Wednesday, November 05, 2008

When to toss shareholder value out of the window.

Alistair Davidson,

Pity the poor CEO. Everyone comes to him/her for decisions. Specialists like the CFO look for a simple system for allocating scarce capital. Financial analysis such as net present value or shareholder value is positioned as providing the answer. But does it? Here are ten examples of where superficial financial analysis can drive your decision the wrong way.

1. The Big Picture

The claim: We need to invest in our core business(es) to maximize shareholder value.

Counterclaims: 1. Disruptive businesses may represent the long term future of the business. 2. Selective extravagance with some critical part of the business may have dramatic pay off.

Example of underinvestment in non-core businesses: IBM’s mainframe business was more attractive than the PC business. Microsoft was late to market on Internet advertising and advertising supported applications.

Example of selective strategic extravagance: Google’s commitment to offering the broadest, deepest and most up to date surveying of the Internet is core to their business model and an area in which they are strategically extravagant.

Prescription 1a: Keep disruptive businesses autonomous. Bear in mind that it takes as much as five years for a disruptive business to become economic. [1]

Prescription 1b: Most business planning can be summarized as “We are the best. Customers love us. We are going to more of everything and diversify and it will cost less to do so.” Instead, identify areas of critical importance in your business and overinvest in them. Overinvestment will ensure commitment and may also deter competitors from imitating your strategy. [2]

2. Planning Processes

The claim: Good planning and detailed budgeting will bring discipline to the organization and improve financial performance.

Counterclaim: The more lines in your budget, the more likely that you will have variances to explain. Unfortunately, the variances will be smaller and have less meaning

Example of wasted budgeting effort: Every business with an overly detailed budgeting system.

Prescription 2: Simplify budgeting and give more autonomy to line managers. Don’t insist on the same degree of detail every year. Consider having “heavy planning years” with more elaborate planning processes and light planning years where the planning exercise is incremental. Use scenario analysis to consider different environments for a given strategy.

3. Managers

The claim: We hire the best, pay them more and get more value for money by working them harder. We are an 80 hour a week shop.

Counterclaim: Working smarter is better than working harder.

Examples of not working too hard: How many times have your solved a problem in the shower or by putting it aside and letting it develop in your subconscious? Netflix is an example where a new business model, or working smarter, completely upset the strategy of traditional retail movie rental operations.

Prescription 3: Don’t measure people by effort. Measure them by quality of thinking and execution. Reward “lazy managers” who come up with more effective solutions.

4. Innovation

The claim: We focus our innovation efforts. We don’t want to waste money.

Counterclaim: The creativity of unleashed managers working in a group can be orders of magnitude higher than bureaucratic innovation processes.

Examples of wildly creative organizations: Nathan Myhrvold’s Intellectual Ventures is in the business of creating and patenting numerous innovations. Like many firms, they have discovered that the quantity of innovation is important in creating value.

Prescription 4: Encourage innovation throughout the organization. Set goals for the percent of revenues and profits that should come from new products. [3]

5. Management

The claim: We are a goal oriented company. Our resources are devoted to achieving our goals so that we can maximize return on capital.

Counterclaim: Innovation occurs in many places. Some companies free up 20% of managers’ time to encourage innovation.

Examples of decentralized innovation: Google encourages self directed innovation; 3M not only allow freedom to managers to develop new products, it sets goals requiring a certain percentage of revenue to come from new products.

Prescription 5: Pay people for useful creativity. Don’t let politics and authority kill off new ideas. Research suggests senior management approval of an idea has little correlation with new product success. Seek researchers and innovation outside the four walls of your organization among researchers, customers, distributors and suppliers. [4]

6. Customers

The claim: We are a marketing and sales company. We design and sell products and obtain premium prices because of the superiority of our offering.

The counterclaim: Designing a culture where companies create, marketing, sell and support products and services on behalf of their customers can create strong loyalty. Loyalty in turn reduces marketing and sales costs and increases word of mouth. The perception that a corporation will reliably offer superior value and support its customers may lower the cost of launching new products and services.

Examples of acting on behalf of customers: credit unions, REI, Eastern Mountain Coop, Netflix, Virgin.

Prescription 6: Focus the organization on customer satisfaction and Net Recommender Scores. Reward employees for accepting and solving customer problems. Let front line employees initiate service and product improvement suggestions and projects. [5]

7. Customer Service

The claim: We run a cost effective customer support operation. Our cost per service call is the best in the industry. We have moved aggressively to outsource to India and to provide self service solutions.

Counterclaim: Customer service centers are opportunities to improve the reputation of your brand, identify problems that need to be solved and sell new services. Most customers are exceptionally annoyed by script-driven customer service reps that simulate the experience of talking to a robot. They are even more annoyed when a legitimate suggestion for product or service improvement disappears down a black hole.

