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Burdened with a division that has been losing money for 5 years, what does a top manager do? Every bit the head of a business organization unit that is just breaking fifty-fifty and that could become either style in the coming decade, how does a middle manager judge in which strategic direction to take it? These are among the nearly important problems that an executive faces in his or her business life. By and large, a decision is reached simply later on years of "getting by," years in which the parent company either ignores complex ways to revamp the troublesome division or the reality that the division should be divested.

In his clear extension of the work of William Due east. Fruhan, Jr. and others, the writer has developed a formula to help managers evaluate the potential for value creation or destruction at the level of business units, rather than the whole corporation. Using basic business and accounting terminology, he provides managers with a new way to await at their concern units that allows them to estimate their performance early, rather than too late, in the business organisation bicycle.

Some companies consistently enjoy share prices that exceed book value. Such value creators range from giants like Coca-Cola, IBM, and Procter & Gamble to less-known pocket-size and medium-sized companies like Pall and Shoney'southward. Other enterprises trade below book value year after year, in both deport and balderdash markets.

Many managers believe that these differences in toll to book ratio practice not stem from real differences in competitive performance but rather from the capriciousness of the stock market. I do non hold that view. I believe that, over the long term, the stock market responds rationally to the adoption of business strategies that change the level and quality of a company'south future cash flows. Most important, evidence shows that—given some exceptions—the stock marketplace processes bachelor strategic information efficiently.i

Accepting this premise has 2 important implications for managers. The kickoff is that they should not waste their fourth dimension blaming a share price below book value on the perversity of investors. The 2nd is that they should expect the stock marketplace to look beyond the short term and to recognize strategies that create value.

Fifty-fifty if they acknowledge the long-term rationality of the stock market, all the same, many managers say that believing in the goal of value creation and interim on information technology are two entirely dissimilar things. Increasing shareholder value requires cognition about the sources of value creation and destruction inside the corporate organisation besides as the value implication of any new strategy contemplated. That knowledge is not piece of cake to come up by.

Executives in a typical corporation must evaluate and compare the performance of a number of unlike concern units, for information technology is at the business unit level that value is ultimately created or destroyed. The tobacco business of Philip Morris, for example, has consistently created value for the company, while the performance of its beverage units has fallen short of expectations. The visitor's option of strategy depends in role on its interpretation of the nature of 7-Up'southward losses. Are they temporary and necessary while building market share and hereafter profits? Volition losses persist without a drastic strategic change like divestment? Or should Philip Morris continue trying to build competitive advantage in that sector by acquiring another well-established soft drink manufacturer?

Trying to respond these questions on a purely qualitative ground can sometimes bulldoze executives to distraction. I have developed a method of value creation analysis that can help managers decide how to bargain with possible "cash traps" like Vii-Up. Although managers may easily place such a trap, they may often underestimate its toll to shareholders. Managers may also avoid making decisions considering they can't estimate the impact on their companies' share prices if they decide to pursue culling strategic directions.

In many cases managers overcome their fear of the impact of disinvestment from a company's original business merely after a very big and unrecoverable loss of shareholder value. SCM's management of its typewriter business is a well-known example. Only recently did the company denote it would halve its investment in typewriters—post-obit years of value devastation from persistent losses and the shrinking of its market place share.

The strategic choices that Philip Morris and SCM face typify those of many companies in today's competitive markets. Here I will outline a procedure that measures the functioning of business units and helps assess the value contribution of alternative strategies.ii While grounded in the principles of modern finance, the technique uses generally bachelor accounting and market place data and yields results in terms familiar to management that have direct practical applicability.

Creating Value

A simple value creation model (see Exhibit I) synthesizes the link between strategy and shareholder value. Value creation is expressed in terms of the fundamental determinants of free greenbacks flows and their nowadays value—the expected return on equity (ROE), the cost of disinterestedness uppercase, the expected growth of the company, and the period during which the company is expected to maintain a positive spread between its ROE and its cost of equity.

