The rule of 72: help for arguing with your mother-in-law

The rule of 72: help for arguing with your mother-in-law (which is never a good idea, you can’t win..).. she says things used to be so cheap in 1960, and you hold your head and cry – haven’t you heard of a thing called inflation? So what is the equivalent in today’s money, then? And so on.. The rule of 72 comes in handy (not that you will win the argument, of course..). The rule of 72 says that for something to double, the product of n, the number of periods, and r, the interest rate, should be 72. Since 1960, it has been 55 years. If the inflation rate has been around 8%, it means prices have been doubling every 9 years. So something that cost 10 rupees in 1960 should cost 10 x 2^6 – that is, 640 today... Works for all kinds of growth rates, discount rates, and the like. So, if the exchange rate in 1990 was $1 =Rs. 14, and the inflation differential between the US and India has been around 7%, the exchange rate should double every 10 years or so... today, 25 years later, it should be around 56 times (square root of 2) – that is, 56 x 1.4 = 78. So 63 doesn’t sound so bad, does it? For those who wonder where this 72 comes from, remember the natural log of 2 is 0.69.. So start with the equation (1+r)^n = 2 n ln(1+r) = ln 2 =.69 the Maclaurin series expansion (approximation) for ln (1+r) is then applied n (r-r^2/2+r^3/3-...) = 0.69 nr(1-r/2+..)=0.69, neglecting the higher order terms substituting 0.1 for r as the range in which we want to look for an approximation gives us nr (0.95) = 0.69, that is, nr = 0.72 roughly.. (actually gives us 0.726 but 0.72 is an easier number to work with).. If compounding is continuous, we get the rule of 69, of course, since the relevant equation is e^nr = 2 nr = ln 2 =0.69 but compounding isn’t usually continuous, so rule of 72 works well.

The Software Organization under EDT

The software organization under EDT (Enterprise Digital Transformation) In this (coming) world, the way software will be written, delivered and deployed, will be radically different. Naturally, it will have consequences for organization structure, HR policies, and work processes. Software will be developed, tested and deployed by small teams of 6-10 people, which may include members of the customer organization and, in some special cases, even end users. The same team will be responsible for design, development, testing, deployment maintenance and the continuous changes they will need to keep making to the software deployed. The teams will operate entirely in agile scrum mode. They will, by definition, be self-governing teams, with little direction from higher levels. The contribution of each member will be crucial but impossible to measure, since it is the team who takes ownership. They will be coordinated by a scrum master, who is a member of the team. Reviews will consist of daily stand-ups of 10 minutes. Because the teams will be working closely with customers and users, and may in fact include members of these outside organizations, security and privacy issues, i.p. protection etc. will take on a different hue. People working on the teams will have to understand key aspects of the customer’s business, technology, and how the user actually uses the software – today, teams are required to understand only technology. Testing as an independent activity will simply disappear…it will become an integral part of the design/dev/deploy process. Consequences for organization structure: The company will be just a collection of self-organizing teams. It is not clear what layers of management above this will actually do – SBU heads, delivery heads etc. will never know enough about the progress of the project to be able to guide and control it. If they insist on reviews, they will only slow it down, and speed will be at a premium in the new world. How will we manage a portfolio of such projects? Who will assign people to them? Who will decide what the team does next, after the project is done? Does the project ever get done? Certainly, account managers will be needed, to nurture the relationship with the customer. Product managers will also be needed, since the software deployments will increasingly look like products – with training, documentation, road maps and so on. But above this, it is not clear what value management can add. These are troubling questions to which we do not have answers today. Consequences for HR policies: The only measurable performance will be of the scrum team, not of individuals. Ownership and accountability is with the team as a whole, not even with the scrum master. How will we reward and promote people? Promote them to what? To a largely meaningless managerial role? Not everyone will be fit for, or interested in, the roles of account manager and product manager. What will be career paths for people? Do they spend their entire lives in one scrum team after another? Do they grow as experts in a certain domain or customer type? Should we consider rewarding and promoting, not individuals, but the team, all together? How do we train and develop people to play multiple, overlapping roles – in multiple technologies, for instance – and in domain, business and user experience? The team will have to include designers, developers, testers, and deployment specialists – and their roles will naturally overlap and even switch as people learn and grown within the team. How do we encourage this to happen faster? Companies who answer these questions first, and best, will be leaders in EDT...

How Valuation is Really done, and what use is that Valuation model in M&A deals?

