Example of Contribution to Market Value of Each Business of a
a
Hypothetical Firm
Firm
Market Value
0 < MD < BD
D
E
C
MC = BC
Total market value
ME < 0 < BE
B
MB > BB
A
MA > BA
Book Value
Total book value
Total Book Value
Total Market Value
B = BA + BB + BC + BD + BE
M = MA + MB + MC + MD + ME
M/B for the overall firm is less than 1
Figure by MIT OCW.
Selecting the Best Strategy for a Business Unit:
Unit:
Evaluation of Alternative Strategic Thrust Options
For each business unit, characterize the strategic options in terms of
market share thrust as:
- Build (aggressively, gradually, or selectively)
- Maintain (aggressively or selectively)
- Harvest
- Divest
Project the equity cash flow associated with each strategic option, &
compute the corresponding M/B ratio.
M represents the present value of cash flow and B the existing book
value of the equity base.
Summarize the M/B values for the different strategic options, for all of
the business units of the firm.
Business unit
Build
Hold
1
2
3
4
5
6
1.0
2.1
0.8
0.3
2.2
0.5
1.6
1.5
1.2
0.5
2.5
0.7
Harvest Divest
1.4
0.9
1.4
0.7
1.8
0.6
1.2
1.8
1.1
0.8
1.9
0.5
Green values represent the M/B ratios under the optimum strategy for
each business unit.
Select, for each business unit, that alternative that takes into account
the optimum economic performance, as well as that host of additional
impacts that the business positioning might have on the overall
competitive standing of the firm.
Figure by MIT OCW.
Principles for Resource Allocation
1. The principle of zero-based resource allocation
A zero-based resource allocation process evaluates the
use of all resources, sunk as well as incremental, to
assure that they are contributing to value creation.
2. The principle of funding strategies, not projects
A business strategy can be regarded as a bundle of
projects. The resource allocation process should
concentrate on the value created by this entire bundle,
rather than looking at individual projects in isolation.
Principles for Resource Allocation (cont’d.)
d.)
3. The principle of no capital rationing
rationing
The assumptions imbedded in most processes of
resource allocation is that capital is scarce but free.
Exactly the opposite is true: capital is plentifully
available, but is expensive.
4. The principle of zero tolerance for bad growth
This principle makes the redeployment of resources
from unprofitable or bad-growth businesses to value
creating ones. It helps to minimize bad growth, and
maximize good growth.
Value Concentration in Typical Portfolio
Percent of
Company’s Total
Value Creation from
Each Business
60%
40%
12 businesses produce capital losses,
offsetting 115% of value created
20%
0%
-20%
Five more businesses add another
115% to total value creation
-40%
100% of total company value creation
comes from two businesses
-60%
0%
20%
40%
60%
Percent of Equity Invested in Each Business
80%
100%
Who creates value?
The 200 companies with the biggest
market caps are listed below by MVA
rank in a field of 1,000 large-cap
companies.
MVA RANK1
1998
19972
19932
What market value added means to you
MVA, in effect, shows the
difference between the capital
investors have put into a
company and the money they
can take out.
Company3
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
2
1
3
5
4
8
7
11
6
10
9
14
18
12
13
26
49
20
42
19
16
15
33
5
2
12
4
24
9
11
16
3
5
7
1
27
77
26
1000
39
15
35
32
48
13
28
24
25
26
27
17
32
39
21
10
*
319
17
28
29
38
93
14
8
Home Depot
AT&T
30
31
45
Bellsouth
General Electric
Coca-Cola
Microsoft
Merck
Intel
Procter & Gamble
Exxon
Pfizer
Philip Morris
Bristol-Myers Squibb
Johnson & Johnson
Wal-Mart Stores
Eli Lilly
Cisco Systems
Gillette
IBM
Bell Atlantic
Walt Disney
SBC Communications
Du Pont
Hewlett-Packard
Abbott Laboratories
Schering-Plough
Pepsico
Lucent Technologies
American International Group
American Home Products
Market
value added
($ millions)
$195,830
$158,247
$143,740
$107,418
$90,010
$88,706
$85,557
$83,835
$82,412
$81,312
$71,433
$69,678
$67,204
$50,422
$50,209
$49,101
$48,414
$46,869
$45,136
$42,631
$42,615
$42,443
$41,143
$40,743
$39,767
$39,697
$38,920
$35,818
$35,214
$34,189
Wealth Predictor
EVA is after-tax net operating
profit minus cost of capital.
A growing EVA is good
sign that a stock will soar.
Economic
value added
($ millions)
$1,917
$2,615
$2,781
$1,921
$4,821
$587
$(412)
$1,077
$3,524
$1,802
$1,320
$920
$199
$1,472
$518
$(1,561)
$1,429
$(968)
$2,234
$975
$152
$1,200
$960
$(218)
$146
$(834)
$503
$462
$(2,892)
$448
Capital
Return on
($ millions)
capital
The Real Story
Does the return on capital
exceed the cost of capital?
If so, then the company is
using investor's money wisely.
Cost of
capital
$59,251
$10,957
$8,676
$23,112
$21,436
$24,419
$88,122
$15,220
$43,146
$14,627
$19,803
$33,890
$13,049
$5,221
$9,724
$66,420
$51,343
$32,707
$41,259
$42,077
$26,507
$10,639
$4,970
17.3%
36.3%
52.9%
23.2%
42.7%
15.2%
9.4%
19.9%
20.2%
25.3%
20.2%
13.5%
14.3%
50.9%
18.8%
10.5%
13.4%
9.0%
16.2%
13.8%
15.6%
23.2%
36.0%
13.8%
12.1%
14.2%
14.5%
15.1%
12.8%
9.9%
12.1%
11.9%
12.5%
12.9%
10.5%
12.8%
14.3%
12.0%
12.8%
9.6%
12.0%
9.3%
11.1%
15.0%
10.9%
14.0%
$18,507
$25,057
$36,590
$19,462
11.5%
12.9%
9.9%
13.8%
12.5%
12.3%
12.3%
11.1%
$9,583
$70,408
16.8%
5.6%
10.8%
9.9%
$35,860
10.8%
9.4%
TH E TO P W EA LTH C R EATO R S
Figure by MIT OCW. Adapted from: Fortune, November 9, 1998.