Managing Portfolio of business for Consistent growth

Traditionally organization that doesn’t maintain portfolio of business appropriately faces natural life cycle of corporate life i.e. start-up, growing, mature & decline phase however if corporate would like to grow consistently throughout their life cycle then they have to chose & update portfolio of business strategy continuously & appropriately.

It is easy to make business strategy for a foreseeable future based on reasonable assumption about development in markets, technologies, regulation & predictable economic situation however after the latest financial crisis & recession, future is very unpredictable & uncertain, so classic business strategy approach doesn’t works in an uncertain environment.

In order to counter uncertain environment & to grow consistently, organization need to follow business strategy “Portfolio for Consistent growth” (PFCG) approach.

PFCG approach is based on risk & reward on time basis. How organization select portfolio of business depends upon its familiarity & knowledge about the business. If organization has thorough knowledge about the industry & its attractiveness, markets, technology, geography, pool of talent etc. then it means they are familiar with the risk and they can provide an initiative to deploy abundance of resources and reap the benefit of knowledgeable risk in the short term.

Organization should spend huge amount of resources in this category of business to get maximum return on short time normally 18-24 months. These businesses are core business and most readily identified with the company name and those that provide the greatest profits and cash flow. Here the focus is on improving performance to maximize the value of business. These types of businesses are run by business maintainence managers within fully installed capability platform to earn maximum return on investment.

However there are certain businesses where organization doesn’t have adequate knowledge, they need to acquire knowledge to develop business. These kinds of businesses come in unfamiliar category where risk is very high at the present situation because organization doesn’t have adequate knowledge about the business, and capabilities were developed or acquired during a period of time. These businesses were developed over a medium-long term time horizon of 5-6 years. These businesses require initial capital which generates future cash-flow over a period of time and they are handled by entrepreneur talent. These businesses are valued not on the basis of profitability but on the basis of NPV and growth. They are the future cash-cow for an organization.

Third category of business that come in PFCG strategy are businesses where future is uncertain & organization can’t predict it during a short period time. These kinds of business were developed considering long term perspective whose benefit can be achieved over a longer period of time. These types of businesses are like research work where organization is using its foreseeable talent to predict future requirement of industry. Here organizations are not very clear about future but there is a vision which drives them.

Normally companies should never invest in uncertain business for short-term benefit however there are exceptions where organization invest in uncertain business for example investing in an industry whose fate depends upon election results and future govt. Opposite is true for familiarity risk category where normally companies don’t invest considering long-term view because maximum benefits can be reaped during the short period of time however here also exception are there like for example a company finds a reservoir of oil but it is not investing because it is not sure how petroleum industry prices will shape up in the future.

The most important part of PFCG is that organization should know when they have to move business from category 2 ( unfamiliar) to Category 1 (familiar) and Category 3 (Uncertain) to category 2 ( Unfamiliar). This is a continuous process where companies must take three steps: undertake a disciplined search for a number of initiatives that provide high rewards for the risks taken; monitor the resulting portfolio rigorously, reinvesting in successes and terminating failures; and take a flexible, evolutionary approach that allows for midcourse corrections. The resulting strategy, like a conscious form of natural selection, identifies the strongest initiatives and sheds the rest. The increasing uncertainty of today’s business environment and the importance of balancing risks with rewards make the Portfolio-of-Consistent-Growth strategy more relevant than ever.

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What is Enterprise Value? How to calculate it?

Every now and then people get confuse about Enterprise Value. Some feels that it is a market capitalization value which is used when buying and selling a company. Today most of the M & A activity happens around Enterprise Value. So it is necessary that we should fully understand what actually is enterprise value and how it affects company’s buying behavior.

Enterprise value is a measure of the actual economic value of a company at any given moment. Enterprise value measures what it would actually cost to purchase the entire company. Many investors use the current value of all of a company’s outstanding shares as its economic value. Known as market capitalization, the current market value of all of a company’s shares is equal to the current number of outstanding shares multiplied by the current share price:

Market Capitalization = Number of Shares Out * Current Share Price

You can find the current share price almost anywhere, thanks to the wonder of 15-minute delayed and real-time quotes. Shares outstanding can be a little trickier, but it can find with the latest quarterly earnings press release or SEC filing. Although the number appears in the quote feeds of a number of data providers, it often lags the latest reported quarter by a couple of weeks and seldom takes into account in timely fashion the shares issued to acquire another company.

