PREFACE AND OVERVIEW

I strongly believe that a firm's long-term performance is a direct result of its knowledge-building proficiency. That belief is the result of my work in two research areas that normally are not connected-finance and knowledge building. First, by way of background, my career in finance began with the startup of the boutique research firm Callard Madden & Associates in 1969. Our primary mission was to understand levels and changes in stock prices worldwide and provide practical insights to enable portfolio managers to make better investment decisions. We devoted considerable effort analyzing management decision-making in the context of a firm's long-term financial performance quantified as life-cycle track records. Over many years I have been fortunate to work with talented colleagues at Callard Madden and later at HOLT Value Associates. Our research addressed a never-ending stream of problems in connecting a firm's accounting-based performance to its market valuation.

While this finance work was progressing, I got hooked on a second research area dealing with how we know what we think we know, which remains my ongoing intellectual passion.1 The more I learned about the knowledge-building process, the clearer it became that knowledge building and value creation are opposite sides of the same coin. The more I analyzed management tasks such as strategy, innovation, employee engagement, development of new capabilities, etc., the more I realized that the root cause of a firm's long-term performance and returns to its shareholders is the firm's knowledge-building proficiency relative to competitors. This book makes what I believe is a strong case that a new holistic theory of the firm, built upon this foundational importance of a firm's knowledge-building proficiency, will improve thinking about the role of firms in society. Moreover, this new theory of the firm is labeled "pragmatic" because it facilitates systems thinking to analyze practical problems thereby leading to improved decision-making for managements, boards, and investors.

Theories of the firm tend to be narrow in scope and ignore how firm performance connects to market valuation. A notable advantage of the pragmatic theory is its explanation of what drives a firm's long-term financial performance and its returns to shareholders. The more one understands long-term stock prices, the better one appreciates the mutual interests of shareholders and other stakeholders.

As to understanding levels and changes in market valuations, my early research at Callard Madden was instrumental in developing the CFROI (cash flow return on investment) valuation model and related global database.2 The CFROI research program is rooted in economically sound principles applied to the construction of long-term, life-cycle track records of a firm's financial performance; the forecasting of a firm's long-term net cash receipts; the calculation of warranted market valuations; and the decoding of investor expectations implied in stock prices. This unique research program was further advanced by HOLT Value Associates, which was acquired by Credit Suisse in 2002. A highly skilled team at Credit Suisse HOLT continues to advance the CFROI valuation framework as part of the Credit Suisse HOLT global database, which is used worldwide by many large money management organizations.

The seven chapters in the book can be distilled into the following fourteen key ideas:

1. Purpose of the firm-The pragmatic theory includes a statement of the firm's four-part purpose, as detailed in Chapter 1, which answers the questions: Why does a firm deserve the commitment and support of its stakeholders, and what unchanging principles will guide management's actions? Maximizing shareholder value is best viewed as the result of a firm successfully achieving its purpose.
2. History of the theory of the firm-The pragmatic theory is more comprehensive than other theories of the firm and treats the firm as a holistic system. As discussed in Chapter 1, this leads to insights that are otherwise unobtainable. The pragmatic theory integrates the firm as the critical unit of economic growth, thereby expanding upon the key ideas of Paul Romer, Robert Gordon, Joel Mokyr, and Edmund Phelps, as reviewed in Chapter 1.
3. Knowledge building-A firm's knowledge-building proficiency is the primary determinant of its long-term performance. Chapter 2 explains the knowledge-building process, including the subtle yet important impact of language.
4. Performance improvement-Chapter 3 uses knowledge building as a framework to explain the similarities and differences among three important approaches to improving the performance of firms: (1) Lean Thinking pioneered by Toyota; (2) the Theory of Constraints developed by Eli Goldratt; and (3) the recent work of Werner Erhard and Michael Jensen on an ontological/phenomenological model. By focusing on the knowledge-building components-purposes, worldview, perceptions, actions and consequences, and feedback-any proposed performance-improvement program can be analyzed for its likely impact.
5. Life-cycle framework-Chapter 4 illustrates how the four stages of the life-cycle framework (high innovation, competitive fade, mature, and failing business model), which are typical of the long-term histories of firms, fit into the pragmatic theory. Instead of beginning with a model of risk and return and elegant mathematics tied to equilibrium, the life-cycle framework focuses on an individual firm delivering economic returns and reinvestment rates over its life cycle, thereby generating net cash receipts that drive market valuation.
6. Excess shareholder returns-Excess shareholder returns (positive/negative) result from life-cycle performance that deviates (better/worse) from initial expectations. The life-cycle valuation model helps to generate insights about a firm's historical performance and to improve forecasts of future financial performance, particularly when such forecasts are benchmarked against the firm's and its competitors' track records. In addition, the model helps gauge the implied expectations of investors embedded in a stock price at a specific time.
7. Alternative view of risk-The Capital Asset Pricing Model (CAPM) and related models define investor risk for an equilibrium setting in the context of the investor's portfolio. Research to advance these models is based on empirically tested factors (as proxies for risk) that seek to explain excess shareholder returns. CAPM equates higher average returns with higher risk. Managements can easily embrace the CAPM view of risk because it facilitates the calculation of a cost of capital. An alternative, although complementary, view of risk is presented in order to facilitate sharper thinking and improve decision making. Firm risk can differ from investor risk. Firm risk is about obstacles management faces that interfere with achieving the firm's purpose. Firm risk increases (decreases) in lockstep with changes that degrade (improve) the likelihood of achieving the firm's purpose. An increase in firm risk, all else equal, means a greater likelihood for a firm to generate lower future financial performance. In the early stage of an increase in firm risk, management may choose to disregard the warning signs, but nevertheless those inside the firm have superior information compared to investors relying on public information. The key insight here is that there can be a substantial time lag between a significant change in firm risk and investor perception of this change. As such, an increase in firm risk will eventually be understood by investors and, all else equal, this adjustment process will cause a decline in the firm's market valuation. How does this adjustment process connect to models of investor risk like CAPM? The stock price declines in order to provide a high enough expected investor return to adequately compensate investors for the increased likelihood of future shortfalls in the firm's financial performance.
8. Systems view-A strong advantage of the pragmatic theory is its systems view of the firm which aids in dealing with complex problems like intangibles (e.g., brands), which dominate value creation and economic growth in the New Economy. The intangibles measurement problem impacts accounting-based performance measures, resource allocation, and market valuation. My blueprint, described in Chapter 5, for handling intangibles indicates that capitalization and amortization are warranted when the duration of expected benefits (economic lives) can be reasonably approximated. This improves the accuracy of economic returns and reinvestment rates, yielding more insightful track records. If economic lives are too speculative to estimate, the benefits from intangibles can be incorporated via more favorable long-term forecasts of competitive fade rates for economic returns and reinvestment rates.
9. New research methodology-A new way to conceptualize research about shareholder returns is presented in Chapter 5 with three levels of cause-and-effect logic: (1) correlation studies using financial variables as potential factors to better model risk and return; (2) targeted causes of excess returns such as intangibles, culture, and ESG (environmental, social, and governance) initiatives; and (3) utilization of a firm's knowledge-building proficiency as the preponderant cause of long-term value creation and...