Example of good customer service: American Express offers superb customer service. One of the key reasons is that senior management actually listens in on calls on a regular basis.

Prescription 7: Try using your own product or service anonymously. Try the competitors’ products too. Create a culture where borrowing good ideas from competitors is not seen as betrayal.

8. Suppliers

The claim: We aggressively forced down the costs of our suppliers. We get the best prices in the industry.

Counterclaim: It does your organization little good if you put your supplier out of business or if their margins are so low they cannot innovate and seek dramatic improvement in costs from new technology.

Examples of helping suppliers: Toyota, Xerox, Walmart

Prescription 8: Work with suppliers to understand how what you do increases their costs. Seek opportunities for synergy by changing the way you inform, contract, deliver and support products and services. Reduce the premium for uncertainty built into their price by lowering supplier risks. If one of you has a lower cost of capital than the other, take advantage of this capacity.

9. Shareholders

The claim: We can’t disclose what is really happening in our business. If we aggregate our data, the investors won’t be able to figure out the problems we have and our shareholder value will drop.

Counterclaim: Research suggests that disclosing strategic performance drivers reduces investor uncertainty and increases the valuation of public companies.

Prescription 9: Interview investors to understand what they understand, misunderstand and don’t know about your business. Communicate key performance drivers and track investor understanding of your strategy. [6]

10. Proprietary Information

The claim: Proprietary information is valuable, creates shareholder value, and we should guard it. We should not let our competitors get their hands on it.

Counterclaim: Sharing information with your ecosystem may improve your brand and accelerate learning within the ecosystem. Some proprietary information has a short shelf life, so the challenge is capturing value from it before it becomes obsolete.

Examples: One major consulting firm has opened up its knowledge of ERP and shared it with customers. It has become a way of promoting their brand and building a relationship with key prospects and customers. [7] IBM now actively licenses its technology to competitors in order to capture value in the window of usage. [4]

Prescription 10: Have a third party document and assess your intellectual property and other assets. Develop a strategy for technology licensing, sale and spin off and value the results. Determine whether you are missing opportunities to capture value from unused or underused assets.

Building Platforms and Capabilities

What many of these prescriptions share is building capabilities, customer relationships,

processes, cultures and capabilities that set the stage for growth. Platform improvement strategies are more difficult to evaluate than incremental product development. Platform strategies sometimes involve “bet the firm” strategies whose shareholder outcomes are potentially highly variable. IBM’s development of the system 360, the first family of compatible computers is an example from the 1960s that clearly established IBM’s dominance for 20-30 years. Google’s focus on search before there was an economic model to monetize search is another example of betting on uncertain capabilities.

This theme of building capabilities is by no means a new one for CEOs, but three examples of competitive strategies that might be filtered out by overly aggressive shareholder value models include:

  • Losing money in order to build a superior cost position. This is a classic strategy in electronics markets with experience curves. You price based on where your costs are going to be rather on where your costs are today. If you price on where you are going to be on the learning curve, your volume increases and volume increases drive down per unit costs – you reach and descend beyond your initial cost.
  • Sell capabilities not products. Google is a rare but superb example of this strategy. Google’s dominance in search and rapid growth in the new market of paid search caused to gain higher brand recognition than Overture (purchased later by Yahoo). This brand equity translated into a major IPO and the ability to fund rapid growth with simultaneous diversification. The low cost of capital due to “sexiness” has provided a significant competitive advantage to Google, allowing to experiment with numerous high risk pieces of functionality that might extend its brand and customer relationships.
  • Build superior infrastructure. Amazon is an example of infrastructure development that is widely misunderstood. Amazon, like Google, rode the dotcom boom to be able to build infrastructure that is compellingly better than its slower moving competitors. But Amazon resells access to its e-commerce and cloud infrastructure in order to accelerate its growth and create difficult to match capabilities.


[1] Christensen, Clayton and Raynor, Michael: The Innovator’s Solution, HBS Press, 2005

[2] Bonoma, Thomas: The Marketing Edge, Making Strategies Work, Free Press, 1985

[3] Varchaver, Nicholas: “Who’s afraid of Nathan Myhrvold?Fortune, June 26th, 2008.

[4] Chesbrough, Henry: “Open Innovation”, Harvard Business Press, 2006

[5] Reicheld, Fred: The Ultimate Question, Harvard Business Press, 2006

[6] Eccles, Robert; Herz, Robert; Keegan, Mary; and Phillips, David: The

Value Reporting Revolution.Moving Beyond the Earnings Games, Wiley, 2000).

[7] Li, Charlene and Bernoff, Josh: Groundswell: Winning in a World Transformed by Social Technologies, Harvard Business School Press, 2008