Financial analysis is widely used to assess investment proposals, but less commonly to evaluate strategy.
Strategy, both at business unit level (are we competing successfully?) and at the corporate level (does this portfolio of businesses make sense for the shareholders?), needs continuing evaluation.
Business-level strategy can be judged by economic value added (EVA) analysis.
Corporate-level strategy can be assessed by breakup analysis.
Line managers are not necessarily motivated to do these analyses; it is thus up to others, especially the nonexecutive members of the board, to advocate them
Many well-known tools and techniques of financial analysis are used by investors, stockbrokers, and corporate managers to assess corporate performance. Their use is particularly prevalent in mergers and acquisitions and in the analysis of capital expenditure. But how often do we say: “Let’s do some financial analysis to see if this strategy is any good. Let’s take a view on the corporate portfolio and the extent to which value is added by the corporate center and use financial tools to do it.” In my experience, this doesn’t happen much.
When companies undertake an acquisition, extensive financial analysis accompanies the investigation by managers, the proposals put to the board, and, if necessary, the story that is told to investors and the financial community. Comparisons are made with valuations of similar businesses and with transactions of a similar nature. Discounted cash flow techniques are used to assess the impact of different outcomes and the extent to which the investment is likely to recover the cost of capital employed in it. So the use of financial analysis for decision-making in the corporate environment is well known and widespread. Indeed, the essence of the core technique—present value and discounted cash flow analysis—has been around for at least 50 years. The tools are well known, credible, and widely accepted.
What about using financial analysis to assess strategy? In nearly all companies there are two levels of strategy that must be kept under constant surveillance by the custodians of stockholder investment. First, the viability of the individual businesses must be constantly examined. Are they earning satisfactory returns—or, indeed, returns in excess of the cost of capital employed in them? Second, does the corporate portfolio make sense? Would some parts of the business be better off elsewhere? There are straightforward tools to help in answering these questions and they should be regularly applied by the board of directors.
Why then does such an analysis not seem to be a widespread and regular practice? I think that the answer is pretty obvious. Top managers often do not want to admit that some parts of their business portfolio are unviable or that they are not the right owners. It’s an agency problem, where management’s motives diverge from the interests of the stockholders. But there are others whose job it is to question performance and to be sure that these agency problems do not stand in the way of the interests of stockholders. Nonexecutive directors on the board of directors are in this position, as are representatives of the investment community who decide on whether to advocate support for the organization. But to assess strategy—both at the corporate level and at the level of the individual business—they need suitable tools.
Corporate-level strategy, as comprehensively described in the writings and teachings of the Ashridge Strategic Management Centre (see the More Info section) involves ensuring that value is added by the corporate center to each and every business unit within the portfolio. A number of useful frameworks and techniques have been available for some time to test the quality and intensity of corporate value added. Managers at both the business unit level and at the corporate center can be challenged to explain the exact nature of corporate value added (what do you do to make this business more successful and thus more valuable?). Long-term competitive performance (market share in key segments) can be used to assess the center’s role in ensuring lasting commercial and financial viability. Comparison of the management structure and style with key comparator companies (especially those with more successful financial performance) can be used to assess both strengths and weaknesses in value added.
It is thus possible to take a reading on whether or not the corporate owners are doing an adequate job. The owners must address two questions: first, do we really add substantive value to each of our businesses; and, second, what businesses should we be in?
But these tests are qualitative. They make use of individual judgments, recollections, and viewpoints. While often pertinent and relevant, they can also be dreadfully biased. An alternative is to make the evaluation a quantitative one.
A straightforward financial tool is available to assess the overall success of the parenting capability of any big company, namely, breakup analysis. Breakup analysis takes an arm’s length view of the market value of each of the company’s businesses and compares the total of these values with corporate market capitalization, which is the value the marketplace places on the corporation as a whole. If the latter is less than the former, corporate strategy isn’t working. The market is saying that the corporate center is destroying value. Synergies are not believed.
How to Do a Breakup Analysis
Subdivide the company into discrete businesses, focusing on particular customer groups and operating in identifiable industries. You will know that you are defining the business at the right level when it is easy to identify comparable companies.
Determine a baseline profit-after-tax figure for each business. Outside analysts will be constrained by the availability of reported information, but insiders should have all the necessary information. If profit performance has been uneven, use the budgeted figure for the coming year tempered by a judgment about how likely it is to be realized.
Corporate overhead costs, if allocated, should be removed from the cost basis of the individual businesses, subject to the limitation that any activities which would have to be added in were the business to be operating on its own must be accounted for. One famous Dutch electrical equipment company assesses a fixed charge for corporate-level R&D on all businesses. If the business in question demonstrably receives little benefit from such services, the charge should be reduced (or eliminated if the business is not really research-dependent) accordingly.
Identify comparable companies whose stock is publicly traded. Make a judgment about whether the business being analyzed deserves a rating below, equal to, or above that of the average of comparable companies. Decide on an earnings multiple and calculate pro forma market value accordingly.
Take note of the current market capitalization of the company as a whole. Make a judgment about whether any exceptional circumstances have caused a temporary departure from the norm. Determine a baseline market capitalization figure. For example, the sudden appearance of very bad news (like a financial scandal) concerning a key competitor can sometimes cause a selloff of major sector participants until the market’s nervousness is allayed. Such an apparent “blip” must be considered.
Compare this latter figure with the total of the pro forma market values of the individual businesses and compare the two figures, after adjusting for borrowings at the corporate level.
Stockbroker analysts often perform similar analyses when judging whether a company is a plausible takeover candidate.
