Strategies For Value Creation: Its Formulation And Measurement

Strategies for Value Creation:Its Formulation and MeasurementArnoldo C. Hax

Sources of Value CreationEconomic value is only created when the businessesof the firm -- and the firm as a whole -- enjoy profitability levels which exceed that of their respectivecost of capital.

The Market-to-Book Value Model (M/B)M - The Investor’s PerspectiveAn assessment of the present value of the expectedcash flow streaming from the assets the firm hasalready in place and those from investments the firmwould have an opportunity to make some time in thefuture.B - The Accountant’s PerspectiveHistorical measurement of equity resourcescontributed by shareholders.

MB Expected future paymentsPast resources committed If M/B is equal to 1, the future payments areexpected to yield a fair return on the resourcescommitted. The firm is neither creating nordestroying 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 thebenchmark provided by the market. The firm isdestroying value for its shareholders.

Stationary Model with Constant Growth gAnnual Profit ROE x BRetained earnings(P)Dividend payments(1 - P)P x ROE x B(1 - P) x ROE x BgxB(ROE - g)xB

Stationary Model with Constant Growth g (cont’d.)Year 1Year 2 Year tB(1 g) B (1 g)t-1 BEarningsROE x BROE(1 g) B ROE(1 g) t-1 BRetainedEarningsgxBg(1 g) B g(1 g) t-1 BDividendPayments(ROE-g) B(ROE-g)(1 g) B (ROE-g)(1 g) t-1 B(1 g) B(1 g)2 B (1 g) t BBook value(beginning ofyear)Book Value(end of year)

Stationary Model with Constant Growth g (cont’d.)M (ROE - g)(1 g) t-1Bt 1(1 kE)tΣMB (ROE - g)kE - g(1)(2)

Valuation of 3M StockEstimated Value per Share ROE - gkE - gxBook Value of3M per Share24% - 7.5%x 28.7213% - 7.5% 86Actual Value per Share 92

The Essential Features of the M/B Model for a Firm Under Strategy GrowthThe profitablefirm or businessThe breakevenfirm or businessThe unprofitablefirm or businessROE kEROE kEROE kEM/B 1M/B 1M/B 1Growth willincrease M/BGrowth will notaffect M/BGrowth will reduceM/BNPV 0NPV 0NPV 0

The Determinants of Value Creation Size of the competitive advantage, measured asspread ROE - kE Number of years in which the spread is maintained N Growth opportunities measured as rate ofreinvestment P

Factors Affecting the Market Value of the Firm Under Stationary Growthfor a Finite PeriodReturn on assetsROA ROS x ATReturn on equity ROE ROA D/E [ROA kD(1-TC)]Leverage D/ECost of debt kDCorporate tax rate TCSize of spread ROE - kERisk-free rate rfCost of equity kE rf βE (rm-rf)Market riskpremium (rm-rf)Beta of the stockβEMarket value of thefirm sharesReturn on equityROEEquity growth P x ROEgNumber of years inwhich spread ismaintained NRetention rate (includingnew equity) PSales margin ROS Profit AfterTaxes/SalesAsset turnover AT Sales/Assets

An M/B-vs.-Spread Graph for the 30 Dow Jones Industrials (1980)M/B RatioMRK3IBMMMM2GEAMB-8XPGEKACDUTXWX TX GF DDN4-4AATUKIP SGMZOI AC JM0.6GTBSHR0.2SD8XONROE - PGSSDTTXUKUTXWXXXONZ AlcoaAmerican CanAllied ChemicalAmerican BrandsBethlehem SteelDu PontEastman KodakGeneral ElectricGeneral FoodsGeneral MotorsGoodyear TireInternational HarvesterIBMInternational PaperJohns ManvilleMinnesota MiningMerck CompanyInco LimitedOwens IllinoisProcter & GambleSears, RoebuckStandard Oil of CaliforniaAT&TTexacoUnion CarbideUnited TechnologyWestinghouseU.S. SteelExxonWoolworthFigure by MIT OCW. Adapted from: Marakon Associates, “Criteria for Determining an Optimum Business Portfolio,” 1981.

