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( 6 ) CHAPTER 10

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THE MARKET-TO-BOOK VALUE [M/B] MODEL The Divestiture Decision
Alternatives for Growth and Diversification



The initial steps in the corporate strategic planning process we presented in Chapter 4 have, as a major objective, the formulation of business strategies which respond to the vision of the firm, and to the competitive pressures faced by each business unit. We are now left with the question of addressing the merits attached to each alternative strategy. In a profit making organization, it is a widely accepted economic criteria that the goodness of strategy should be measured in terms of total value created for the firm's shareholders. In other words, the economic objective of the firm is the maximization of the shareholders' wealth. We will pursue two different issues in this chapter. First, is the presentation of a simple rule - the market to book value [M/B] model - to guide managers in addressing the question of value creation both, at the firm and at the SBU levels. Second, we want to discuss another kind of portfolio matrix - the so-called profitability matrix - which again might cast some light on the question of the value added by each of the various businesses of a firm. Prior to addressing these subjects, we will make a few comments on some broad conceptual issues: 1] There is no question that the best methodology available to assess the economic value of the firm, or a business unit belonging to the firm, or a project within an individual business unit, is to compute the Net Present Value [NPV] of the future cash flows generated by that economic entity, discounted at an appropriate rate, adjusted for inflation and risk. We will assume through-out this chapter that the reader is conversant with the mechanics of cash-flow discounting, as well as the underlying principles leading toward the selection of NPV as a preferred method for economic evaluation. For a justification of this statement, see, for example, Brealey and Myers [1981, Chapter 5]. 2] A meaningful proxy for the value of the equity of the firm in a country with an efficient capital market, such as the one prevailing in the United States, is given by the market value of the common stock. The assumption is that the market price of common shares represents a consensus of the present value assigned by investors to the expected cash flow streaming from the assets the firm has already in place, as well as from investments the firm will have the opportunity to make at some time in the future, once the interest payments to debtholders have been substrated. Therefore, within an efficient capital market setting, the objectives of the firm equates to maximizing the market value of equity, provided that the capital structure of the firm has already been defined. A broader objective would be the maximization of shareholders' wealth, considering the capital structure as one of the decision variables. 3] The market value of a firm's common shares is an indicator that can assist managers both in assessing the shareholders' wealth, as well as in measuring its economic and financial performance vis-a-vis other firms in its industry. It is not surprising, therefore, that managers carefully observe long-term trends in the capital market as an ultimate guidance for the managerial success of business firms. On the other hand, excessive concern in day-to-day movements of stock market indicators has been repeatedly stated as one of the most negative forces pressuring American managers to inappropriate short-term orientation. Therefore, there seems to be a paradox in the capital-market messages to the manager. But this is not so. There is plenty of evidence that the market does reward long-term performance, and penalizes erratic behavior intended to hide unfavorable developments in the short-run. 4] The above considerations make highly desirable the use of evaluation methodologies in which the market price of the common shares plays an essential role, while retaining the legitimacy of the NPV approach. The M/B model represents such a tool. The most attractive feature about this model is that it lends itself to a fairly simple interpretation in two basic dimensions: - The economic and financial performances of the firm [whether the firm is earning a return higher than its cost of capital, or equivalent, whether its economic value exceeds its accounting value], and - Its competitive performance, measured by the resulting [M/B]s among the leading firms competing in the same industry.



