Monday, January 24, 2011

Strategic Planning Analogy #373: Value is in the Context

A couple of years ago I put together a wish list on so my family would have some ideas about what to get me for gifts (at their insistence). One of the items I put on that list was a book of comic strips from one of my favorite comics.

Recently, my wife bought me a copy of that book. I was enjoying the comics. The note from Amazon said it was a used copy of the book. I assumed that meant that my wife got the book at a discounted price, since when I put the book on my Amazon wish list, used copies were selling for about $5.. Thinking that the book didn’t cost much, I found myself enjoying the value of all the jokes in the comics. What a bargain!

Halfway through reading the book, my wife informs me that she had to buy the book used because it was out-of-print. It was so scarce, that she had to pay $150 to buy the book, a very steep premium over the original list price.

Suddenly, the jokes in the remainder of the book didn’t seem funny enough to justify the price. The enjoyment value to me dropped considerably.

I guess I should have checked how much the price of the book had changed between the time I put it on my wish list (and was still in print) and today (when it was out of print).

Strategic planning has a lot to do with choosing among options:

a) Should I buy company A or B?
b) Should I sell division C or D?
c) Should I increase or shrink investment in product E?
d) Should I pursue opportunity F?

In making these choices, we tend to rank order the options in terms of value and then choose the option(s) with the best value (adjusted for risk tolerance).

As a result, the level of success in strategic planning has a lot to do with how well one places values upon the various options. If you place the wrong values on the options, you will make the wrong choices.

At first, one might think that value is based solely on what you are getting, since that is what you are buying. For example, this line of reasoning would say that the value of a box is equal to the value of the contents of that box.

Yet, this did not appear to be the case with my book of comic strips. The quality of the humor in the book stayed constant over time. The jokes in the book didn’t change. The number of pages in the book didn’t change. Yet the price of the book fluctuated wildly. Some paid about $20 for a new copy of the book. Some paid about $5 for a used copy of the book. Others paid about $150 for a used copy of that same book (30 times more than the $5). Today I checked and Amazon is trying to sell the book for over $700 (140 times the $5). Obviously, the value of that book is not based solely on adding up the intrinsic value of each joke within the book. Something more is going on here.

If a little book of comics can fluctuate in value by so much, even when its contents are easily comprehended and do not change, then it shouldn’t surprise us that values on our more complex strategic options can also vary wildly. Like that book, more is going on in determining the value of these strategic options than just looking at the contents within that option. If you only look at the contents of what you are getting, you may value the option improperly.

And just because some people may be willing to pay as much as $700 for that book does not mean that it is worth $700 to everyone. The proper question is not “What is the book worth?” That question mistakenly assumes that value is based on something constant—like the constancy of the contents of the book. However, the value has more to do with the user of the book (an external factor) than the content of the book (an internal factor). Depending upon the user, you will get a different value for the book.

So instead of asking “What is the book worth?” (a question which has no single answer), we need to ask “What is that book worth to me?” This latter question may require a more detailed analysis of me than of the book.

The principle here is that values need to be computed within a context. If you only look at the contents, you will come up with the wrong value. To get the proper value, one must also factor in the context in which the contents find themselves. For example, a bottle of milk within the context of a refrigerator is worth more than a bottle of milk under a heat lamp. The contents are the same—milk. However, the refrigerator keeps the milk from spoiling, so it makes the milk more valuable.

In particular, there are three types of context which should be included in your valuation analysis.

1. The Context of the Marketplace
One of the great contributions to strategic analysis was Michael Porter’s Five Forces. The premise behind this concept is that a strategic option’s value changes depending upon five forces external to the contents of the option. These five forces are:

1. Bargaining Power of Buyers
2. Bargaining Power of Sellers
3. Threat of Substitute Products or Services
4. Level of Rivalry Among Current Industry Participants
5. Threat of New Entrants into the Business

For example, when my book of comics was still in print there were many sellers of many copies of the book, so the Seller’s power was low (and the price of the book was low). Once the book was out of print, there were fewer copies for sale, increasing the bargaining power of the Seller, causing the price to shoot up to over $700.