Two stories: In the early 80s, GM bought EDS (Electronic Data Systems). In the weeks before the acquisition was announced, an analyst in the Treasurer’s office at EDS was summoned by the CFO and asked to ‘model’ the share price of EDS. The analyst was a bit perplexed – after all, one could look up the share price in the Wall Street Journal (no internet in those days, remember).. but he did as he was bidden, sat down on his PC (IBM XT, I think it must have been in those days, and Lotus 123, not Excel) and put numbers into his spreadsheet that would justify the share price at the time - $25 or so. Took it to his CFO – CFO shook his head and gestured upwards with his thumbs.. back the analyst went to his PC, changed a couple of numbers in the projection and came up with $35. Surely the CFO would be happy now? No, he got the same response. But, by now, the analyst had gotten smarter too – he asked the CFO what he should have asked him in the first place – ‘what number are you looking for?’. The CFO told him - $44. Well, it didn’t take long to conjure up $44 on the spreadsheet – the CFO pronounced himself satisfied and took the spreadsheet up to the executive floor to show the CEO and Chairman and the rest of the bigwigs. When the acquisition was announced, at $44, our analyst naturally felt pleased – but he also wondered how the CFO knew the answer.. turns out he didn’t, it was just his best guess of what GM would be prepared to pay. Imagine the feelings of both the CFO and the analyst when it was later revealed that, the same day, there was a gentleman from GM in the building with an authorization his pocket from GM’s chairman, to pay $50 a share! Story number 2: I was once involved in a merger of equals (no names this time). There were 4 people present in the room – myself, the chairman of the acquiring company, and two senior executives representing the company to be acquired. The opening remark from one of these senior executives was – the two companies are pretty much the same size, aren’t they? So shall we just value them as equal? We all looked at each other and nodded – it took about 5 seconds for the valuation to be done! Needless to say, some Big $ company was given a huge fee to do the valuation, after the fact, of course – their role was to justify the number we had already agreed on. The fact is, valuation is explicitly a matter for negotiation – it is decided by negotiation, by each side trying to figure out what the other side will go by. There are excel sheets and ‘times revenue’ models and ‘P/E’ models, but they are all really just rules of thumb, to make sure the negotiation is not just going way off base. So is the valuation model useless? Why do I teach it to everyone as an essential tool of finance? For that, we need a third story: During the negotiation of several (not just one) of the acquisitions I have been part of, it is useful to have some basis for negotiation. If I say the company is worth 10 and the target company says it is worth 20, how do we converge? Should we just split the difference? What I usually do is pull out my excel spreadsheet and say, all right, let us see what it would take to justify 20 – pretty soon, it becomes obvious that, to justify a price of 20, the company would have to do something extraordinary and unprecedented, like achieving double the margins it normally manages, or growing twice as fast as it ever has in its history. Then the negotiation can begin – the point is, now we have something to discuss, other than ‘10’ or ‘20’.. the spreadsheet serves as a very useful negotiation tool. It is nothing more than that, but nothing less, also... is it useless? No. But is use is not what people think.

what NPV and IRR are really used for - not what the textbooks say!

Every textbook on finance will tell you that capital budgeting techniques (NPV, IRR and all the rest of it) are used by companies to make investment decisions. My experience as a financial analyst and consultant tells me the truth is quite different..and quite a bit more subtle. In practice this is what usually happens - a decision is made by management, generally on considerations like strategy, positioning, market opportunities -I would go so far as to assert that the more important a decision, the less it is driven by financial analysis. Utterly trivial decisions (that is, from a strategic point of view, trivial), may get decided by the 'numbers' alone -they may get done if the financial analysis shows it is a slam-dunk and only an idiot would not make the investment, whatever it is.. when the numbers overwhelmingly argue, cry out even, for an investment decision, it may get made, but not otherwise.. (an anecdote here - a lifetime ago, when I was a financial analyst, it was my doubtful privilege to take before finance committee a proposal to buy a slide-maker - this was in the days before ppts, of course. I thought I had done a marvelous analysis, with NPV and IRR all worked out, and the finance committee rejected my modest request for $200K, after giving me hell for about an hour. Next up was a proposal to build a data center for $15 M.. passed without discussion! Why? as my boss, the treasurer, was kind enough to explain to me,it is not because finance committee didn't like my face, it was just that the company is not in the business of making slides, so the slide machine had to be a slam-dunk, justified overwhelmingly by the numbers alone. The data centers, on the other hand, were the life-blood of the company..) So, if NPV and IRR are not used to make decisions, not important ones anyway, what good are they. Here is an insight you will never find in any of the textbooks - they are used to structure the project so that the decision to invest gets justified! That is, not to decide whether to do the project, but to decide how to do the project. It is a guide to action, a playbook. After all, it is used mainly by middle-managers, not by CxOs. Remember, the role of middle management is not to make strategic decisions - it is their role to implement strategic decisions! So is capital budgeting useless? Not at all - but not the way the finance textbooks think But them what would you expect? Finance textbooks are written by people who have never seen the real world!