The M/B is a blend of two different perspectives of the firm. In the denominator, the book value of the firm's shares provides the accountant's perspective, which corresponds to the historical measurements of resources contributed by shareholders. In the numerator, the market value of the firm's shares gives the investor's perspective, which corresponds to an assessment of future payments generated from the assets the firm has already in place and from the investments the firm would have the opportunity to make at some time in the future. Therefore, the M/B ratio can be equated to: Expected future payments/Past resources committed. The basic message of the M/B model can be summarized as follows: - If M/B = 1, the future payments are expected to yield a fair return on the resources committed. The firm is neither creating nor destroying value. - If M/B > 1, there is an excess return. The firm is creating value for the shareholders. - If M/B <1, the return is under the benchmark provided by the market. The firm is destroying value for its shareholders. When we refer to book value, we assume that all distortions induced by accounting rules have been corrected, mainly the ones produced by inflation and the charges of certain investments as expenditures in one period [most notably R&D and advertising]. Prior to discussing the utilization of this model at both the firm and business levels, we should get a sense of the basic relationships that exist among market and book values, and some key economic and financial indicators characterizing the performance of the firm. The essence of this model is to capture the market reaction to managerial decisions in a way consistent with NPV calculations. As with all models, a number of simplifying assumptions need to be made to make the problem more tractable from an analytical point of view. The M/B model, in its basic form, assumes a firm is in a situation of stationary growth, characterized by: 1] An initial book value of equity equal to B. 2] An initial total debt equal to D. 3] A constant yearly rate of growth of equity equal to g. 4] A constant debt-to-equity ratio, which implies that D is also growing at a constant yearly rate g. Consequently, total assets, which are equal to debt plus equity, also increase at the same rate g. 5] A constant return on assets [ROA]. 6] A constant return on equity [ROE]. 7] A constant cost of debt [KD]. 8] A constant cost of equity [kE]. 9] A constant payout ratio [dividends over earnings] equal to [1 p], p being the profit retention rate. 10] The reinvestment of all depreciation charges as well as retained earnings. 11] A flow of new debt that replaces the maturing debt outstanding every year, in addition to the fresh resources required to increase the total debt outstanding at the rate g. 12] New equity is never issued. All current and future dividends belong exclusively to actual stockholders. [If new equity were to be issued, and the perfect market assumption is made, the wealth of actual stockholders would be unchanged]. In figure 10.1 we present a diagram of the cash flows in a firm growing steadily at a rate g, which illustrates the set of assumptions introduced. Basically, these assumptions ensure that a company's rate of growth has H 59 696 696 1Hreached a point of stability. Experience with the use of this model, however, indicates that even if a firm does not strictly fulfill these assumptions, the model results are still useful in two dimensions: one, in providing strategic insights for increasing shareholders value; and two, in suggesting some rules of thumb for evaluating competing strategic alternatives. Under the model assumptions, the book value of equity grows at a constant rate which may be derived by considering the total return on equity [ROE] and the reinvestment rate [p]. If at the beginning of any year the book value of the firm is B, then total earnings amount to ROE. B and the amount reinvested is p. ROE. B. Therefore, the book value at the end of the year becomes: B + P. ROE . B="[1" + P. ROE]. B The yearly rate of growth is then g="p" . ROE. And the dividend paid in that same year is [1 p]. ROE. B, which can also be computed as [ROE g].B. Under this steady situation, with a constant growth of the firm, the cash-flow stream transferred to shareholders in the form of dividend payments is derived below: YEAR 1 YEAR 2 YEAR 3 Book value [beginning of year] B [1 + g]B [1+g]     t-1 B Earnings ROE . B ROE [1+g]B ROE [1+g] t - 1 B Retained Earnings g.B g[1+g]B g[1+g] t - 1 B Dividend Payments [ROE g]B [ROE g][1+g]B [ROE-g][1+g] t - 1 B Book value [end of year] [1 + g]B [1 + g] 2 B [1 + g] t B Notice that retained earnings is computed as p. Earnings. Thus, for the first year, for example, the corresponding value is p. ROE . B, which is equal to g. B. To determine the market value of the firm shares, donated by M, we should obtain the NPV of the dividend stream discounted at the cost of equity capital, kE [for an explanation of this statement, see, for example, Brealey and Myers, Chapter 4.] Thus: The net present value of the dividend stream is an unbiased assessment of the market value of the firm. For a cost of capital kE, we obtain the following value for the market value: M="[ROE" g][1+g]  t-1  B/ [1 + kE] t  [1] The M/B ratio can be directly derived from this expression by simple algebraic manipulations. The value thus obtained for a firm growing steadily at rate g is: M/B="ROE" g / kE g [2] There is a wealth of fundamental economic and strategic implications that can be derived from this simple model: 1] The relationship between [M/B] and spread. As immediately apparent from the the expression of the M/B model [relation [2]], the firm creates value, that is, it is economically profitable, if and only if ROE is greater than kE. This implies the following relationship between market to book value [M/B] and spread, [ROE kE], spread being defined as the difference between the return on equity and the cost of equity. M/B> 1 == ROE - kE > 0 M/B = 1 == ROE - kE = 0 M/B <1 ROE KE < 0 2] A key distinction between accounting and economic profitability. From an accounting perspective, a business is profitable if earnings are positive [the books are in the black], and, therefore, the resulting ROE is also positive. H 59 696 696 1H However, from an economic perspective, a business is profitable if the return on equity exceeds the cost of equity, which implies that the spread is positive, and consequently its [M/B] ratio is greater than 1. It is economic and not accounting profitability, that determines the capability for wealth creation on the part of the firm. It is perfectly possible that a company is in the black and yet its market value is way below its book value, which means that, from an economic point of view, its resources would be more profitable if deployed in an alternative investment of similar risk. Figure 10.2 contrasts the difference between accounting and economic profitability. 3] The impact of growth. Very often, growth is stated as one of the foremost strategic objectives, and growth goals are established without any reference to its implications for the profitability of a business or a firm. However, as can be inferred from the [M/B] model, growth cannot be separated from the profitability status. In fact, if a firm or a business is profitable, that is, its return on equity exceeds its cost of capital [ROE> KE], growth significantly helps in increasing its market value. It is also immediately apparent from relationship [2], that when the condition of the firm or business is such that ROE = kE, growth has an indifferent impact, neither damages nor hurts, the value-creating capabilities of the firm. However, if a firm or a business is economically unprofitable [ROE KE] versus unprofitable [ROE 100%, it is a cash user. Finally, the area of each circle is proportional to total sales.


