Strategies for Value Creation:Strategies for Value Creation: Its Formulation and MeasurementIts Formulation and Measurement

Arnoldo C. Hax

Economic value is only created when the businesses of the firm -- and the firm as a whole -- enjoy profit-ability levels which exceed that of their respective cost of capital.

Sources of Value CreationSources of Value Creation

M - The Investor’s Perspective

An assessment of the present value of the expected cash flow streaming from the assets the firm has already in place and those from investments the firm would have an opportunity to make some time in the future.

B - The Accountant’s Perspective

Historical measurement of equity resources contributed by shareholders.

The MarketThe Market--toto--Book Value Model (M/B)Book Value Model (M/B)

M Expected future payments =

B Past resources committed

• If M/B is equal to 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 is greater than 1, there is an excess return. The firm is creating value for the shareholders.

• If M/B is less than 1, the return is under the benchmark provided by the market. The firm is destroying value for its shareholders.

Stationary Model with Constant Growth gStationary Model with Constant Growth g

Annual Profit = ROE x B

Retained earnings (P)

Dividend payments (1 - P)

P x ROE x B (1 - P) x ROE x B

x B (ROE - g) x Bg

Stationary Model with Constant Growth g (contStationary Model with Constant Growth g (cont’’d.)d.)

Year 1 Year 2 … Year t

Book value (beginning of year)

B (1+g) B … (1+g)t-1 B

Earnings ROE x B ROE(1+g) B … ROE(1+g) t-1 B

Retained Earnings g x 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

Stationary Model with Constant Growth g (contStationary Model with Constant Growth g (cont’’d.)d.)

(1)M = (ROE - g)(1 + g) t-1B

(1 + kE)t Σ

t=1

∞

(2)(ROE - g)

kE - g = M

B

Valuation of 3M StockValuation of 3M Stock

Estimated Value per Share = ROE - g kE - g

x Book Value of 3M per Share

= 24% - 7.5% x $28.72 13% - 7.5%

= $86

Actual Value per Share = $92

The Essential Features of the M/B Model for a Firm Under StrategThe Essential Features of the M/B Model for a Firm Under Strategy Growthy Growth

The profitablefirm or business

The breakeven firm or business

The unprofitablefirm or business

ROE > kE ROE = kE ROE < kE

M/B > 1 M/B = 1 M/B < 1

Growth will Growth will not Growth will reduce increase M/B affect M/B M/B

NPV > 0 NPV = 0 NPV < 0

• Size of the competitive advantage, measured as spread = ROE - kE

• Number of years in which the spread is maintained = N

• Growth opportunities measured as rate of reinvestment = P

The Determinants of Value CreationThe Determinants of Value Creation

Factors Affecting the Market Value of the Firm Under StationaryFactors Affecting the Market Value of the Firm Under Stationary GrowthGrowth for a Finite Periodfor a Finite Period

Sales margin ROS = Profit After Taxes/SalesReturn on assets

ROA = ROS x AT

Cost of debt = kD

Leverage = D/E

Risk-free rate = rf

Corporate tax rate = TC

Beta of the stock βE

Market risk premium = (rm-rf)

Asset turnover AT = Sales/AssetsReturn on equity ROE

= ROA + D/E [ROA -kD(1-TC)]

Cost of equity kE = rf + βE (rm-rf)

Return on equity ROE

Retention rate (including new equity) P

Number of years in which spread is maintained = N

Equity growth g = P x ROE

Size of spread = ROE - kE

Market value of the firm shares

An M/BAn M/B--vs.vs.--Spread Graph for the 30 Dow Jones Industrials (1980)Spread Graph for the 30 Dow Jones Industrials (1980)

-8

X BS GT

HR

Z OI AC JM

IP S UK

T

GM

AA

WX TX N GF

UTX DD

AMB GE EK

PG

MMM IBM

SD XON

MRK

ACD

-4

0.2

0.6

2

3

M/B Ratio

ROE - kE Spread

4 8

AA AC ACD AMB BS DD EK GE GF GM GT HR IBM IP JM MMM MRK N OI PG S SD T TX UK UTX WX X XON Z

= = = = = = = = = = = = = = = = = = = = = = = = = = = = = =

Alcoa American Can Allied Chemical American Brands Bethlehem Steel Du Pont Eastman Kodak General Electric General Foods General Motors Goodyear Tire International Harvester IBM International Paper Johns Manville Minnesota Mining Merck Company Inco Limited Owens Illinois Procter & Gamble Sears, Roebuck Standard Oil of California AT&T Texaco Union Carbide United Technology Westinghouse U.S. Steel Exxon Woolworth

: Marakon Associates, “Criteria for Determining an Optimum Business Portfolio,” 1981. Figure by MIT OCW. Adapted from

An M/BAn M/B--vs.vs.--Spread Graph for the 30 Dow Jones Industrials (1987)Spread Graph for the 30 Dow Jones Industrials (1987)

-8 0.4

0.6

0.8

1

3

6

10

-6 -4 -2 0 2 4 6 8 10 12 18 20 22

TX GM

AA IP

CHV

BA

S

BS DD

PG

Z

UTX

PA T GT

ALD IBM

UK MO

MRK

Forecast ROE less Cost of Equity (%)

M/B

Rat

io

MCD

KO GE

EK WX MMM

AXP XON

AA ALD AXP BS BA CHV DD EK GE GM GT IBM IP KO MCD MMM MRK MO PA PG S T TX UK UTX WX XON Z

= = = = = = = = = = = = = = = = = = = = = = = = = = = =

Alcoa Allied Signal American Express Bethlehem Steel Boeing Chevron Corp. Du Pont Eastman Kodak General Electric General Motors Goodyear Tire IBM International Paper Coca-Cola McDonald's Minnesota Mining Merck Company Philip Morris Primerica Procter & Gamble Sears, Roebuck AT&T Texaco Union Carbide United Technologies Westinghouse Exxon Woolworth

Figure by MIT OCW. Adapted from: James M. McTaggart, “The Ultimate Takeover Defense: Closing the Value Gap,” Planning Review,January-February 1988, pp. 27-32.