Now, if market capitalization is the value of all of the outstanding shares, why use enterprise value at all? I mean, enterprise value only appears in a few business school textbooks that focus on cash-flow valuations. The rest of the investment media uses market capitalization.

Although market capitalization is the key component of the actual economic value of a company, it is hardly the only one. Using only market capitalization to value companies is kind of like using the down payment on a house as a proxy for how much a house is worth. The larger the mortgage on the house is, the more wrong you end up being. When a company carries long-term debt, which is essentially what a mortgage is, the company has pledged its own assets to borrow money. If someone were to acquire that company, she would also acquire responsibility for that debt. Much like the person who “assumes” a mortgage of $50,000 after paying $20,000 in equity for a home, a company that pays $20 million for the stock of a company with $50 million in debt has really paid $70 million for the entire company.

The simple fact is that debt matters. Now, many companies have an inconsequential amount of debt; however, there are plenty where the amount of debt that the company has is quite consequential. A controversial, Nobel Prize winning economic theory called M&M (after two professors named Modigliani and Miller) proposed that the effective capital structure of a company was the market value of its equity plus its debt. The controversial part was when they went on to say that there is no optimum capital structure, meaning that every dollar of debt a company carried consumed a potential dollar of equity. Put another way, a company’s value was a given. Whether it chose to recognize that value all in debt or equity was the company’s choice — there was no capital structure that resulted in a higher valuation without increasing earnings somehow.

Another very important factor to consider when analyzing a company is what it has in the bank. If a company has a hoard of cash or significant equity stakes in other publicly traded businesses, these are pretty easy to value and are obviously sources of liquidity for the company. Going back to our home example, say you bought a home for $70,000 — $20,000 in cash and $50,000 in debt after assuming the mortgage. When you walked in the house, you found $20,000 in cash left by the previous owner. After putting this $20,000 in the bank, your effective purchase price becomes $50,000. Although you paid out $20,000 to the owner, you got it right back.

Because of the rather complicated rules of acquisition and corporate ownership, this somewhat ludicrous example happens all of the time in the business world. If a company has $20 million in cash in the bank, it is not like the outgoing Chairman can put it in his pocket as he leaves. That money belongs to the company — and those who own the company. If someone is buying the company, that money really belongs to him or her. No one else can take it. As a result, when the old owners are paid off they are paid off with cash from the new owners — leaving any cash in the company behind for the new owners to keep. Given that equity stakes in other publicly traded companies are really just as good as cash — heck, maybe even better — it makes sense to count this as part of the cash hoard for the purposes of determining what the actual economic price of a company is.

Given all of this, you can see that the real, economic purchase price of a company at any given moment is the value of the stock (the market capitalization), plus the debt that the company has taken on, minus any cash or investments it has on the books. This is what we call enterprise value. We use this instead of market capitalization because it is the actual economic purchase price of a company at any given moment. Enterprise value reflects the actual purchase price anyone acquiring a company would have to pay.

Enterprise Value = Market Capitalization + Long-term Debt – Cash & Investments

Why go to all of this trouble when some people argue that the value of the stock has already been adjusted for the debt and cash a company has? Because no matter how much the actual price of the stock changes, the debt and the cash do not go away. An acquirer still has to take on the debt and still gets to put the cash in the bank whether the company’s stock is worth $1 billion or one dollar. Debt and cash are economic realities and must be factored into the purchase price an acquirer pays for a company. Enterprise value is not a valuation, meaning the theoretical price at which a company should trade, but a value, meaning the current, real price as definite as if stuck on with a pricing gun.

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Who is ths best owner of a business?

Frankly, we never know who the very best owner of a business might be; we can only know who is probably the better owner among competing alternatives. A better owner could be a larger company, a private-equity firm, a sovereign-wealth fund, or a family. It could also be an independent public company listed on a stock exchange, a mutual (owned by its customers), or even a government- or employee-owned entity. Being better owners, each of these types of companies may add value to a business in a number of ways.

Better ownership is not permanent or static but rather can change over the life cycle of a business. Too many companies don’t recognize that even if their own distinctive capabilities remain the same, the needs of a business naturally change as it matures and the industry in which it competes changes as per time.

A company’s business founders are its first best owners. Their entrepreneurial drive, passion, and commitment to the business are necessary to get the company off the ground. As it grows and requires larger investments, a better owner may be a venture capital firm that specializes in helping company to grow by providing capital, improving governance, and enlisting professional managers to handle the complexities and risks of scaling up an organization. Eventually, the venture capital firm may need to take the company public, selling shares to a range of investors to finance further growth. As the public company grows, it might find that it can no longer compete with larger corporations because, say, it needs global distribution capabilities far beyond what it can build in a reasonable amount of time. It may thus sell itself to a larger company that’s the better owner because of an existing global distribution network, thereby becoming a product line within a division of the larger company.