The Divestiture Decision

We have seen that the market value of a firm is always positive, even under fairly low profitability conditions. This is so because the liquidation value of the firm represents a lower bound on its market value as depicted by the horizontal line at the level L/B in Figure 10.4. However, individual businesses within a firm can, in fact, subtract value if their profitability is low and they are sustained by resources allocated from the corporate level. Businesses of this sort are referred to as "cash traps" involving a permanent negative cash flow which is diminishing the contribution of other businesses having positive cash flows. Under such conditions, divestiture might be the most logical decision for a firm to consider. The central question pertaining to that issue is whether or not the liquidation alternative is better than holding onto that unprofitable business. A market-to-book value model can be of assistance in addressing that question. A graphic illustration of the M/B model for a business unit within a corporation is presented in Figure 10.16. Notice that now the M/B versus ROE relation is truly a straight line, allowing M/B to assume values below L/B and even negative. In the example presented in that figure a business with profitability ROE1 is definitively subtracting value from the firm, and it should be liquidated, even at a cost. If the business were to be performing at a level ROE2, it is still adding value to the firm, but that is below the liquidation value L, and therefore should be divested. If the business performance were given by ROE3, we have a situation where the business is unprofitable, since it is not making its cost of equity capital kE. However, it is adding value above its liquidation value L; and, therefore, the business should not be divested. Strategic Planning Associates [1981] have documented several situations involving Huffy, GAP corporation, and Borden, where divestment of business with negative contributions to the firm have been translated into increases of the stock prices of the firm. This means that the capital markets are "intelligent" enough to understand sound decisions involving units' redeployments. A compact way of summarizing the market value contribution of each individual business of the corporation is presented in Figure 10.17, where market value is plotted against book value. As can be seen from that graph, the company as a whole has a market value lower than its book value, which might suggest that it is an organization in trouble. However, a more careful look indicates its basic businesses A and B are pretty healthy, and business C is earning its cost of capital. Business D is adding value, but its profitability is below its cost of capital. It should be a candidate for divestment if its liquidation value L exceeds the value contributed by the business. Finally, business E should be divested as soon as possible, since it is subtracting value to the firm. With those rearrangements of the firm's portfolio, the company situation should improve markedly.


Evaluation of Broad Action Programs Supporting a Business Strategy

There are three levels of economic evaluation which are important for strategy development. One, is the assessment of the value of the firm, which we have addressed rather exhaustively in previous sections. Two, is the assessment of the value contributed by business units and particularly the understanding of how that value changes with different strategic alternatives to help support the development of this business. Three, the evaluation of projects, which is conventionally done by discounting the cash flows attributed to the project at an appropriate cost of capital. It is the second of these evaluation issues, perhaps the most important and difficult within of the evaluation problems, which constitute the concern of this section. Within the steps of our proposed corporate strategic planning process [described in Chapter 4], this discussion is relevant to step 6, where the firm undertakes an initial assessment of the broad action programs stemming from its business units. A primary concern which is often raised, in the strategic planning process is that there is very little of true evaluation being done at the corporate level. Frequently, strategic alternatives are generated and discarded at intermediate levels, and when the proposals finally reach the top, there is nothing left to be decided upon, and the corporation becomes a rubber stamper of economic decisions already made by business unit managers. Marakon [1980] proposes an intelligent way of forcing true strategic options to be evaluated and reported at the corporate level. The proposed process is illustrated in Figure 10.18. It starts by requiring four options to be assessed, which summarize the competitive strategies of a business unit: build, hold, harvest, and divest. In passing, it is worthwhile to notice that these strategic options are not essentially different from the priorities for resource allocation in step 6 of our corporate planning process. For each option, the corresponding market-to-book value should have to be evaluated. We already have discussed in detail the alternatives available for evaluating market value at the business level in a preceding section of this chapter. The strategy which shows the highest M/B is the one selected for that particular business. An illustration of the M/B values for each strategic option and for all the business units of an hypothetical firm is presented in Figure 10.19.



Before we conclude this chapter, we would like to make some final and brief comments on two important subjects relevant in guiding managerial thinking for the generation of strategic alternatives.

