As he approaches retirement from McKinsey & Co. in February, Koller hopes his colleagues will continue championing what he sees as the core of sound decision-making: pursuing growth only when it delivers strong and sustainable returns on capital.
In a conversation with Mint, the valuation expert reflects on heated equity markets, the rise of retail investing and the myths that still cloud our understanding of performance, while reminding companies that long-term value still depends on fundamentals, not momentum. Company leadership should pursue the “right balance” between “growth and return on capital” to drive valuation, he says, adding that profits must be sustainable and capital must be allocated and reallocated to strategic growth opportunities. Edited excerpts from the interview:
These are interesting times. India’s primary market is seeing a flurry of IPOs, which include several startups and e-commerce companies. They are offered at mind-boggling valuations, which run contrary to your thesis on valuations—that is, focus on cash and not earnings. This is also compounded by the fact that smart investors are selling their stakes in these startups, whereas small investors are buying in. Do you foresee a scenario where the small investors will hold the can?
Koller: The most crucial thing to look at is who’s driving the share prices. If you look at the mega seven companies in the US, you’ll see that the percentage of shares owned by retail investors is about double that of most companies. So, the share prices are being driven by relatively unsophisticated investors. And so that’s when you, you know, you have to be cautious.
If I’m thinking about the valuation of an e-commerce company, there are a couple of things that I would do. One is to know what the actual market dynamics are, who’s buying what. I would also look at the fundamentals, not of today but look into the future. What is reasonable for this value, based on where the company could be in seven or 10 years? Is that reasonable? We can’t extrapolate from today’s situation, because often their profits are zero or negative. But we can look forward and ask: how big is the market they’ll be in? What kind of market share can they achieve? What kind of margins, what type of return on capital, given the economics of that business? What is the potential for that business? And then you can work backwards to see whether the valuations are reasonable. That’s the second thing.
And the third thing is, you have to realise you’re going to be wrong, okay? Because a lot of the outcomes for these companies are, I’ll call it bi-model.
Again, if you look at India, our stock indices touched an all-time peak earlier this week. What do you think about a retail investor?
Koller: My advice is, regardless of what stage of the market you’re in, to not look so much at the market aggregate but look at it by sector or by company to see what’s really going on. And typically, there are many sectors where valuations are what you’d expect. There may be some sectors that are hot right now and see retail investors piling into. I remember that if you go back to the dot-com bubble (1999-2000) and the stock market went down in 2001-2002, about 40% of the companies in the S&P 500 went up.
Okay, so the real question is looking down a layer or two over the years. You know, I’ve been doing this for a long time, and I’ve always found that looking at too high a level, two aggregated numbers, doesn’t tell me anything, doesn’t give me any insights, or doesn’t give me a way to take an action, right? So that’s why you always have to, you know, disaggregate and look at different industries. So that’s what I would do, what industries are driving the market as a whole?
Valuation is in its eighth edition. Is it very different from the past seven editions, or are there any updates that keep up with the times?
Koller: So, the fundamental ideas have remained the same, which is a good thing. So, you know, companies create value through the combination of how fast they grow their revenues and what their return on capital is, what drives their profits and their cash flows. And that’s ultimately what mattered; it hasn’t changed at all.
We also believe, from the first edition onward, that companies should be long-term oriented because if you pass up investment opportunities to meet your short-term results or targets, someone else may do so. You’ll get beaten comprehensively or miss out on an opportunity. So those two things have not changed at all, and we’ve made a lot of progress over the 35 years in getting companies to think about return on capital. We’ve gotten people away from pure accounting numbers to more economic numbers, which is a good thing. Most likely, most US-based companies now reconcile their accounting results to more operationally oriented profit numbers, right? And that allows investors to decide which adjustments they like and which they don’t, right? So we’ve made a lot of progress there.