As the division’s market matures, the larger company may decide to focus on faster-growing businesses. In this case, it might sell its division to a private-equity firm—a better owner if the firm can eliminate corporate overhead that’s inconsistent with the business’s slower growth and thereby leave the division with a leaner cost structure. Once the restructuring is done, the private-equity firm can sell the division to yet another better owner: a large company that specializes in running slow-growth brands.

The best-owner life cycle makes that executives must continually seek out new acquisitions for which their companies could be the best owner while at the same time divesting businesses for which they no longer are. Since the best owner for businesses constantly changes, any corporation, large or small, should acquire and dispose of them regularly.

For acquisitions, applying the best-owner principle often leads acquirers toward targets very different from those that traditional target-screening approaches might uncover. Traditional ones often focus on targets that perform well financially and are somehow related to the acquirer’s business lines. But through the best-owner lens, such characteristics might have little or no importance. It might be better, for instance, to seek out a financially weak company that has great potential for improvement, especially if the acquirer has proven performance-improvement expertise. Or it might be better to focus attention on tangible opportunities to cut costs or on the existence of common customers than on vague notions such as how related the target may be to the acquirer.

Keeping the best-owner principle front and center can also help with negotiations for an acquisition by keeping managers focused on what the target is worth specifically to their own company—as well as to other bidders. Many managers err in M&A by estimating only an acquisition’s value to their own company. Because they are unaware of the target’s value to other potential better owners—or how high those other owners might be willing to bid—they get lulled into conducting negotiations right up to their breakeven point. Of course the closer they get to it, the less value the deal would create for their own shareholders. Instead of asking how much they can pay, they should be asking what’s the least they need to pay to win the deal and create the most value.

Consider the example of an Asian company that was bidding against a private-equity firm to purchase a European contract pharmaceutical manufacturer. The Asian company estimated the target’s value to itself and also to the private-equity firm, which could add value by reducing overhead costs and attracting customers that hadn’t used the target’s services because it was owned by a competitor. The Asian company estimated that the contract company was worth $96 million to the private-equity firm.

The Asian company could make the same overhead cost reductions and add similar customers—but on top of this, it could move some of the manufacturing to its lower-cost plants. As a result, the target’s value to the Asian company was $120 million, making it the best owner and enabling it to pay a higher price than the private-equity firm would, while still allowing it to capture significant value. As a side note, the value of the target to its European parent was only $80 million.

Knowing the relative values, the Asian company could afford to bid, say, $100 million, pushing out the private-equity firm and gaining $20 million in potential value creation. The Asian company could further increase its share of the value to be captured, by announcing plans to enter the business even without making the acquisition. If the seller and the private-equity firm were convinced, they would have to reduce their estimates of the target’s value, and the Asian company could reduce its bid, capturing more value still.

For divestitures, including both sales and spin-offs, the best-owner principle allows managers to examine how the needs of the businesses they own may have evolved in different directions. For example, most pharmaceutical companies grew up as parts of diversified chemical companies because the basic manufacturing and research requirements were the same. But as the two industries specialized, their research, manufacturing, and commercial requirements diverged so much that they became distant cousins rather than sisters.

Today, running a profitable commodity chemical company demands scale, operating efficiency, and the ability to manage costs and capital expenditures. But creating value in a pharmaceutical company requires a deep R&D pipeline and large local sales forces, as well as specialized expertise in areas such as the regulatory-approval process and dealing with large public and private purchasers. While having both kinds of businesses under one owner made complete sense 50 years ago, it no longer does. That is why nearly all former chemical and pharmaceutical combines have split up over the past three decades; Zeneca, for example, separated from ICI in 1993, and Clariant and Sandoz parted ways in 1995.

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How to maintain maximum return on Portfolio of Business?

One of the most challenging task a top executive of a business faces is to maintain & grow portfolio of business that provides maximum returns to an organization.

In today’s environment companies that actively mange their portfolio of business are finding that the traditional method of balancing portfolio like invest free cash flows in more attractive businesses, preferably with synergies to existing ones, and look to build a strong position—often creates little value. Given the breadth and pace of today’s global markets, companies must constantly compete for acquisitions across the world and pay a hefty premium for highly attractive businesses. Often, merely reinvesting free cash flows makes little difference to the portfolio’s value.