Generic Strategies for Value Creation

In order to review the basic options available to create value for the firm, it is useful to represent its market value in terms of the contribution stemming from operations [the unlevered market value] and that originated in the financial policies, mainly the debt policy: Market value of the firm = Unlevered market value of the firm (contribution from operations) + Contribution from financial policies (mainly debt policy) We can express the unlevered value of the firm in terms of revenues, costs and the discount rate for the business, obtaining thus an expression showing more clearly the variables that managers can influence: Unlevered market value of the firm = [Revenues - Cost] / [1 + ku] t  where ku = Costs of equity capital for the unlevered firm. Similarly the contribution from the debt policy is the value attached to the tax shield, which depends on the capital structure, and the discount rate for debt capital: Contribution from financial policies= [tax shield from debt] t/[1+ kd]t where kd = Cost of debt capital. Adding the two terms, we get: Market value of the firm= [Revenues - Cost]t/[1+ku]t + [Tax shield from debt]t/ [1 Kd]t. Fruhan (1979) proposes the following basic options to create value suggested by the various components of the market value of the firm: 1] Increase revenues, for example by "pricing the product higher than what had been possible without the existence of some entry barrier. The barrier could be the existence of patents or some form of successful product differentiation. The barrier might also result from the simple exercise of market forces such as that enjoyed by a monopolist." 2] Reduce costs below that of competitors, "again perhaps as a result of the existence of some barrier that prevents all competitors from achieving equal costs. The barrier in this instance could be, for example, scale economies achievable by only the largest firm in a market, or the ownership of captive sources of low-cost raw materials." 3] Reduce the cost of equity capital, for example, through the "design of an equity security that appeals to a special niche in the capital markets and thereby attracts funds at a cost lower than the free-market rate for equivalent risk investments," or simply by reducing the business risk below the level enjoyed by competitors. 4] Maximize the financial contribution to the market value of the firm by increasing the tax shield from debt and reducing the cost of debt capital. This can be done by designing a debt security that is suited for a special group of investors in the market.


Alternatives for Growth and Diversification

The patterns of growth in the American industry has been well-documented by Chandler (1962). The major generic alternatives are depicted in Figure 10.20. After the introduction of a successful product, the first logical strategy to follow is that of horizontal growth; that is, keep on expanding the existing business within its current product-market structure. This can be accomplished by further penetration leading toward increasing sales volumes and geographical expansion, including perhaps international coverage. Moreover, extensions of the existing market and product breadths are basic strategies for horizontal growth. Once horizontal saturation has been reached, the second major strategy available to firms is vertical integration, which is an attempt at increasing value added within a given business base. There are two forms of vertical integration; forward integration, which leads the firm closer to its customers, and backward integration, which moves it closer to its suppliers. Having reached a saturation of the vertical integration opportunities, a logical next step is to seek entry into new businesses via diversification. The nature of the diversification could be either related or unrelated, this last type conducive to what is referred to as conglomeration. The most logical form of related diversification is anchored in the value added chain, thus the firm could attempt to enter into new businesses, where the key for success can be traced back to one or more of the stages of value added in which the firm currently excels, that is, product and process R&D, procurement, manufacturing, marketing, distribution, and retailing. All of these alternatives for growth can be achieved either via internal development or acquisition. The pursuit of internal development has the advantage of establishing a strong base with deep cultural consistency. The obvious advantage of acquisition is its speedy and expedient accessibility to skill and competency not available internally to the firm. Acquisition prevails in the execution of unrelated diversification. For a good coverage of these topics, the reader is referred to Salter and Weinhold (1979), and Bradley and Korn (1981). The selection of the strategies for growth as well as the intensity in which to carry out each one of them requires the exercise of a high level of judgment. There are clear dangers in not pursuing a strategy of extending the product line, for example, when competitors are including various features to differentiate their products. However, there are also serious problems in going too far in product line extensions, when product differences only contribute to increased inventory and lower productivity without adding significant value to the business. Even more difficult is designing a proper strategy of vertical integration. If one is too aggressive in implementing a forward integration strategy, one could antagonize its own customers and pay dearly for it. Likewise, a backward integration strategy might result in severe negative responses on the part of one's own suppliers. And yet if one's own competitors seek a strategy of value added maximization, it would be hard to compete if vertical integration is not properly undertaken. And then, there is always the risk that your own customers integrate backwards or the suppliers integrate forward. Where would you be left if you do not know exactly what to do under those conditions? We have found that a discipline which is enforced by carefully analyzing each one of these generic strategies contributes to the quality of the overall assessment of the opportunities available to a firm. This framework could generate alternatives to be subjected to a careful economic analysis, ultimately leading towards a preferred strategic direction for a firm. Please also see the following: 1] Appendix to chapter 10 [The definition of cash flows and the selection of proper discount rates]. 2]Chapter 11 [Industry and competitive analysis- A financial statement approach]. 3]Part three [A methodology for the development of a corporate strategic plan].Also the schematic portion of this part is included in our chapter headed [Joining pieces of the jigsaw puzzle of Strategy by figures]. All the above are from book titled. Stategic Management, An integrative perspective by Arnoldo C. Hax and Nicolas S. Majluf. Prentice- Hall, Inc.






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