Showroom I The Value Creation Model

The sources of shareholder value are two. The visitor creates value by maintaining a positive spread between its ROE and its cost of equity upper-case letter (that is, it generates profits that exceed what investors crave from companies in the same class of risk). The company too creates value from growth opportunities (investment in new avails) at a positive spread. On the other hand, the visitor destroys value when the spread is negative. If the ROE is expected to remain below the price of equity capital, faster growth will simply accelerate destruction of shareholder value.3

Exhibit II provides a unproblematic illustration. In 1983, the spread between Philip Morris'due south ROE and its cost of equity was vii.four%. At the end of 1983, the stock market expected the company to maintain its superior performance and rewarded it with a share-price-to-book ratio of 2.22. Theoretically, the visitor had created value equal to 122% of book equity for its shareholders. The spread betwixt SCM'southward 1983 ROE and its cost of equity was, however, –14.4%, and its end-of-1983 price-to-book ratio was only 0.68, which ways that the company had dissipated shareholder value equal to 32% of volume disinterestedness.

Exhibit 2 Company and Segment Data for Philip Morris and SCM 1983

To formulate its strategy, a company must trace the source of its amass performance to the operating unit level. Because most companies evaluate business concern units in terms of return on investment and pretax margin on sales rather than ROE, I commencement determine the minimum margin on sales and ROI that a business unit must have to create shareholder value. You lot tin await more closely at the case of Philip Morris to see this indicate. Although it seems clear in Exhibit II that the tobacco business of Philip Morris creates substantial shareholder value while the soft drink business organization loses money, y'all cannot define the contribution of the beer unit. Render on investment by itself is not sufficient to decide its value contribution.

Setting Business Unit Functioning Standards

The company's strategic plan will ordinarily provide data on each business organisation unit's projected pretax margin on sales and ROI. I have arrayed such projections for a hypothetical company, the TTW Corporation, in Exhibit III.

Showroom III Projected Functioning of TTW'south Business Units

To evaluate the projections, you lot must know above which ROI level each unit will create shareholder value. I ascertain ROI as the return on the total investment in the business concern unit afterward income taxes merely earlier the tax savings produced by financial leverage. That is,

where t is the effective revenue enhancement rate applicative to the concern unit and EBIT, its earnings earlier income and taxes. Value creation requires a positive spread between ROE and the cost of equity or a positive spread betwixt ROI and a unit'south weighted average cost of equity and debt majuscule (WACC). I define WACC in the usual way:

where symbols E, D, k, and r denote equity, debt, the cost of equity, and the interest rate on debt. In other words, the unit of measurement'southward break-even ROI equals its WACC.

In this analysis the concern unit's WACC thus plays a central role. The WACC often varies from unit to unit because of differences in business hazard and debt chapters. The debt capacity of a concern unit depends on such factors as the behavior of the unit of measurement's cash menstruum, its sales volatility, its profitability, the fiscal practices of its industry (for example, the extent of supplier credit), the marketability of its assets, its need for a strategic borrowing reserve, and the target bond rating of the corporation.4

I take calculated the WACC of TTW's units in Exhibit Four. The figures for the cost of equity differ across units considering of differences in concern risk. In practice, a manager tin estimate the cost of equity of each unit past using the capital nugget pricing model methodology and stock market information for companies specializing in the same business as the unit.5 Because the price of debt is the weighted cost of interest-begetting and not-interest-bearing liabilities incurred in guild to finance the business unit's avails, it differs across units, fifty-fifty though the interest charge per unit the company pays is the same no matter what information technology uses the funds for. The effective income tax rate can too vary beyond business units.

Showroom IV Debt Capacity and Cost of Capital of Business Units

In TTW's case (see Exhibit III and Showroom IV), machine tools' ROI exceeds its WACC by 3.two%, while electronics just breaks even and metal products performs at 2.6% below its break-even ROI. Restating the results in terms of sales margins produces a more than intuitive and operational evaluation of performance. A function of the unit of measurement'south WACC, taxation rate, and asset turnover, the pause-even margin on sales increases with its WACC and tax rate and decreases with its asset turnover:

where turnover = sales/avails.

Faced with the pause-even sales margins shown in Exhibit V, TTW'southward management has to decide whether it can e'er eliminate the negative spread of metal products and whether it can go beyond the break-even performance of electronics.