Perhaps the most famous example of a failed corporate-level strategy was that characterizing Imperial Chemical Industries (ICI) in the 1980s, at the time Britain’s largest industrial company. ICI was a dominant player in basic chemicals, a notoriously cyclical and increasingly competitive business, where returns have often been unsatisfactory. It also owned a highly successful pharmaceuticals business which produced most of ICI’s profit. Outside observers noted that an arm’s length valuation of the pharmaceutical business alone was worth more than all of ICI together.1 This is just another way of saying that the corporate-level strategy was a failure (or that the chemicals business was worth less than nothing). Had ICI’s board made this calculation and honestly confronted it, it would have broken the company up itself rather than waiting for a threat from outside to necessitate it.
Business Unit Strategy
Similarly, many tools and techniques are available to assess the viability of strategy at the level of each business in the corporate portfolio. Each company has its own favourite measures, against which managerial bonuses are often paid. Much attention is paid to these measures, and therefore what they are, and the objectivity with which they have been selected, is important for stockholders. Alas, there are many ways to rig the numbers to make the outcome appear satisfactory even if the reality is somewhat different.
But there is one measure that is hard to rig. Economic value added (EVA) analysis simply calculates business profitability after the imposition of a charge for the capital employed in the business. The tools for doing this are highly developed and, indeed, are championed by a number of consulting firms. The measures can be applied to any business in any company. A division earning $10 million pretax on turnover of $100 million and capital employed in the business of $60 million might, at first glance, be viewed as displaying creditable performance. But at a 35% tax rate and with a cost of capital of 12%, EVA is negative ($10 million × 65% − 0.12 × $60 million = $6.5 million − $7.2 million = −$0.7 million).
The implications of such an analysis are clear. If a business consistently demonstrates negative EVA, it is “parasitical”—eroding stockholder wealth. New investment is folly unless a fundamental game change can credibly be expected to result in positive EVA.
There is the possibility that it is not the fault of the operating management team. Some industries, in the aggregate, produce negative EVA. Airlines are the classic example. Warren Buffett recently observed that the total profitability for the entire industry since its inception has been zero. No one in their right mind would start an airline now. Since deregulation in 1978, there have been at least 100 bankruptcies in the airline businesses.2 Management teams operating in one of these unhappy industries may actually be doing a good job on a relative basis but, alas, not for their stockholders or for the economy as a whole. How is it possible that an entire industry, perhaps with one or two exceptions, can fail to earn an “economic rent”? How can investors continue to commit capital to industries in which acceptable returns are unlikely? A number of explanations have been offered.
In developed economies major employers, with the major political pressure they can bring to bear, often prop up failing performers and keep marginal plants open, as in the car industry. Barriers to exit can be formidable, especially in industries where capital equipment is only of use in that industry and lasts a long time. Measures of profitability may be misleading. Managerial bias and incentives can prevent problems from being addressed in an objective way. Managers in unsatisfactory industries may not want to admit to the situation because it could make them look foolish—or worse, unemployable. And investors may simply be incompetent. It is not enough to suggest that they might simply buy stocks with high dividend yields on the basis of a very low valuation of assets. Any investor looking to the longer term, as most institutional investors seem to do, will eventually focus on total stockholder return. Term lenders presumably do the same. They’ll want capital investment to pay out.
How to Calculate EVA
The formula to calculate EVA is fairly simple. The formula is: EVA = net operating profit after taxes less the after-tax cost of capital employed.
The operating profit includes deductions from revenues for the cost of goods sold and for the operating expenses. Interest expense is then subtracted to cover the cost of the debt capital used, income taxes are then subtracted, and, finally, a cost for the equity capital is subtracted from the net income after tax to obtain the EVA.
The cost of equity capital can be derived by using any one of several approaches. Perhaps the simplest approach is to use the interest rate that a company can borrow at and then add a risk premium. The risk premium is added because investors require a higher return to invest in stock than they require for bonds. This is often called the bond yield plus risk premium approach. A typical equity risk premium is about 4%, so if a company can borrow at 10% its cost of equity capital would be 14%. Alternatively, use the weighted average cost of capital (WACC), a figure that is often well known to big companies and available from public data sources.
Alternatively, the cause of negative EVA may simply be poor management and a consistently weak competitive position. The managers of such a business are simply not offering a product or service which pleases enough customers for the business to be viable. We call this a failed competitive strategy.
Whether the problem at business unit level is participation in a low-profit industry or a failed competitive strategy, the business does not deserve further investment. It should be liquidated in the best way possible. Such businesses are likely to display longer-term negative EVA.
Understandably, there are those who resist the notion of assessing strategy at either level by means of quantitative measures and analysis. Many such arguments claim unfairness, or a lack of true comparability. We see this for example in the daily news, when head teachers complain about league tables (often, of course, because the tables give their school a low rank) because, they say, the circumstances of their school are exceptional. They may even be right. But the school’s performance is still lousy.
Similarly, business people will often argue in this way against the imposition of regular objective checks.
Financial calculations of the kind described above which give a clear indication of failed strategy at either the corporate or business unit level require action.
Failed corporate strategies call for remedies ranging from reinvigorated management to structural breakup. It is up to the board to decide on the seriousness of the problem and the nature of the appropriate remedies. Failure to take appropriate action will often result in stockholder dissatisfaction and attempts by outsiders to restructure the company.
Failed business unit strategies likewise demand action, since continuing on this basis constitutes a de facto drain on capital. Obviously, this cannot continue indefinitely. Whatever the remedy, the key is a managerial realization that “business as usual” is not an option.
This thinking and approach to analysis is simple. Good stewardship demands that these questions are raised regularly and acted on.
1Geoffrey Owen and Trevor Harrison. “Why ICI chose to demerge.” Harvard Business Review (March–April 1995): 133–142.
2Jon Bonné. “Airlines still struggle with paths to profit: After 100 years, it’s no easier to get rich flying planes.” msnbc.com (December 12, 2003).