting thepotential of mass production. Peter Druckersseminal guidebook, The Concept of theCorporation (1946), laid out the precepts ofcontemporary 1920s corporations, based onthe specialization of labor, mass production,and the efficient use of physical assets.

Change came slowly in the 20s, when the firstS&P index of 90 important US companies was formed. In the 20s and 30s the turnoverrate in the S&P 90 averaged about 1.5 percentper year. The average new member of the S&P 90 could expect to remain on the list for more than 65 years. Companies built onthe assumption of perpetual continuity werein business to transform raw materials intofinal products and to avoid the high costs ofinteraction between independent companies in the marketplace. This required them tooperate at great scale and to control theircosts carefully. These vertically integratedconfigurations were protected from all butincremental change.

But the 70-year period of corporatedevelopment that began in the 1920s has cometo an end. By 1998 the turnover rate in theS&P 500 was close to 10 percent, implying anaverage lifetime on the list of 10 years, not 65.While some may discount a single yearsperformance as an aberration, we predict thatit is not, and that by 2020, a 10-year averagelifetime of a corporation on the S&P will bethe rule rather than the exception.

The age of discontinuity

A wave of change is under way that began inthe 1980s when the S&P began substitutingnew high-growth and high market-capcompanies for slower-growing and even

shrinking-market-cap older companies. When the markets collapsed in the late 80sand a short-lived recession hit the Americaneconomy in the early 90s, the rate of sub-stitution in the S&P 500 fell. But even at itslowest point, the rate of turnover was higherthan it had been during a decline in the 1970s.The minimum level of change in the economyhad been quietly building and was increasingagain. This was even more evident as thetechnology-charged 1990s kicked into gear,accelerating the rate of the S&P indexturnover to levels never seen before. By theend of the 1990s, we were well into whatPeter Drucker calls the Age of Discontinuity.

Incumbent companies have an unprecedentedopportunity to take advantage of these times.But if history is a guide, no more than a thirdof todays major corporations will survive overthe next 25 years. To be blunt, most of thesecompanies will die or be bought out andabsorbed because they are too slow to keeppace with change in the market. By 2020,more than 75 percent of the S&P 500 willconsist of companies we dont know todaynew companies drawn into the maelstrom ofeconomic activity from the periphery,springing from insights unrecognized today.

Becoming masters of creative destruction

Corporations have to become masters ofcreative destructionbuilt for discontinuity,remade like the market. They must increase the pace of change to levels comparable withthe market. Reorganizing the corporation toevolve quickly rather than simply operate wellrequires more than simple adjustments(Exhibit). The fundamental concepts ofoperational excellence are inappropriate for acorporation seeking to evolve at the pace and


Thriving in discontinuity: An excerpt from Creative Destruction | 13

scale of the markets. One cannot just add oncreation and destruction; one has to designthem in. Corporations must be redesigned from top to bottom based on the assumption of discontinuity. Management must stimulatethe rate of creative destruction through thegeneration and acquisition of new firms andthe elimination of marginal performerswithout losing control of operations. Ifoperations are healthy, the rate of creativedestruction within the corporation willdetermine the continued long-termcompetitiveness and performance of thecompany.

The increasing pace of change in the marketsrequires a new operating model, one that

encompasses both creating and trading.Certainly, there are variations of ownershipstructures, as exemplified by private equityfirms, that have demonstrated an improvedability to change at the pace and scale of themarket, and that have sustained superiorreturns for doing so over the past 20 years.Private equity firms embrace the create,operate, trade model, as does GeneralElectric. Regardless of the type of company,mastering creative destruction will be aprerequisite for strong, sustained performance.And, as weve seen, there are already too fewexamples to look to.

Richard Foster ([email protected]) is a

director in, and Sarah Kaplan is an alumnus of,

McKinseys New York office. Copyright 2001

McKinsey & Company. All rights reserved.

MoF

Creating: Companies must regularly and systematically

create sustainable new businesses. They must find and

nurture businesses internally and also look to the market

periphery for smaller companies to acquire.

Destroying: Companies must learn to exit a business before

it peaks in growthnot after it turns downward. Exiting

includes trading to other companies that can propel a

business to new levels. Planning should start in the

earliest stages of a new business proposal with the

questions of Who will buy this business? How much will

they pay? and, When will they buy it?

Managing risk, not eliminating it: Everyone knows the old

parable, no risk, no reward but few internalize it. Too often

corporate strategy planning takes on the role of eliminating

risk rather than managing the appropriate level of risk.

