The Math of Low Trust

Trust in business has declined in recent years. One reason why can be demonstrated with a bit of math.

Assume two streams of income, with a net present value calculation for each. (I’ll use a 10% discount rate to simplify). Income stream A has a big payment in year 2 and then pays slightly more per year – but only for 5 years, after which it all ends.

Income stream B is steady and solid, giving less income per year – but lasting 8 years.

NPV Chart

Which income stream do you choose? If you’re a dutiful MBA or financial manager, then in theory you choose B, the one with the higher NPV. In fact, in the real world, stream A is chosen far more often – for two reasons.

Reason 1. What if the example were ended after 7 years, instead of 8 years? In that case, the NPV of Income Stream B would drop to $44.72 – so presumably you’d choose Stream A, which is  unchanged at $46.17.

Timeframe makes a difference. If the average time you spend in a job is less than 8 years, and you are a rational self-maximizing business person, you’ll choose a far shorter timeframe in which to maximize your performance, because that’s what you can control. And these days, it’s more like 2 years than 8.

Reason 2. In the above example, the unspoken assumption is that it is, in fact, a solitary single example. But assume there are thousands of investment opportunities out there, with very similar payoff characteristics. In which case the smart thing would be to take Income Stream A – and then sell it after two years.  Then go find a new Income Stream A in which to invest your profits, and do it all over again. That way you’ll vastly out-perform either strategy, in virtually any time frame.

Or – would you?

Trust and Net Present Value

What’s this got to do with trust? Think back to Walter Mischel’s famed marshmallow study on deferred gratification. We do not trust people who have no self-will, who cannot defer their desire for instant gratification, because they are not in charge of their own desires. But that’s just one marshmallow incident; the rationale doesn’t go beyond Reason 1 above. What happens when one’s choices can be made over and over again?

That pattern – endlessly taking short-term gratification and jumping off onto a new high-then-low curve – is a very familiar one. It is what characterizes alcoholism, addiction, and it explains why junk food sells. “Just one more drink; one more cigarette; one more Frito. I’ll quit tomorrow, honest.”  But there’s always another drink at hand, and cigarettes and Fritos are ubiquitous.

The connection to business? Easy. Think about the obsession with quarterly earnings. Think about Wall Street’s “IBGYBG” mantra (I’ll be gone, you’ll be gone – do the deal). Think sales quotas, weekly P&Ls, constantly refreshing online metrics for performance. A myriad of new front-end loaded opportunities for instant gratification. Running a business this way perverts strategy in favor of a series of opportunistic NPV calculations.

Business Since 1970 – One Major Trend

Biggest trend of the last 40 years?  An obsession with markets. We have pursued, especially in finance, the grail of frictionless markets, believing that the Invisible Hand will save us by converting our individual selfishness into collective good.

It’s a crock. What markets have also done is encourage NPV calculations everywhere, all the time, and everything is monetized so we can compare them. There’s always another front-end loaded curve to buy into. Buy it and flip it. Invent a new business and IPO it before it goes profitable. IBGYBG. Markets – abetted by modularization and outsourcing and communications – have enabled massive short-termism in business.

The game works until the game doesn’t work. It works if you assume your grandchildren’s world will not suffer by your focus on short-term NPV enhancement. It works if you assume that a culture of instant monetization will beat Chinese strategies from a civilization accustomed to thinking in centuries.  It works if you assume that long-term good is achieved by means of constant short-term optimization.  But it isn’t.

Trust and Short-Termism

There’s  a reason that one the Four Trust Principles is “Focus on the medium-to-long term, not the short term; develop relationships, not transactions.” It’s because trust is born from long-term commitments; the confidence that the other party is after something besides their own instant gratification. Short-termism is perhaps the most perniciously anti-trust business phenomenon of our times. We have been poisoning our corporate cultures through a relentless focus on markets, monetization, analytics and processes.

Those are not the basis of trust. A commitment to long-term principles and relationships is the basis of trust.

Destroying Shareholder Value: One Quarter, One Customer at a Time

I spoke with a mid-level consultant at a medium-large American consulting firm. His project had an overrun. Question was, how to handle it.

Me: How big an overrun?

Him: $80K—a 50% overrun.

Me: A big percent, but not a big dollar number. Tell me about the client.

Him: Medium sized for us; decent relationship; we do 5-6 projects a year with them.

Me: What do you each say?

Him: They agree they signed a contract saying they were responsible for the disputed work. We thought their interpretation was wrong. We ended up doing the work, but disagree about who’s responsible.

Me: Of the $80K, how much would they agree is their fault?

Him: Maybe $20K of the $80K.

Me: And you?

Him: We think $70K of the $80K.

Me: That is a mere $50K issue. You’re a big company, this is a good client relationship—$50K is chump change.
Why don’t you go to them and say, ‘Look, we value this relationship. There is an $80K overrun here; why don’t you pick the number between $0 and $80K that you think is most fair, and we will pay it.’ Give them total choice. Let their choice reveal their character and their intent, and show good faith on your part. Work the relationship, not the negotiation.

Him: Well, they might take advantage of us.

Me: Of course they could. And if they do, you’ll know if these are people worth trusting in the long haul, or whether henceforth you get tighter controls and/or give this client over to a competitor. Do you want a relationship, or a petty quarrel? How much do you think they would offer?

Him: I’d guess they’d offer us maybe $40K. And I think what you say is the right thing to do. But my [service offering] leadership team won’t go for it.

Me: Why not?

Him: They think we deserve more, and they can get most of it by holding out.

Me: For how much?

Him: They think they can get $70K.

Me: You realize, that is only $30K of difference between the two of you.

Him: Yes, but they are really under pressure to make their profit bogeys. There’s really nothing I can do.

If you’re not sickened by this dialogue, let me break it down.

It sounds like a bad divorce settlement. Two large firms wasting time and creating bad blood—over $30K. A true imbalance.

But it’s worse.

This was probably a good relationship.  Let’s assume it might have generated five projects a year for 8 years going forward. Further, that benefits to the client would have increased as the consultants gained more familiarity and expertise over the years.

Suppose that amounts to a present value of, say, $10M in fees.

Assume that the bad blood generated results in lower trust—more haggling over fees, lower fees, more competitive bidding, more audits, more skepticism over advice—all resulting in, say, 30% reduction in the present value of expected fees.

That’s $3M reduction in present value. For $30K on a quarterly P&L.

Many think it doesn’t matter because it doesn’t hit the P&L. It’s true that FASB rules don’t book present value, at least not through the income statement.

But it is real. The eagle eyes on Wall Street know very well how to discount future streams. Private equity firms know the value of customer retention rates.

In other words, the financial metrics that matter most—those of the market, not of the accounting books—do know the cost of this firm’s decision.

You may think the young manager is at fault for not standing up for what he knew was right. Or, you may think his bosses are to blame.

I think the real culprit is endemic bad business thinking. Business thinking that mindlessly focuses on short-term metrics of short-term behavior, linking the two by short-term incentives. The solution doesn’t lie in more short-term thinking ("I know, let’s analyze imputed market discounts and allocate them across quarterly bonus pools for each decision!").

The resulting behavior is value destruction by any sensible definition. Bad business. They call it financial management. It is anything but.

Yet this way of thinking, as anyone in the corporate world knows, is the rule, not the exception. Anyone who believes in perfect market theory need only look at daily management behaviors to find their disproof; everywhere managers behaving in ways that destroy value. Believing that they’re creating it.

Bad thinking.