There are still some myths about consensus earnings and their importance. There are myths about taking writedowns. One of the latest myths is that European companies and other countries’ valuations are lower than the US’s because of investors, rather than because of performance. Whenever we analyse valuations, we find that differences are due to different industry mixes and performance levels, not because listing in the US automatically yields a higher valuation. The things we keep on adding to the book are whatever topical items are. So, for example, there is a chapter on digital and AI, okay? And how do you think about the impact of that on valuation; there’s a chapter on sustainability, and how do you think about the implications of that on valuation; there’s a chapter on the softer elements of planning and resource allocation.
You have an interesting view on conglomerates. There is one group in the market with a rights issue that some analysts say is undervalued, and there is talk of India’s biggest conglomerate taking the plunge by listing. How can conglomerates avoid the discount that the markets often levy?
Koller: Most of the time, when we analyze conglomerate companies, we find that any perceived discount in their valuation usually stems from their performance. While I cannot comment on specific Indian companies, we often see that when we compare conglomerates to their peers—especially those performing similarly, not just within the same industry—there is often no significant conglomerate discount in markets like the US and Europe.
One reason for a conglomerate discount is the additional overhead costs associated with maintaining a corporate centre. Once a business is fully developed, the question arises: Is that corporate centre still necessary? This extra layer can become a burden. The crucial question is whether the individual businesses within the conglomerate are performing as well as their pure-play counterparts. If they are, there should not be a conglomerate discount. Thus, it is important to examine whether the discount is a structural issue in the market or can be explained by actual performance and decision-making.
Many of India’s retail investors are investing in the US market, in what they look at as diversifying their investments. Recently, a retail investor told me about his investment in Palantir and a few US-based chipmakers, saying ChatGPT’s recommendation influenced his punt. Are these dangerous diversions?
Koller: I can’t talk about individual companies, but you can ask questions when you’re thinking about an investment. You have to consider not only how good the company is, but how good the company is relative to the price you have to pay, which a lot of retail investors don’t do.
If you buy a great company at too high a price, it’s still going to be a bad investment. One of the techniques I advocate is reverse engineering and asking: what would you have to believe about a company’s future performance five to seven years down the road to justify today’s value? And is that realistic or not? Is that achievable or not? That’s one thing you also have to look at, competition, right? Yes, the AI, you know if you take something like semiconductors, right…you know, how many companies will ultimately succeed, right? In building chips. Will there be competition? How intense will that competition be… those kind of questions. We don’t know the answer, but traditionally, the semiconductor industry has been pretty competitive. And so, you look, and you say, oh, there are a lot of companies out there trying to build AI chips of different types. So, you have to ask the question: how competitive will that industry be in five to seven years.
Do you expect a market correction?
I couldn’t say anything about that because you’re talking about different types of businesses. If you take the mega-seven companies, we observe that retail investors’ share of ownership in those seven companies is about double that of the typical large company, right? So, the share prices of some of these companies, if they’re being driven primarily by retail investors, that’s an important fact, because retail investors often don’t do a lot of numerical analysis… A good investment is a combination of how good the company is and what the price one has to pay. And they may not be thinking about that.
So, it is important to look at the market dynamics. When you try to think about that question—what are the fundamentals, what are the economic prospects of these companies, also see who’s driving the share prices.
US President Donald Trump recently said he wants to do away with quarterly corporate earnings. Many CXOs are looking at quarterly earnings, so their focus is on the short term. Do you agree with this?
Koller: I know, parts of Europe have already moved in that direction. In the UK, they do semi-annual earnings. I don’t see it saving money. Because many companies invest significant time and energy in those quarterly earnings—a lot of management time. It is not affecting valuations or corporate behaviour very much though, because whether people are looking at the quarter, the half year, or the year, it’s going to be the same set of issues. I personally think so. I don’t see it having a big effect on corporate behaviour.
A year is still a short term in a way. If I’ve got a target for my annual earnings, and in order to meet it, if I cut back on innovation, that’s still going to happen, regardless of whether it’s quarterly or semi-annual or annual; I think the timeframe of most investment decisions that make things short- or long-term is more than six months or more than a year.
So, going from quarterly to semi-annual is not going to make that much of a difference. There will be investors who like the quarterly stuff because it creates opportunities for trading. But long-term investors won’t care one way or the other.