An M/B-vs.-Spread Graph for the 30 Dow Jones Industrials (1987)10MRKKOGEMCDEKMMMXON WXBAAXPUKPGSCHVZ T GTIBMPADDALDIP BSUTXAAM/B Ratio6310.8MOGMTX0.60.4-8-6-4-2024681012Forecast ROE less Cost of Equity MOPAPGSTTXUKUTXWXXONZ AlcoaAllied SignalAmerican ExpressBethlehem SteelBoeingChevron Corp.Du PontEastman KodakGeneral ElectricGeneral MotorsGoodyear TireIBMInternational PaperCoca-ColaMcDonald'sMinnesota MiningMerck CompanyPhilip MorrisPrimericaProcter & GambleSears, RoebuckAT&TTexacoUnion CarbideUnited TechnologiesWestinghouseExxonWoolworthFigure 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)7KOMMMMRKMarket Value-to-Book Ratio6DISPGMO54321MCDGETALDEKXONWXDDBAJPMIP UKZ UTXTXIBMAXPCHVGTCATS AABSGM-5%0%5%10%15%20%Forecast Equity Spread (ROE - Cost of MMCDMMMMRKMOPGSTTXUKTUXWSXONZ Figure by MIT OCW.Adapted from : Value Line Investment Survey (1992), Marakon Associates analysis.Aluminum Co. of AmericaAllied Corp.American ExpressBethlehem SteelBoeingCaterpillarChevronDu PontWalt DisneyEastman KodakGeneral ElectricGeneral MotorsGoodyear TireInt'l Business MachinesInternational PaperCoca-ColaJ.P. MorganMcDonald's3MMerck & Co.Philip MorrisProcter & GambleSears, RoebuckAT&TTexacoUnion CarbideUnited TechnologiesWestinghouseExxon Corp.Woolworth (F.W.)

Profitability of 15 U.S. Industries (September 1987)DrugPaper &forest productsMetals/Mining4.03.0IntegratedpetroleumM/B od processingBrewingShoesSteel-general Machine toolsOil field services0.40.2-14 -12-8-6-4-2024681214Forecast ROE less Cost of Equity (%)Figure by MIT OCW. Adapted from : McTaggart, 1988.1618 20

Profitability of Paper and Forest Products Companies (Spring 1987)CPERFHP WMTTBOWJRPNTASPP4.0M/B Ratio3.0FBO2.0UCCTINW1.00.8CHABCC0.6IPGPWYLPXMEA POPPCH CSKGNNDTC0.40.2-6-4-20246Forecast ROE less Cost of Equity (%)Figure by MIT OCW. Adapted from: McTaggart, HPNTAPOPSPPTINUCCWWMTTWY Boise CascadeBowater Inc.Champion InternationalConsolidated papersChesapeake Corp.Domtar Inc.Federal PaperboardFort Howard PaperGreat Northern NekoosaGeorgia-PacificInternational PaperJames River Corp.Louisiana PacificMead Corp.Potlach Corp.Pentair Inc.Pope & TalbotScott PaperTemple InlandUnion CampWestvacoWillamettWeyerhauser

Profitability of Company PortfolioSpecialty4.0EngineeringM/B arsFlowAutoMachinery-5%0%Forecast of ROE less Cost of EquityCircle Size Equity InvestmentFigure by MIT OCW. Adapted from: McTaggart, 1988.

Historical Equity Spreads Across Industries (1976-91)1816Packaging & ContainerHotels/GamingTire & RubberBasic ChemicalsAuto & Truck Mfg.14Integrated PetroleumMetals & MiningFood WholesalersTextiles1210PublishingAir TransportGrocery StoresSteelTobaccoOilfield ServicesEthical Drugs8Soft Drinks/Beverages6420-20%-16%-12%-8%-4%-0%Source: Value Line Investment Survey (1992), Marakon Associates analysis.4%8%12%16%

Historical Equity Spreads within the Chemicals Industry (1976-91)6Rohm & HaasDowDupont5IFFMonsantoGreat LakesUnion Carbide4WD-40Olin3210-20%-16% -12%-8%-4%-0%4%8%12%Source: Value Line Investment Survey (1992), Marakon Associates analysis.16%20%32%

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 - k E Market value of the firm shares . An M/B-vs.-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