The market economy thrives on competition, which in turn induces risk-taking behavior and dynamic decision-making among firms. Positive externalities derive from the activities of certain successful firms, with benefits accruing to the overall economy. In a 1968 work titled The Dual Economy, the American economist Robert Averitt called them “central firms”. Central firms are sizable entities that make investments in areas that are crucial for economic growth: R&D, product innovation, infrastructural goods.
These are firms that are able to look ahead because they use the flow of revenues and their reputation on financial markets to shield their vital core, constituted by knowledge-generating activities, from external shocks. They focus on the long term and have managerial procedures for internal allocation. A lot has changed since 1968, but central firms maintain the same basic traits. With respect to the past, they are now more open, since they simultaneously compete (on products) and cooperate (on development of new technologies) with other firms. A recognizable trait is the careful attention they devote to the measurement of performance.
This kind of performance culture takes precedence over the widespread rituality of planning, which in many firms is simply about extrapolating the past without paying attention to actual value drivers, which is conversely what central firms always do. A central firm does not think in terms of value multipliers (P/E times profits, EV/Ebitda times the gross operating margin etc.), but in terms of fundamentals, in the sense that the most important indicator of performance is sustainable revenue. A central firm is dynamic insofar as it maintains a long-term economic and financial balance by continuously substituting new value drivers for old ones.
With the deepening of competition and the widening of markets over the last two decades, every firm wanting to evolve out of a niche must start behaving like a central firm, by nurturing its distinctive sources of competitive advantage and investing major resources to strengthen its core competence. You have to work on the processes and go through the numbers, by changing allocation processes and measures of performance, which in turn lead to a change in attitudes within the firm. For this to succeed, it is crucial to design a suitable architecture for information systems. You can’t control what you don’t measure, and you cannot manage what you can’t control.
Unfortunately, capital markets have been taking the attention of firms away from fundamentals and the measurement of long-term performance. But the times have now changed: corporate planning and stock-exchange multipliers are increasingly passé. Sustainable performance is the key issue a firm must evaluate in order to make sound business choices and take calculated risks. From this perspective, the relationship between finance and firms is bound to change, by focusing less on future expectations and more on the fundamentals of the business.
by Mauro Bini,
Full Professor of Corporate Finance, Università Bocconi