Profitability of Dow Jones Industrials (1992)Profitability of Dow Jones Industrials (1992)

-5%

Mar

ket V

alue

-to-B

ook

Rat

io

1

2

3

4

5

6

7

0%

GM

S AA

GT

IP UK JPM DD

MCD

XON ALD

TGE

DIS PG MO

MMM MRK KO

BS

Z

CAT AXP TX

UTX BA

WX EK

CHV IBM

5% 10% 15% 20% 25% Forecast Equity Spread (ROE - Cost of Equity)

AA ALD AXP BS BA CAT CHV DD DIS EK GE GM GT IBM IP KO JPM MCD MMM MRK MO PG S T TX UK TUX WS XON Z

= = = = = = = = = = = = = = = = = = = = = = = = = = = = = =

Aluminum Co. of America Allied Corp. American Express Bethlehem Steel Boeing Caterpillar Chevron Du Pont Walt Disney Eastman Kodak General Electric General Motors Goodyear Tire Int'l Business Machines International Paper Coca-Cola J.P. Morgan McDonald's 3M Merck & Co. Philip Morris Procter & Gamble Sears, Roebuck AT&T Texaco Union Carbide United Technologies Westinghouse Exxon Corp. Woolworth (F.W.)

Figure by MIT OCW.Adapted from: Value Line Investment Survey (1992), Marakon Associates analysis.

Profitability of 15 U.S. Industries (September 1987)

-14

0.2

0.4

0.6

0.8

1.0

2.0

3.0

4.0

-12

M/B

Rat

io

Integrated petroleum

Auto

Steel-general

Shoes

Machine tools

Brewing

Advertising

Food processing Metals/Mining

Drug

Hotel

Electronics

Paper & forest products

-6 -4 -2

Forecast ROE less Cost of Equity (%)

0 2 4 6 8 12 14 16 18 20-8

Oil field services

Profitability of 15 U.S. Industries (September 1987)

Figure by MIT OCW. Adapted from: McTaggart, 1988.

Profitability of Paper and Forest Products Companies (Spring 198Profitability of Paper and Forest Products Companies (Spring 1987)7)

0.2

-6 -4 -2

BCC

TIN

FBO

BOW PNTA

JR

IP GNNCHA

CPER FHP

GP

PCH MEA

CSK

WMTT

SPP

POP

WY LPX

DTC

Forecast ROE less Cost of Equity (%)

M/B

Rat

io

0 2 4 6 8 10

0.4

0.6

0.8

1.0

2.0

3.0

4.0

W

BCC BOW CHA CPER CSK DTC FBO FHP GNN GP IP JR LPX MEA PCH PNTA POP SPP TIN UCC W WMTT WY

= = = = = = = = = = = = = = = = = = = = = = =

Boise Cascade Bowater Inc. Champion International Consolidated papers Chesapeake Corp. Domtar Inc. Federal Paperboard Fort Howard Paper Great Northern Nekoosa Georgia-Pacific International Paper James River Corp. Louisiana Pacific Mead Corp. Potlach Corp. Pentair Inc. Pope & Talbot Scott Paper Temple Inland Union Camp Westvaco Willamett Weyerhauser

UCC

Figure by MIT OCW. Adapted from : McTaggart, 1988.

Profitability of Company PortfolioProfitability of Company Portfolio

-5%

Machinery Auto

Flow Gears

Building products

Engineering

Specialty

Rotary Insurance

Forecast of ROE less Cost of Equity Circle Size = Equity Investment

M/B

Rat

io

0.0

0.5

1.0

2.0

4.0

0%

Figure by MIT OCW. Adapted from: McTaggart, 1988.

Historical Equity Spreads Across Industries (1976Historical Equity Spreads Across Industries (1976--91)91)

18

16

14

12

10

8

6

4

2

0

-20% -16% -12% -8% -4% -0% 4% 8% 12% 16%

Packaging & Container

Tire & Rubber

Auto & Truck Mfg.

Metals & Mining

Textiles

Air Transport

Steel

Oilfield Services

Hotels/Gaming

Basic Chemicals

Integrated Petroleum

Food Wholesalers

Publishing

Grocery Stores

Tobacco

Ethical Drugs

Soft Drinks/Beverages

Source: Value Line Investment Survey (1992), Marakon Associates analysis.

Historical Equity Spreads within the Chemicals Industry (1976Historical Equity Spreads within the Chemicals Industry (1976--91)91)

6

4

2

1

3

5

0

Rohm & Haas

Dupont

Monsanto

Union Carbide

Olin

Dow

IFF

Great Lakes

WD-40

-20% -16% -12% -8% -4% -0% 4% 8% 12% 16% 20% 32%

Source: Value Line Investment Survey (1992), Marakon Associates analysis.