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 ultimately shareholder returns.
10. Crossover problem—The knowledge-building process that is fundamental to the pragmatic theory sheds light on how accounting-based performance metrics, applied at lower levels in the firm, can be at cross-purposes with performance improvement actions keyed to process (nonaccounting) variables. The solution is to employ systems principles in the development of more effective language keyed to performance improvement.
11. Management's priorities—Chapter 6 explains, using well-known and prominent company examples, the underlying logic for management's priorities to change, dependent on the firm's life-cycle position, as follows: for the high innovation stage—test critical assumptions; for the competitive fade stage—build or acquire capabilities to expand; for the mature stage—adapt early to fundamental change; for the failing business model stage—purge a culture of business-as-usual.
12. Organizational structure—A critically important part of sustaining a knowledge-building culture that minimizes bureaucratic waste is a firm's organizational structure. In Chapter 6, the benefits and challenges from transitioning to flatter organizations are analyzed. The evolution of a large Chinese firm, the Haier Group, is reviewed focusing on its changes in organizational structure attuned to the company's size and competitive environment.
13. Company histories—Throughout this book, company histories are analyzed that spotlight a company's long-term life-cycle track record with its key comparison of economic returns (returns on capital) versus the cost of capital. These track records are essential for any long-term study of how firms create or dissipate value. Life-cycle track records applied to a firm's business units will improve resource allocation decisions, and are especially helpful for analyzing the risk and potential reward from owning a firm's shares.
14. Progress Studies—There is a growing demand for a new academic discipline, Progress Studies, that will advance our understanding of the complex system relationships involved with dynamism and economic growth. Integrating the pragmatic theory of the firm with Progress Studies will accelerate an understanding of the processes by which firms build knowledge, create value, and generate progress—a bottom-up, concrete body of knowledge using the individual firm as the unit of analysis, as it should be: the firm is the fundamental unit of capitalism.

In conclusion, I was fortunate to have two friends volunteer to extensively edit the entire manuscript. As to writing, both are perfectionists. Jack Reardon is the author of economics textbooks and the founding editor of the International Journal of Pluralism and Economics Education. Bryant Matthews is Global Director, Credit Suisse HOLT Research and the coauthor of Beyond Earnings: Applying the HOLT CFROI and Economic Profit Framework. Others at Credit Suisse have helped me on my journey: Jim Ostry, co-Head and Managing Director of Credit Suisse HOLT; Tom Hillman, Managing Director and head of HOLT's research team; and Rick Faery, Global Head of Corporate Insights Group, Credit Suisse Investment Banking. Especially useful comments were provided by Joe Cursio, Jerry Ellig, Maureen Ryan Healy, Keith Howe, Tom Malatesta, Jeff Ubois, and my sons, Greg Madden and Jeff Madden. I am grateful to Mark Frigo, who frequently invited me to present many of the ideas in this book to his MBA students at DePaul University. I appreciate the graphic design skills of Kimberly and Johnny Allgaeuer, who produced the book's many figures.

Finally, I am on the Executive Advisory Board of the Center for Advancing Corporate Performance (CACP) started at the Illinois Institute of Technology. I am working with Mark Ubelhart, David Koenig, and others to make CACP a world-class organization in providing practical insights about value creation for broad stakeholder groups using the business firm as the fundamental unit of analysis.