Showroom 5 Projected and Interruption-Even Sales Margins

A company can justify the consistently negative performance of a unit such as metallic products just if the company expects that performance to turn positive in the future. Otherwise, information technology should divest. The analysis of the disinvestment selection helps test the validity of value creation assay based on book value. If the gain from disinvestment are dissimilar from the book value of the unit's assets, direction should recalculate the unit's ROI and its interruption-fifty-fifty margin on sales past using liquidation rather than volume value. When liquidation value is below book value, recalculation may show that the unit actually creates value in excess of its liquidation value and should be held rather than liquidated.

Unit Value Creation

Although top management can use its evaluation of the required ROI and margin on sales for each business unit to discriminate between those that create value and those that destroy it, the assay will not provide dollar estimates of the unit's contribution to the visitor's blended value or to its price per share. Direction will need such estimates to decide whether to maintain or revise its strategic plan. Fortunately, the elements needed for this kind of evaluation at the business unit of measurement level are readily bachelor. Managers tin use the projections of ROI and debt ratios to estimate the unit'south render on disinterestedness. While you can estimate ROE by drawing upwardly pro forma income statements for each unit, you can too utilize the following formula:

ROE = ROI + [ROI–(1–t) r] D/Eastward

The 2nd term of this expression is the contribution of debt leverage to ROE and equals the spread betwixt ROI and the later on-revenue enhancement cost of debt multiplied by the debt-disinterestedness ratio. Showroom 6 shows the contribution of leverage to the ROE of TTW's units, while Showroom VII shows the unit's contribution to shareholder value by matching the computed ROE with the unit's cost of disinterestedness. I take assumed that machine tools will maintain its positive spread for 20 years, electronics volition keep to break fifty-fifty in the future, and metal products will eliminate its negative spread in five years. The growth rate for each unit comes from the strategic plan. I obtained each entry in the "Economic value/book value" column past calculating the costless cash menstruum generated by the unit, discounting information technology to its nowadays value at the unit of measurement's cost of disinterestedness, and dividing the present value by the initial book value of the unit's equity. The results prove that the machine tool unit of measurement created value equal to fifty% of its disinterestedness and that metal products destroyed value equal to 22% of its equity. The impact on TTW's consolidated position brings the potential stock toll premium over book value down from $iv.33 (if the company consists solely of the machine tools unit of measurement) to $ii.87 per share. In other words, metal products has dissipated $one.47 per share.

Exhibit 6 Projected Return on Disinterestedness for Business organization Units

Exhibit 7 Value Creation by Business organization Units

The case of TTW embodies the spectrum of divisional performance typically found in diversified companies. For example, machine tools represents value creators such as tobacco in Philip Morris and coatings and resins in SCM. Electronics represents mediocre units such as beer in Philip Morris and paper in SCM. Finally, metal products represents value destroyers such equally Vii-Upwardly and the typewriter unit of SCM.

Evaluating Strategic Decisions

The arroyo used to evaluate the outcome of current strategies can also be used to evaluate potential strategies toward each business organization unit. For case, consider the post-obit four potential strategies for TTW'due south metallic products division:

1. Invest to modernize and gain market share. An additional capital letter investment of $v million, lx% financed by debt, volition develop better technology and issue in price reduction, improved quality, and increased ability to compete for market share. The value creation analysis shows that although the unit's average ROE during the next four years would be only fifteen%, information technology volition increase to xx% once the division has consolidated its marketplace position. Assets and sales will grow at 5% per year.

two. Stop asset growth. Under this strategy, metal products will forgo marketplace share in order to limit value devastation. The unit of measurement will buy no more assets, limit investment to maintaining productive capacity, and drive downwardly costs. Boilerplate ROE will be 12% during the side by side five years and will friction match the cost of equity (17%) in the years afterward.

3. Harvest. The unit will maximize its greenbacks flow by eliminating investment for growth and replacement of productive chapters. The unit of measurement will curtail maintenance expenses and R&D and reduce product of lower margin product lines as capacity shrinks. After 5 years of harvesting, TTW will redeploy the unit of measurement's remaining assets, including real estate, to other divisions or liquidate them. Management expects harvesting to recoup the book value of those assets and to increment ROE to 15%. Because the greenbacks catamenia from depreciation will exist ten% of the book value of assets, the unit's assets volition shrink 10% each year.

iv. Sell out. TTW'due south remaining culling is to sell metallic products at a 10% discount on the book value of its avails.