In order to take decision beyond the conventional model of portfolio management, today’s business mangers take ad-hoc decisions and act more on gut feeling rather than on actual data. Portfolio strategy, at its core, is about being or becoming the natural owner of businesses and balancing investment opportunities against the supply of capital, given the predicted returns of current and potential investments.

What’s natural owner of business & how to become the natural owner of your business?

Companies can be natural owner of business in several ways depending on how they add value to a business-

Operational synergies, for instance, may let them use the same technology, produce in the same plants, or distribute to the same channels where business systems overlap. In specific situations, such as emerging markets, natural ownership can include superior access to capital and talent—one of the reasons emerging markets still have conglomerates with a broader business mix than in more developed markets.

A company that isn’t the natural owner of a certain type of business can decide to become one by building a large enough position and striving for distinctive performance in key areas. When many universal banks acquired investment banks in the 1990s, they worked to become natural owners in a very attractive business segment. Many failed, but some of the most successful global banks built their position in this way.

Corporate skills also can be a source of natural ownership. The skills of any company are the product of its culture and history. Certain oil companies know how to foster operational excellence in refining; these companies have repeatedly created significant value by acquiring refining assets from other oil companies and improving their performance.

Measuring natural ownership isn’t straightforward but does provide an important point of comparison among portfolio options.

The best test for natural ownership is whether a different owner would ascribe a higher value to a business. Measuring this point is difficult and subjective, but business managers can do so for an existing business by valuing their plans assuming realistic performance levels and then comparing this value with the price the business would command if it were sold, using either private equity-style valuation models or recent M&A multiples. For M&A opportunities, managers can compare the price they could rationally offer with the likely bids of others—keeping in mind that other offers aren’t always rational.

Portfolio Balancing Opportunity with Capital

Even if a company is the most natural owner of all its businesses, merely investing free cash flows in the most attractive ones may not be the best approach for generating maximum returns. Companies must consider that almost all businesses can be bought or sold and that capital can be raised or returned to shareholders. Therefore, managers must constantly examine a company’s entire portfolio of businesses and opportunities as if they were planning to reinvest all its capital.

The notion of capital balance starts with the mix of investments in new and existing businesses—the mix that creates the most value. More often than not, the amount of capital a company has for investment doesn’t equal the amount of capital required by all of its opportunities. Companies with more investment opportunities than capital, such as a fast-growing technology company with interesting intellectual property, tend to look for more capital. These companies will be more aggressive on divestments, impose higher hurdle rates on investments, and ponder raising more capital through additional debt or equity issues. Companies with more capital than investment opportunities, such as a successful company in a mature market, tend to accept lower returns from new opportunities, are more reluctant to divest, and look for ways to return cash to shareholders via buybacks and dividends.

Calculating capital balance requires a clear understanding of the current portfolio, investment and divestment opportunities, and available capital and financing.

In analyzing the capital balance, business managers should distinguish among three types of capital decisions:

Capital deployed in existing businesses

Almost all businesses require a certain rate of reinvestment—for example, to develop new products or keep production facilities up to date. While the current rate of reinvestment may create the most value for a mature business, a higher rate may be necessary to gain market share or expand into new markets.

Capital deployed in larger investment opportunities

Big opportunities include completely new investments, such as an acquisition or a market entry, and dramatic shifts in current businesses. An example of a dramatic shift could be a decision to transform a company from a technology provider into a service provider that owns and operates its technology.

Capital gained by exiting existing businesses

Exiting some businesses, such as those that have scarce assets—say, mobile-phone businesses in markets with a limited number of licenses—often brings a company a premium above the current value. In other businesses, an exit won’t necessarily generate a price that reflects the business’s true economic stand-alone value; in many transactions potential buyers discount the price they’re willing to pay by assuming a worst-case economic scenario. Certain businesses are too interlinked with other operations or the corporate identity for divestment to be practical. Some involve government or other stakeholders that put a sale beyond a company’s control.

In all situations business managers who understand the elements of capital balance can make better-informed decisions. These managers have to arrive at a number of judgments on the relative merits of investments and divestments, such as trade-offs between strategic fit and short-term value creation and whether to modify hurdle rates.

One niche services company had calculated its current capital balance realized that it could create further value in its core business but would be better off diversifying into adjacent businesses with a superior long-term outlook and uncorrelated risks.