Controlling what you must, not what you can: Companies in

the midst of rapid change lose control when complexity or

operations increase too fast. At the same time, tightly

controlled companies can squelch the innovation necessary

to remain ahead of the curve.

Deploying talent: Many companies deploy their best people

against their largest cash businesses. Instead, deploy the

best talent against the future of the organization, not the

past.

Forcing radical decentralization: Most corporations adopt

the spirit of decentralization, but corporate expenses,

assets, and liabilities are still centralized. Contrast that

with the capital markets, where all financial elements are

decentralized.

Refocusing top management: Top managers spend much of

their time on operations. Instead, they should spend the

majority of their time managing the cycle of entry and exit,

leaving day-to-day operations to trusted managers.

Exhibit. Seven key elements of changing at the pace and scale of markets1

1 Exhibit was synthesized from Creative Destruction and other materials by the authors.

It was inevitable. Last years decline in the NASDAQ composite index brought asudden halt to a headysome would sayrecklesstime for investors and acquisition-minded companies, particularly those focusedon anything and everything connected withthe Internet. Predictably, this slump has nowsent the pendulum swinging in the otherdirection; many investors are staying awayfrom the sector entirely, and established brick-and-mortar companies are scaling back theiron-line initiatives. The survival of even leading Internet firms is being questioned.

The Internet roller coaster may rank as themarkets most dramatic upheaval over the past 20 years,1 but it certainly hasnt been the only one. Remember biotech? Realestate? Leveraged buyouts? What about JapanIncorporated? Each fad was accompanied bythe conviction among market bulls thatsomehow, this time, classical notions of valuecreation, such as approaches that emphasized a companys cash flow, were hopelessly out oftouch with the new vision of investing. In fact,investment values always eventually revert to afundamental level based on cash flows.

Although investors and companies can nolonger throw money at every dot-com idea,they shouldnt abandon the Internet. As they ponder the reality of a greatly reducedNASDAQ, they should cast a gimlet eye on

the real sources of the sectors value. Such ananalysis, together with an understanding ofthe basic principles of value creation, willgenerate new insights into the potential valueof Internet opportunities.

Cash flow is king

In an earlier article on valuing dot-coms,several colleagues and I argued that solidinvestment analysis has never really beenabout shorthand metrics such as price-to-earnings multiples or multiples of revenue ortraffic.2 These approaches, in vogue during theInternet boom, do not consider a companysparticular characteristics, nor do they accountfor the way investments in intangible assets(such as the cost of acquiring customers) flowthrough the income statement rather than thebalance sheet.

Our approach involved applying a long-term discounted cash flow (DCF) analysissupplemented by three twists. First, instead of starting with the current level ofperformancethe usual practice in DCFvaluationsstart by thinking about what theindustry and the company would look like in a state of sustainable, moderate growth, andthen work that estimate back to currentperformance. For Internet businesses, thisplateau of economic stability is probably atleast a decade away.

Valuing dot-coms after the fallLast years fall reminds us that stock prices eventually reflect acompanys fundamental economic performance. Here are the keyquestions to ask.

Timothy M. Koller


Valuing dot-coms after the fall | 15

Second, instead of a single forecast, useprobability-weighted scenarios of futureperformancean approach that can helphighlight the inherent uncertainty in valuinghigh-growth technology companies. Thesescenarios should include extreme outcomes,such as very high returns and, conversely,bankruptcy. Finally, use tools such as customervalue analysis to understand more fully howvalue is actually created.

Spotting the value creators

The development of a fundamental economicperspective for analyzing companies with noprofits and negative cash flows must beginwith a focus on the way companies createvalue. The ultimate drivers of value creationare the potential revenue of a company and itsability to convert that revenue into cash flowfor shareholdersan ability best measured byits long-term return on invested capital. Peoplewho are looking for real value in an Internetsector that has fallen down to Earth can beginby asking three questions.

How will the company generaterevenues?

Getting money from customers is an obviousplace to startright? Yet only a short time ago,investors were buying companies without aclear sense of how they would generate suchrevenue. In fact, most of the ways to generaterevenues have already been unearthed. Inbusiness-to-consumer (B2C) markets,companies can sell physical products, services,information, entertainment, and financialproducts; they can earn revenue fromadvertising and collect fees for facilitatingtransactions. In short, B2C companies mustcollect their revenue either from consumers orfrom other businesses that use their sites to

reach consumers. Sources of revenue aresimilar in the business-to-business (B2B)market.

