Risk and return have a positive relationship; ideally, product lines with low margins and high volatility should be divested. Risk / return profle analysis of a company's product lines is a useful guide to assessing future investment decisions. Companies that have several product lines often struggle to understand how a single product line interacts with other products.
Risk and return have a positive relationship; ideally, product lines with low margins and high volatility should be divested. Risk / return profle analysis of a company's product lines is a useful guide to assessing future investment decisions. Companies that have several product lines often struggle to understand how a single product line interacts with other products.
Risk and return have a positive relationship; ideally, product lines with low margins and high volatility should be divested. Risk / return profle analysis of a company's product lines is a useful guide to assessing future investment decisions. Companies that have several product lines often struggle to understand how a single product line interacts with other products.
outcomes, if the risks associated with the margins are overlooked. Risk and return have a positive relationship; ideally, product lines with low margins and high volatility should be divested as they clearly overexpose the company to a high level of risk without suffcient returns. However, low- margin, low-volatility product lines do not expose the company to excessive risks, but they may still be considered if proftability can be improved. Investment decisions. The risk/ return profle analysis of a companys product lines is a useful guide to assessing future investment decisions and how they may impact the overall level of risk facing the company, as well as the cost of fnancing via an increase in the cost of capital. Investment appraisals. As different product lines tend to have different risk/ return profles, to apply a common cost of capital in an investment evaluation of all of the product lines would result in biases in the assessment of the projects. The risks facing some product-line projects would be overestimated which would result in a project that would potentially lead to companys value being overlooked. At the same time, the level of risk for the product lines in other projects would be underestimated, which could lead to a decision to embark on projects with risk profles that are too high. Projects based on this premise could lead to value erosion rather than creation, or may simply be not aligned with the corporate strategy for risk. Introduction Companies that have several product lines often struggle to understand how a single product line interacts with other products and the resulting impact on their businesss proftability and risk profle. This is an important corporate strategy consideration, as a full account of the risk and return profle of each product line can guide a more informed decision-making process around: Sales and marketing campaign strategy. Product-line sales volatility and margins are two key factors that drive proftability and marketing strategy as they represent the risk and return of each business line, respectively. Insights on product line margins and sales volatility inform the company of the actual returns for each business unit as opposed to the risks faced. This will help to assess the businesss best sales and marketing terms. Inventory management strategy. Sales volatility is a serious challenge to a companys ability to manage inventories cost effectively. Its proftability is threatened as it causes revenue volatility and has a signifcant impact on inventory costs. The worst- case scenario would be serious risk of cash shortfall that would affect the companys fnancial stability. Cost-cutting decisions. Companies often use proft margins as a key reference point in decisions about product-line divestments. However, choices based only on an assessment Product portfolio analysis: a tool for a more informed corporate strategy A sly rabbit will have three openings to its den Chinese Proverbs Performance 55 Product portfolio analysis Product portfolio analysis has proven value as a tool for assessing the risk/ return profle of several product lines and for guiding a better-informed decision- making process on which to base corporate strategy. Companies often have in several product lines and, as such, can be viewed as portfolios of several assets, with the assets being the product lines. Each asset has its own features in terms of risk (sales volatility) and return. The latter can be represented by several fnancial metrics according to the reason for the analysis. Commonly suggested metrics are: sales margin, inventory stock margin; ROA; proft margin; etc. The ability to analyze a product line not only from a return perspective, but also from a risk perspective, provides a further dimension that is extremely valuable in corporate strategy. This approach has several implications that inform various CEO decisions. Sales and marketing campaign, and inventory management Companies have traditionally focused on the proftability of product lines only. However, the measurement of product-line risk is crucial for an accurate comparison of product-line portfolios. High returns are usually associated with high risk; this maxim is at the core of basic fnancial theory as high returns are the incentive for taking higher risks. An ideal situation would be to have high returns associated with low volatility. On the contrary, low returns and high volatility would create serious concerns about the ability of the product line to generate value to the frm without increasing the overall risk profle. Figure 1 is an analysis of a company that has several asset classes and depicts the sales margin versus sales volatility for seven product lines. Figure 1: Portfolio analysis Product_line 1 Product_line 2 Product_line 3 Product_line 4 Product_line 5 Product_line 6 0 . 2 . 4 . 6 . 8 1 S a l e s
m a r g i n 0 5,000 10,000 15,000 20,000 Sales volatility Not optimal Not optimal Divest Improve terms Tight inventory control Grow Product_line 7 Performance 56 Figure 2: Product lines cash analysis Product_line 1 Product_line 2 Product_line 3 Product_line 4 Product_line 5 Product_line 6 0 . 2 . 4 . 6 . 8 1 S a l e s
