Saturday, June 2, 2007

Theory of Business Relativity

One time I was making a presentation to the top executives of a large corporation. I suggested that they might want to consider the acquisition of a particular retail company. I felt that this company might provide a good opportunity for them if purchased, because:

1) It would quickly and efficiently provide the corporation with a new channel of distribution.

2) It could provide a foundation for a new transformational strategy—significantly different from what the current owners were doing with the assets, and unique for the marketplace. It was an opportunity to get in on the ground floor of a revolutionary new retail concept which required this type of distribution channel.

3) Because the transformational strategy had the potential for being copied, acquiring a company that already had a national presence would provide a platform for rapid expansion, in order to claim the market before anyone else.

4) Given that the company was not implementing this transformational strategy and instead had an old positioning in the marketplace that was fairly weak, one could probably attain the assets fairly inexpensively.

It turns out that these executives I made the presentation to apparently had selective hearing. They heard the part about this potentially being a good acquisition, but seemed to miss everything else.

Here’s what they did.

1) The bought the company, but paid an outrageous premium price for the privilege. At that price, it would be difficult to get an adequate return, even if everything went right.

2) They did not implement the transformational strategy. Instead, they continued operating a variation on the old, failing strategy of the prior owners.

3) Even though it was a different channel of distribution, requiring a different approach to operating the business, the acquiring firm tended to operate it too similarly to the channel of distribution they were more familiar with.

4) The reason proposed for buying the firm was to penetrate the national market quickly with the new concept. Instead, they moved very slowly with any sort of small movement in the direction of the transformation.

As a result, the acquisition was a disaster and was eventually sold to a hedge fund at a significant loss.

Absolutes can create easier decision-making. If something is always good or always bad, then it is easy to know what to do. Unfortunately, the answer in the business world more often than not is not “it is bad” or “it is good”, but rather “it depends.”

Take the example in the story above. Was acquiring the business a good idea or a bad idea? The answer is “it depends.” If one pays too much for the business and does little to add value to it (as this company did), then the answer to the question is that the acquisition was a bad idea. However, if it had been purchased at a more reasonable price and had been used as a launching pad to create a new transformational strategy, then the acquisition would probably have been a good idea (it is hard to say, because this path was not taken).

Business strategies often include recommendations concerning the buying or selling of assets/companies. Whether or not these strategies are successful can often depend more on the manner in which the assets are acquired/disposed of than in the original idea of doing the buying or selling. Therefore, the process of strategy should not end once recommendations are made to buy or sell an asset. To prevent selective hearing, the voice of strategy needs to continue throughout the entire process, in order to ensure that the execution is consistent with the strategic intent.

The principle here is the Theory of Business Relativity. The idea is that the concept of whether an asset is good or bad is not always absolute, but can vary depending on other factors. The two factors which most impact whether an asset is good or bad are:

1) Price; and
2) Use

These are discussed in more detail below.

1) Price
Whether something is of great value depends in part on the intrinsic value within the asset. For most business assets, the intrinsic value of an asset is determined by the value of the cash flows which the asset can create for the company which owns it. However, of equal importance is the price associated with obtaining that asset. If the price one pays for the asset is far less than the intrinsic value, than the asset is very good and valuable to the firm. However, if one pays far more than the intrinsic value, then one has destroyed value and purchased a “bad” asset.

In both cases, it is the same identical asset with the same identical intrinsic value. However, the price one pays for it determines whether that is a good value or a bad value.

This principle is easy to see in stock trading recommendations. There could be a great company out there with outstanding prospects for growth and profitability. However if the price of the stock in that company has been run up too high, it could be a bad stock to buy at the going price. Conversely, there could be a very weak company out there with low profit prospects, but if the stock is priced low enough, it could be a great value to buy the stock of this “weak” company. Good or bad is only partly determined by the strength and weakness of the company’s prospects. The rest is determined by the price it takes to participate in those prospects.

So when someone asks whether a particular company is good or bad, you can say that it depends. The good news is that since intrinsic value is only part of the equation, you can have greater control in determining its total value based on your negotiating skills. If you are highly skilled in this art, you can make almost anything a good value, regardless of its intrinsic value.

With this in mind, a good strategy must first research an asset to best determine its intrinsic value. Then it must participate in the negotiation to ensure that the price of the transaction is favorable relative to the intrinsic value.

2) Use
Depending on how an asset is used, it can have a different intrinsic value. For example, let’s assume that there are two identical factories—each owned by a different company. Each company paid the same price to obtain their factory. The first company uses its factory to make a very profitable product. The second company uses its factory to make a very unprofitable product. So is this factory a good asset or a bad asset? The answer is, “it depends,” based on how it is used.

In the hands of the first company, the factory is a very good asset. It provides profits far higher than the price paid for it, because of the way it is used. In the hands of the second company, the factory is a very bad asset. It provides losses, so that the company will never get a profitable return on the investment in the factory.

Intrinsic value varies based on how the asset is used. In the original story, I felt that the company in question could be purchased at a good value, because I believed I had a better use for the assets in question than the current owners. As a result, I could afford to acquire the assets for more than the intrinsic value perceived by the current owners, but less than the intrinsic value available with my transformation strategy. That could provide a win-win on the price.

Unfortunately, the company doing the acquiring in the story paid a price about equal to the transformational intrinsic value, yet operated the business at the older, lower intrinsic value.

Therefore, it is very important to understand the strategic intent for the asset at the time of the evaluation. In addition, it is important to make sure that the asset is used in a manner consistent with the strategy, in order to create the value upon which the strategy was based.

The “goodness” or “badness” of an asset’s value is only partially due to the current intrinsic value in that asset. The greater determinant of good or bad has to do with one’s strategy regarding that asset—namely how much you are willing to pay for it, and how you are planning on using it to create cash flow.

The better one’s strategy and the better the follow-through in executing that strategy, the more likely the asset will be “good” in your hands.

I worked with an executive at a different company who would ask us to go off and determine the intrinsic value of a company. We’d come back and report to him what the intrinsic value was. His response would be, “Well, if that is what the company is worth, then that is what we should pay for it.” We’d then try to explain to him that if the price he pays is equal to its intrinsic value, then he has created zero value for the company. Value is only created if you pay less than what the asset can provide in cash flow.

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