Be cautious about business models based onfuture revenue for anything that peoplewouldnt pay for today. America Onlinemanaged to build its business on membershipfees from the start by offering consumerssomething they were willing to buy. Yet toomany so-called lifestyle sites first aim to builda user base and then try to figure out how togenerate revenue from sources beyond mereadvertising. Similarly, Internet banks that uselow prices and little else to lure customerscould well see cost-sensitive customers goelsewhere when prices rise.

What will be the average return oncapital once the industry matures?

In the Internet world, it has too often beenassumed that successful companies would earnvery high returns on their fixed assets andworking capitalperhaps 20 percent or moreafter taxesbecause they rely on intangiblerather than tangible assets or because networkeffects create effective monopolies. Thisblanket assumption is dangerous. Industriesearn high returns on capital if their products,

Few industries in the Internet world

have the structural characteristics

needed for high returns on capital.

One exception may be those B2C

and B2B marketplaces whose

customers naturally gravitate to

the biggest site.

such as patented pharmaceuticals, arenonsubstitutable and legally protected; ifbranding is important and consumers areindifferent to price; and if a product, such as Microsofts Windows operating system,becomes more valuable to customers as more people use it.

One reason to be skeptical about claims thatInternet companies will earn high returns isthat intangibles dont necessarily earn them;the industry structure does. Considerinvestment banking and movie production,two industries with considerable intangiblecapital. In both, most of the value goes to thetalentbankers, actors, and directorsnot tothe shareholders.

Few industries in the Internet world have thestructural characteristics needed for highreturns on capital. One exception may bethose B2C and B2B marketplaces whosecustomers will naturally gravitate to thebiggest site, thus creating a winner-takes-allopportunity for high returns. But most B2Cand B2B marketplaces will earn returns thatare close to or only marginally above theircost of capital. Internet retailing, for example,doesnt exhibit any of the traits associatedwith high returns. Products are substitutable,and consumers are sensitive to prices; theymay, for example, seek information at oneWorld Wide Web site but shop at another oroff-line. (My wife loved one site for its toys,but once she found a product she would oftenbuy it elsewhere; that site has since closed.) Asimilar logic applies to on-line financialservices and entertainment sites.

How big is the relevant market?

Most analysts focus on the size of a market,but these estimates can be inflated or even

irrelevant. Many Internet companies, forexample, rely on advertising for revenue, but itis fairly certain that ad expenditures will be arelatively small part of the total economythough they might rise somewhat over time.

Be wary, too, of the way companies assess thesize of the relevant market or even measuretheir own revenue. In airline travel services,for example, the relevant market isnt theentire revenue of the airlines but rather themuch smaller fees that they pay to on- or off-line agents.

Finally, ask yourself if the management,technology, brand, and head start of acompany will allow it to beat the industryaverage. Keep in mind that few companies do so for long.

This fundamental approach to valuation is by no means a panacea. For starters, it wonteliminate uncertainty. Continual innovationand an inability to predict consumer behaviorwill ensure that volatility and risk remainimportant parts of the dot-com landscape. Yet investors and companies following theseprinciples will at least be asking the rightquestions. They will have a better chance of success than they would if they simplyfollowed the herd.

Tim Koller ([email protected]) is a principal

in McKinseys New York office. Copyright 2001

McKinsey & Company. All rights reserved.

1 As reckoned by value.

2 See Driek Desmet, Tracy Francis, Alice Hu, Timothy M.Koller, and George A. Riedel, Valuing dot-coms, TheMcKinsey Quarterly, 2000 Number 1, pp. 14857.

MoF


Shed no tears for poolings demise | 17

Shed no tears for poolings demiseThe US Financial Accounting Standards Board has eliminated poolingaccounting for business combinations. How can companies make themost of purchase accounting?

Neil W. Harper, Robert S. McNish, and Zane D. Williams

When the US Financial AccountingStandards Board (FASB) on June 30eliminated the pooling method ofaccounting for business combinations, theusually staid world of accounting rules saw the curtain fall on one of its most vociferousand political dramas in recent memory. Intaking aim at pooling, which had been one oftwo accepted ways to account for combiningbusinesses, FASB sought to bring greaterclarity and consistency to accounting rules. But its effort drew the ire of corporateexecutives and venture capitalists, some ofwhom went so far as to invoke the nationalinterest to preserve an accounting method they considered a dynamo of M&A activityand economic prosperity. Even members ofthe US Congress jumped into the fray over theotherwise arcane accounting topic.