m a r g i n 0 2,000 4,000 6,000 8,000 Total sales in 000s Cash driver Dog Stars Prot driver Product_line 7 volatility similar to product lines 1, 3 and 6, is not matched by the same margins. The company should divest from product line 2 as it only increases the overall risk profle, without providing an adequate return. Product line 7 is not optimal either. Despite having the lowest margin relative to all other product lines, its low sales volatility is a positive feature. Therefore, the company should explore the opportunity to improve sales terms to increase proftability. The stock margin is another useful fnancial matrix that can be used to analyze the risk/return profle of product lines. This represents the sales margin given the overall investment in inventory, and it helps to assess the effciency of the inventory management policy. Another aspect worth considering is the product lines ability to generate cash. This is particularly relevant in current market conditions, where credit availability is limited and the ability to generate cash is a key challenge for companies in meeting their outstanding debt obligations and avoiding the fnancial distress that would result from an increase in the cost of Figure 1 shows that product lines 4 and 5 are the best performers in terms of their risk and return profles. Their sales volatility (risk) is relatively low, while their margins (return) are very high, compared with the companys other product lines. This is an ideal situation and the company should grow its market share in these two product lines. Product lines 1, 3 and 6 are consistent with the general risk/return profle. High sales volatility is matched by high returns. However, the high sales volatility may raise some concerns about inventory management. Therefore, tight inventory control is recommended. Product line 2 is not optimal: the high sales Performance 57 Figure 3: Portfolio analysis cost-cutting and investment decisions Product_line A Product_line B Product_line C Product_line D Product_line 1 Product_line E 10% 15% 20% 25% 30% 35% 40% 0.00 0.05 0.10 0.15 0.20 0.25 0.30 0.35 Revenues volatility M a r g i n Efcient frontier High margin Low margin Medium margin funding. Figure 2 represents the same product lines analyzed from a different perspective. Here, the sales margin and total sales of the product lines are the key variables. These help to identify the product lines that could generate more cash and drive proftability in the company. Product lines 4 and 5 indicate low total sales. However, these two product lines are proft drivers because of the high margins they are able to generate. Product lines 1, 3 and 6 are the best performers stars - in terms of their ability to generate cash. Large sales volumes are matched with reasonably high sales margins and, as such, these product lines are generating most value for the company. Product line 2 has low margins. However, large sales volumes make this product line a cash driver. Finally, product line 7 has low sales margins, which are associated with low sales volumes. Cost-cutting and investment decisions Cost-cutting and investment strategy are crucial as they affect a companys proftability in the medium to long term. Several factors affect these types of corporate strategy decisions. Therefore, portfolio analysis is another valuable tool to assist the decision-making process. Figure 3 illustrates a potential scenario for a company that has several product lines. The product lines have been divided into three categories: low, medium and high margin. Product lines A and E have similar margins. Therefore, from a pure margin perspective, they seem to be similar and bring the same value to the company. However, product line E has much higher sales volatility. Product line A is preferred as, for the same margin (return), the sales volatility (risk) is much lower. The company should divest product line E and consider divesting product line C as it features similar volatility to product lines A and D, but lower margins. An ideal situation for the company would be to reach a performance level illustrated by the orange line, which represents the effcient frontier. This is the best achievable risk/return trade-off for this companys product-line portfolio. The companys corporate strategy needs to take account of the existing risk/return profle and assess whether new decisions about its product-line investment are likely to lead to signifcant changes in its overall risk exposure leading to a rise in cost of its funds. The decision to invest in a product line that has both high margins and volatility, for instance, is likely to bring the companys overall risk toward the effcient frontier. Performance 58 Investment appraisals Appropriate investment valuation is the main route to value creation for most companies. However, many companies often fail to fully assess the level of risk associated with the various product lines. Instead, they use their common cost of capital to evaluate different investments in different product lines. The main danger with this approach is that it may either under or overestimate the true product-line risk. Investments that are not aligned with the corporate strategy and policy, because the level of risk and cost of capital attached are too low, or projects that have the potential to generate value, may be rejected because they are evaluated using too high a risk factor and consistent cost of capital. An extension of portfolio analysis is to apply econometric techniques to assess the level of risk associated with various product lines. The companys beta is the most widely used measure to assess its risk. Taking the view that a company with several products is a portfolio of assets, each asset will have a risk profle that can be measured by the beta. This implies that the companys beta is the weighted average of the product lines beta. The weights are represented by the share of revenues generated by each product line, or the share of company assets invested in each product line. Historical data on the companys beta and product-line weights can be used to estimate the beta for each product line. Figure 4 illustrates the security market line for the company and all of its product lines. The security market line plots the beta and the attached return. The companys beta is the weighted average of the beta of several product lines, where the weights are represented by the revenue share each product line is able to generate. Figure 4 also shows how applying the same risk (beta) to the investment appraisal project or all product lines would lead to biased results as an erroneous cost of capital would be used. A low level of risk would be attached to product lines A, F and G leading to the acceptance of the project with a higher risk profle than permitted under the companys strategy and policy. On the contrary, a high risk profle would be attached to product lines C, D and E, leading the company to reject projects that may actually deliver value because it used too high an estimated cost of capital. Portfolio analysis and beta disaggregation, however, would help to guide a more informed and robust investment decision process, and limit the risk to pursue investments not aligned with the companys policy. Conclusion Portfolio analysis is a powerful and quick tool that can be used to improve the decision-making process in several areas of a companys corporate strategy. Its fexibility to be applied to various challenges that CEOs face on a daily basis makes it an essential tool to inform corporate strategy. Our experience suggests that many successful organizations have achieved higher value using this tool to guide their strategic decisions. Author Fabrizio Jacobellis is a Manager in the Valuation & Business Modeling Practice, Ernst & Young UK Figure 4: Security market line Product_line A, 1.1 Product_line B, 1.7 Product_line C, 0.7 Product_line D, 1.4 Product_line E, 1.1 Product_line F, 2.0 Company 1.26 15% 20% 25% 30% 35% 40% 0.5 0.7 0.9 1.1 1.3 1.5 1.7 1.9 2.1 Beta R e t u r n