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Strategic Corporate Finance: Applications in Valuation and Capital Structure by Justin Pettit

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ANALYZING THE CORPORATE PORTFOLIO

A calculation of economic profit involves three components of data: revenue, expense, and capital. The cost of capital is more an economic determination than an input. At the consolidated level, an EP calculation is typically simple with few issues of data availability and clarity. Similarly, intrinsic value can also be determined and benchmarked wherever a financial outlook can be estimated. But at more granular levels (product, brand, SKU, customer), important measurement issues arise. Can the economic benefit (attributable revenue) be appropriately captured? How are indirect cost and capital allocations best handled? How are unit costs best measured?

And does managing for value—be it a portfolio of businesses, products, brands or customers—mean that each manager should grow businesses earning returns above their cost of capital and sell or close all businesses earning returns below their cost of capital (book value issues aside)? Despite the appealing simplicity, we argue against this approach due to four common pitfalls.

Inadequate Time Horizon

Economic profit is a period measure, yet value is determined by the present value of performance in this period plus all periods going forward. A company, business unit, product, or customer may offer negative economic profit now, but each represents considerable value if it is likely to be sufficiently positive in the future to offset the cost of holding the negative. The early years of negative economic ...

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