True, the new rules, which dispatch pooling infavor of the alternative purchase method ofaccounting, represent a compromise. But webelieve it is a step forward, particularly forthose companies that prepare themselves forthe post-pooling world.

Poolings supporters liked the method becauseusing it for M&A transactions could result in higher reported earnings and, they argued,

greater value creation than would be possibleusing purchase accounting. The debatecentered on goodwill, or the amount paid for an acquired company above the fair valueof its book assets. In pooling accounting, thebook value of the acquired company is carriedover as is, with no goodwill. In contrast, underthe new version of purchase accounting,goodwill is to be recorded as an asset that must be periodically tested for a loss in valueor impairment. If it is judged to have fallen invalue, the difference must be written down andcharged against earnings. Both methods resultin identical cash flows, since any write-down ofgoodwill would result in a noncash charge.

The new rules accommodate those whoobjected to the change by eliminating theearlier purchase accounting requirement tosystematically amortize goodwill via annualcharges to the income statement. Instead,FASB agreed that companies be required totest the goodwill balance for impairment onlyperiodically, and to take a charge againstearnings only when such impairment is foundto have occurred.

Our view is that purchase accounting does not destroy value, as its critics charged,regardless of whether or not it requires

Viewpoint

systematic goodwill amortization. Substantialevidence suggests that analysts, investors, andultimately capital markets see throughaccounting treatmentand that the form ofaccounting for combining businesses has noimpact on shareholder value. For example, ithas been shown that price-to-earnings ratiosof companies that have entered into purchasetransactions tend to rise to offset goodwillamortization (Exhibit).1 It has also beendemonstrated that market-to-book ratios ofacquirers remain constant once accountingtreatment is taken into account.2

Indeed, there are many examples of deals thathave been well received by the market despitethe fact that purchase accounting drovesignificant earnings dilution. For example, themarket celebrated Viacoms proposed $37billion purchase of CBS by increasing its stockprice 12 percent,3 despite a projection that theway the combination was accounted for woulddilute earnings per share (EPS) by $0.33, or43 percent.4

Finally, although McKinsey research has foundlittle statistical difference in how purchase andpooling deals perform, we have seen many

cases where pooling accounting actuallydestroyed value. Companies expend significanthard costs to qualify for pooling treatmentand subject themselves to a range of hiddencosts, for example, forgoing restructuringoptions for up to two years following atransaction in order to comply with poolingregulations that limit significant divestitures.

Getting the most out of purchase accounting

The compromise thus represents a significantstep forward in bringing clarity andconsistency to accounting and avoiding therisk of significant value destruction. However,the change requires corporations to preparefor purchase accounting to help ensurecontinued value creation from strategicallyrational business combinations. Executiveslooking to make the most of the new regimewill need to reevaluate internal deal evaluationprocesses, prepare for a greater set of externalcommunication challenges, and minimize timeand money spent in testing goodwill forimpairment.

Reevaluate internal deal evaluation processes

Rethinking the processes used to evaluatedeals is a good place to start. To succeed inthe post-pooling world, it will be important tounderstand where dilution is coming from andto focus only on what is most important tothe marketthe sources of true value andtheir impact.

Internal M&A processes frequently gauge the attractiveness of prospective deals byforecasting whether the deal will bolster or dilute EPS. This created an implicit biastoward pooling accounting. We have


Executives can take advantage

of the opportunity to engage

investors on more critical topics

such as cash flow, growth, and

synergies. Some companies are

already breaking new ground in

discussing cash earnings or

cash EPS with investors.

Shed no tears for poolings demise | 19

participated in many discussions with senior management where there appeared to be unanimous agreement regarding thestrategic rationale and value creation potentialfor a transaction, only to see the deal killed because it looked likely to dilute near-termearnings.

The fact is, not all dilution is created equal.Earnings dilution is an important considera-tion in deal evaluationbut only when it iscaused by two factors. The first is thepremium paid in excess of clear synergy value.The other is the prospect of uncertain futuregrowth in the acquired business. When a dealdilutes earnings for these reasons, shareholdersare right to ask pointed questions. However,dilution caused by accounting treatment isirrelevant, and the market knows it. Moreover,dilution caused by choice of financing, such as how much debt is taken on or how muchequity is issued, should be considered anddiscussed as a separate effect that does notcomplicate the decision to go ahead or backoff from an acquisition.