Assessing Future Investment Returns

To allocate capital among various opportunities, management has to understand the future economic returns that potential investments will generate, but assessing future returns is a very challenging task. Many management teams still focus on accounting returns, such as profits on book capital, ignoring the fact that the market value of an existing business is higher than the book value if its returns are above the cost of capital (and lower if its returns are below the cost of capital). Likewise, the value of new businesses must account for any goodwill paid to acquire them. Management often compare the book returns of existing businesses with the net value creation from new ones; the result is an unfortunate bias toward keeping lackluster businesses and shying away from new opportunities that require the payment of goodwill or entry costs.

For Example any new deal’s value creation depends on the potential synergies (cost, capital, revenue, and growth) it produces and the extent to which the premium paid cancels out those gains. Synergies, of course, must be rigorously quantified. The likelihood of actually realizing forecast synergies also needs to be assessed, along with such offsetting factors as lost revenue. The projected value created must then be weighed against any premium paid over the target’s intrinsic value rather than against the current share price, which often reflects takeover speculation.

Calculating the net returns of a portfolio of investments can be complex, as actual returns may differ markedly from accounting ones. The most accurate approach is to decompose net returns into the underlying future returns of the business, minus entry costs and plus synergies gain. Management can estimate this value by using simple proxies; for example, they can usually derive a good estimate of future returns from long-term returns on invested capital, which are surprisingly stable in many industries. Note that long-term growth heavily influences future returns; at typical levels of profitability, growth at twice the rate of GDP generates returns that are two to three times higher than growth at GDP.

The main reason many companies fail to create value when they change their corporate portfolios is that managers have misjudged the exit or entry costs, such as acquisition goodwill or start-up losses. Again, managers should consider external proxies. In the case of acquisitions, executives know the premiums paid for past transactions, and premiums for new businesses can be justified by synergies even if they are assessed only approximately. In the case of a divestment, a substantial loss of value can result from the loss of synergies, and while few companies bother to quantify the synergies among existing businesses, that oversight can lead to unpleasant surprises at the moment of a divestment. When a large financial institution tried to divest its asset-management business, it found that more than a third of its value depended on captive business, which buyers would exclude from a stand-alone valuation. As a consequence, the company had to grant extensive guarantees in order to sell.

One proxy for future returns that is often used—but should not be—is short-term growth in earnings per share. This approach does not adequately account for the amount of capital needed to acquire or maintain an investment, so it tends to favor acquisitions even if they will destroy value.

A practical approach should be to calculate the net return, typically over the next five to ten years, from all portfolio moves under consideration: keeping a business, investing in step changes or new businesses, or selling businesses. Managers should always calculate returns relative to the current value of a business, existing or new. Coincidentally, this metric resembles the approach taken by private-equity firms. It lets managers easily link the results of portfolio strategy to a business’s medium-term targets for growth and returns. In that sense, only investments that give a company some form of advantage sufficient to pay back the costs of entry and exit are likely to generate sufficient returns on capital. Here, the connection to natural ownership becomes clear: the ideal investment is one where natural ownership leads to superior net returns. The ideal portfolio is one with enough such investments to deploy all the available capital at rates clearly above the cost of capital.

Given the complexity of portfolio decisions, how should managers go about defining a portfolio strategy? Here are four useful hints-

Understand the context and objectives

Approaches to portfolio strategy can vary considerably, depending on the context. One company may want to determine which businesses it can divest with minimal loss of value and strategic coherence. Another might want to assess the range of investment options for cash flows generated by its current, maturing businesses.

Manage Decision Issues

Operational managers do not have the best position for making portfolio decisions: they are often inclined to favor the businesses they are currently responsible for, so they are reluctant to recommend reallocating capital to new opportunities. To overcome such decision issues, a company should charge people who are independent of the operating businesses—typically, the board, advised by the CEO and the CFO— with the responsibility for making all final portfolio decisions.

Do Rigorous Analysis

Any rational portfolio decision depends on a true understanding of a business’s performance and upside. Management often claims they have all the data, although those data are purely internally focused. To analyze a portfolio, a functional team, led by the CFO, should rigorously and quantitatively benchmark the returns and growth of individual businesses as compared with those of their peers. The team also needs to challenge internal plans by comparing them with the historical performance of the business or that of peers.

Maintain Capital Discipline

Even the best portfolio strategy cannot adequately account for all future developments. Investors do not expect a company to predict the future, but they do expect it to show discipline once projected returns do not materialize.

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