I have arrayed the value implications of each strategy in Exhibit VIII, which shows that modernization is clearly preferred. That strategy will take a unit of measurement that destroyed $4.4 one thousand thousand of stockholder value and plow it around to produce an disinterestedness value $2.two million above book value (a $6.half dozen million improvement equivalent to $ii.20 per share). Side by side all-time is harvesting, which minimizes value destruction by recouping $49 million of the $l million investment.

Showroom VIII Value Implications of Strategies for Metal Products in Millions of Dollars

The strategies to be evaluated in each case depend on the nature of the business unit under consideration. For example, in the case of Philip Morris's soft potable unit, a possible investment strategy is acquiring a company synergistic with Seven-Upwards. On the other paw, SCM seems to be much more restricted in terms of feasible strategies for its typewriter unit of measurement. Given the rapid technological modify that has swept the industry, investment for modernization is likely to be out of SCM'southward achieve at this point. Moreover, information technology might be also late to implement a sustainable harvesting strategy. The only possibilities open up to SCM seem to be selling the unit or peradventure entering into a partnership with an efficient, technologically capable manufacturer.

Direction should evaluate the outcome of strategic decisions for all concern units, including those that create shareholder value. Such an evaluation either confirms the electric current strategy'southward validity or points out better alternatives. At the very least, evaluating the implications for shareholder value contributes to a amend understanding of the assumptions on which current strategy is predicated and prepares height management to respond strategically to time to come developments.

My technique for evaluating the performance of business units and the impact of strategic decisions on them consists of four steps:

1. Estimate basic data for each unit—toll of equity and debt, debt chapters and taxation charge per unit, and the turnover, sales margin, ROI, and asset growth expected.

ii. Set performance standards (required sales margin and ROI) and compare them confronting projected performance.

3. Estimate the value cosmos implications of the current strategy. Use ROI and fiscal leverage information to limited the unit's performance in terms of ROE and cost of equity and to estimate the unit of measurement'southward contribution to the value of stockholder equity.

4. Evaluate strategic decisions having to do with the units, such as changes in production and marketing, alternative investment and growth rates, and harvest and liquidation options.

The implementation of value creation analysis can exist facilitated past carrying out the computations associated with the above steps on an electronic spreadsheet. The potential user is, however, cautioned against relying on mechanical applications of the approach. Value creation analysis has been designed to complement rather than to substitute for managerial creativity and adept judgment.

References

1. For a discussion of market efficiency, see Thomas R. Piper and William East. Fruhan, Jr., "Is Your Stock Worth Its Marketplace Price?" HBR May–June 1981, p. 124. The standard reference on the relationship betwixt strategy and shareholder value is William East. Fruhan, Jr., Financial Strategy: Studies in the Creation, Transfer and Destruction of Shareholder Value (Homewood, Ill.: Richard D. Irwin, 1979).

ii. An important earlier contribution to this subject field was fabricated by William W. Alberts and James M. McTaggart, "The Divestiture Decision: An Introduction," Mergers & Acquisitions, Autumn 1979, p. 18. See besides their "Value Based Strategic Investment Planning," Interfaces, January–February 1984, p. 138, and Alfred Rappaport, "Selecting Strategies That Create Shareholder Value," HBR May–June 1981, p. 139.

3. For discussions of the value cosmos model and its empirical foundation, see Fruhan, Financial Strategy. The relationship between growth and value is analyzed by Fruhan in "How Fast Should Your Company Grow?" HBR January–Feb 1984, p. 84.

four. For a recent discussion of debt policy, see Thomas R. Piper and Wolf A. Weinhold, "How Much Debt Is Right for Your Company?" HBR July–August 1982, p. 106.

5. Run into, for example, James C. Van Horne, "An Application of the Capital letter Asset Pricing Model to Divisional Required Returns," Financial Direction, Spring 1980, p. 14, and Diana R. Harrington, "Stock Prices, Beta, and Strategic Planning," HBR May–June 1983, p. 157. This technique is evaluated in Russell I. Fuller and Halbert S. Kerr, "Estimating the Divisional Cost of Capital: An Analysis of the Pure-Play Technique," Journal of Finance, December 1981, p. 997.

A version of this article appeared in the January 1986 issue of Harvard Business Review.