Therefore, when valuing a strategic option, one must not only value the contents, but also the marketplace in which the contents operate. Otherwise, you will miss out on the impact of these five forces upon the value. And in most cases, these five external forces have far more to do with the real strategic value than an intrinsic evaluation of the internal contents. The market determines the value, not the contents. Ignore these five forces at your own peril.

2. The Context of the Recipe
By itself, the desirability of flour as a food is not very high. If you don’t believe me, try to eat a spoonful of plain flour. It’s awful. However, if you put that flour into a recipe for bread, its desirability as a food goes up. And if you put that flour into a recipe for cake, the desirability goes up even further. The point here is that the value of an ingredient (like four) changes depending upon the context of the recipe.

In addition, if you are missing some of the ingredients for your recipe, it impacts the value of all the other ingredients. For example, if I have all of the ingredients needed to make a nuclear weapon except one, I really do not have a nuclear weapon, so all of the ingredients I do have are fairly worthless. Until I get that last ingredient, I have nothing. But once I get that last ingredient and make the bomb, I have created something of great value. So how much is it worth to me to get that last ingredient? How much am I willing to pay to complete the recipe?

Great strategies are like great recipes. They take a number of strategic components (ingredients) and add them together in such a manner as to create a finished product worth far more than merely the sum of the parts. Apple is a great company because it has a great recipe: cool products, with cool features, with tons of cool apps, sold in a cool way, from a company with a cool culture and a cool leader. The value lies in the way all of this seamlessly works together. Take away the ingredient of the cool apps and the value of the iPhone drops dramatically. Or a great app store without a cool device for the apps to play on isn’t worth much either. You need the whole recipe to create the optimum value.

Therefore, when creating your strategy, keep in mind the context of the recipe. First, make sure your strategic plan has a greater recipe. If all you have is a collection of individual ingredients (or businesses) working in isolation, you haven’t created much value. For a strategy to create great value, it must end up converting those ingredients into a finished, integrated plan with a value worth well more than the sum of its parts.

Second, don’t value the strategic options in isolation. Think of their impact on the value of the entire recipe of your strategic positioning. Your greater recipe helps determine how much value each option is worth to you. Just as steel is a more valuable ingredient to an auto maker than it is to cake baker, some strategic options will be more or less valuable to you depending on your recipe. Make sure you understand what ingredients make your recipe the best.

Third, make sure your strategic plan includes all the ingredients necessary to create the finished strategic product. Be willing to pay extra to get the last missing component.

3. The Context of Time
Things change over time. These changes can impact value. For example, the value of that book of comics changed when the book shifted from being in print to being out of print.

Never assume a constancy of value. The power of the five forces can change over time. Your recipe can change over time. Consumer interests can change over time. Products and industries move through lifecycles, where each phase (introduction, rapid growth, maturity, & decline) impacts value. Things which used to have a lot of value in the past may have very little value in the future (and vice versa).

Strategic planning is supposed to be maximizing the longer-term interests of the firm. Therefore, when making valuations, be sure to look at those values within the context of the future, which is where the strategy is going to be operating. Don’t be afraid to radically change your portfolio in order to optimize the times. The single most important factor to the long-term success of GE has been its willingness to add and subtract to its portfolio in order to stay relevant to the changing times.

The true value of a strategic option usually has more to do with factors external to the option than factors internal to the option. Therefore, make sure you consider external factors in your evaluation. This would include externals like Porter’s Five Forces, the context of your Strategic Recipe, and the context of Time.

After finding out how much the price of that book had changed between the time I put it on my wish list and the time my wife bought it for me, I decided I needed to go back and monitor that wish list more frequently. For the same reason, it’s probably a good idea to go back and monitor the values of your strategic portfolio on a regular basis as well. Otherwise, you may not see when the values change (and they will change).

1 comment:

  1. Gerald Nanninga,

    You are 100% right. A widow, whom I know very well, was paid a huge sum of money to sell her house to a commercial enterprise. She refused adamantly even though she was many fold the house worth. Why? The emotional value of her memories with her late husband was priceless.
    The value is contained within the boundaries you defined in this post.