Prepare for greater externalcommunication challengesMoving to purchase accounting will providesome companies with a valuable opportunityto improve their overall dialogue withinvestors. Over time, continued discussions of EPS accretion and dilution and earningsestimates are likely to prove unsatisfying. But executives can take advantage of theopportunity to engage investors on morecritical topics such as cash flow, growth, and synergies. Some companies are alreadybreaking new ground in discussing cashearnings or cash EPS with investors. WellsFargo, for example, followed its acquisition ofFirst Interstate by issuing a special report toshareholders focusing on cash earnings anddisaggregating the impact of the purchasemethod on the transaction.

Cash EPS is a more elusive concept, withseveral possible definitions. Typically it iscalculated as standard EPS plus goodwillamortization. The move toward cash EPS is a positive development. Still, it falls short of

1 Significant at 99 percent confidence level.2 Industries where there is a small variation in P/Es across firms.3 Industries where there is a small variation of EV-to-EBITDA multiples across firms.Source: E. Lindenberg and M. Ross, To purchase or to pool, Journal of Applied Corporate Finance, Summer 1999; and McKinsey analysis.

EPS

Pooling Purchase

(10%) +10%

P/E

Pooling Purchase

Price

Pooling Purchase

All industries

P/E industries2

Cash flowindustries3

11.8%

Percent increasein P/E for 10% pointincrease inamortization1

12.2%

10.5%

P/Es increase to offset lower EPS

Exhibit. Evidence suggests that investors and analysts see through accounting treatment


what every companys aspiration should bea robust dialogue around long-term valuecreation potential and the free cash flows thatdrive it. Briefly stated, the problem with cashEPS is that it is neither cash nor EPS.

In a mature business generating positiveearnings and cash flows, a good first stepwould be to move toward true cash measures.Corporate America already reports substantialcash flow information. Moving the dialoguetoward measures such as operating cash flowper share or free cash flow per share is just aseasy and more robust than moving to cashEPS. Better yet, executives should focusdiscussions with investors on growth in freecash flow and the spread between return oncapital and cost of capital as the simplest andtruest drivers of value creation.

Minimize time and money spent intesting goodwill for impairment

Finally, executives would do well to keep an eyeon the time and money they spend meeting thenew FASB standards. The rules eliminate theneed for companies to systematically amortizepurchase accounting goodwill. Instead, theyrequire companies to periodically test suchbalances for impairment and to take a chargeagainst earnings whenever such impairment hasoccurred. In practice, companies will have theoption of avoiding a charge to reportedearnings if they can meet one key testthatthe fair value of each relevant reporting entityis greater than book value, including goodwill.If this test is not met then any impairment iscalculated by valuing goodwill in essentiallythe same manner as at the time of the initialbusiness combination. While companies mustspend some time evaluating the carrying valueof goodwill, we believe that extensive andcostly efforts to avoid an earnings charge

should be avoided. We have found no evidencethat such charges have any impact onshareholder value.

We should note, however, that executives must be mindful of what annual goodwillwrite-offs may suggest to investors. A highwrite-off could be interpreted as a signal thatan acquisition has failed or as an attempt tomake future profits look better against lowerfuture write-offs. Furthermore, large goodwillwriteoffs could turn corporate net income intoa loss, triggering debt covenants that were notconstructed to consider such circumstances.

The new FASB accounting rules emerged froman uncharacteristically vocal debate over thevalue creation inherent in accounting methods.Now CEOs and CFOs must ensure that theircompanies are well positioned to continuereaping the benefits of transactions that createvalue, as well as reposition internal processesand external communication with investors totake advantage of the opportunity created bythe new accounting landscape.

Neil Harper ([email protected]) is

an associate principal and Zane Williams

([email protected]) is an associate

in McKinseys New York office. Rob McNish

([email protected]) is a principal in

McKinseys Washington, D.C. office.

1 E. Lindenberg and M. Ross, To purchase or to pool, Journalof Applied Corporate Finance, Summer 1999.

2 Vincent, Equity valuation implications of purchase vs.pooling accounting, Journal of Financial Statement Analysis,Summer 1997.

3 Measured over the 7-day period prior to announcement.

4 Sanford C. Bernstein & Co., Viacom, CBS grab each other,September 10, 1999.

MoF

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