Why HR is so difficult..

It has become virtually impossible to find the ideal HR head - at least in IT companies. When this happens so repeatedly, it is time to suspect that there is something wrong in the way we are defining the job, in our expectations of the role-holder – it seems to me we are designing the role for failure. A good HR needs to run a tight ship – highly process-oriented, because he has to apply policies transparently across thousands of employees. He has to be ruthless with non-performers, uncompromising with values, and fiercely protective of the corporate budget. This calls for a certain kind of person. At the same time, the HR head has to be compassionate caring and human – he has to develop people, instil courage and confidence in them, not fear and loathing. He has to have the ‘personal touch’, he has to be everybody’s friend and guide. Can the same person so both? I don’t think so. I think it is time to recognize that we need to redefine the function – maybe split the function into two, maybe get someone under the HR head to run the processes and ask the HR head to stay out of compensation, appraisal and policy implementation discussions – whatever works. But the current way we are defining the role absolutely guarantees failure..

On Pikkety and the future of capital

Thomas Pikkety has dropped a bomb on the economics community with his painstaking exposition of the fact that, over reasonably long periods of time, the return to capital has exceeded the growth in the economy. The result is an increasingly polarized world, where the rich get richer, even if the poor don’t get poorer, but then, it is all relative, isn’t it? Very well, then, if we accept as a proven fact, that the return to capital is greater than economic growth, we should pause to ask – why is it so? Only then will we be able to say whether this is an accidental many-time phenomenon, a fatal flow in the capitalist system, or simply something will inexorably ground down by the law of diminishing returns. I offer two arguments: 1. The ‘return’ on financial assets, as they teach us in Finance 101, is partly a reward for taking risk – remember the good old CAPM? In that case, the average return to capital (let us say, the equity market), is necessarily greater than the riskless rate – and the growth in the economy is just one component of the riskless rate (inflation and risk-aversion are the other two). Then there is nothing surprising or evil about capital earning more than the ‘economy growth rate’. The higher average rate is offset by the wild fluctuations in the return, which means there are periods when financial assets yield highly negative returns too – the economy as a whole doesn’t usually crash by 40% in a day – the stock market can, and often does. 2. Financial assets, by definition, reflect and ‘price in’ the future – imagine a company whose earnings are growing fast and is expected (by the market, that is) to keep growing fast – its share price will reflect the expected high growth while its earnings reflect the current growth (like the growth rate in the economy). We can easily imagine such a company having a rapidly increasing P/E ration – which is the equivalent of what Pikkety says is happening in the economy as a whole. Extrapolating to the economy as a whole, if the market forecast of the economy continues to look better and better, the value of financial assets will keep rising – faster than the economy itself, because financial assets price in the future, while the growth rate reflects only the current situation. Will this necessarily result in a crash, sooner or later? Some day, the economy will indeed stop growing, perhaps because of a war, global warming, or even another 2008-style meltdown – in which case financial returns will go abruptly negative while the growth numbers in the economy may turn only mildly negative. In short, there are very good reasons why the return to capital can exceed the growth rate in the economy, and no guarantee that it will either continue forever or, for that matter, that it will inevitably stop – after all, wars and disasters are not inevitable – not even global warming is! So, what should we do about it? The only way to deal with the root causes is by abolishing risk-aversion (good luck with that! It is a deep-seated human instinct) or by forcing the economy to stall, which, of course, our politicians around the world are trying their best to do every day! Denying climate change? That is a good way, too – then the catastrophe will be upon us and there will not future, so financial assets will stop growing.. again, something all worthy politicians are working hard at anyway.

The 98% syndrome

how interesting. I thought, when my newest client told me they achieved 98% of their target this year.. that is what ALL my clients are telling me! it doesnt seem to matter what the target actually is, 98% of it is what they achieve.. sounds familiar? Reinforces the thinking I was exploring in my earlier post on targets.. if you want to set targets (which is debatable), set them high - you will achieve 98% anyway!