New research to quantify the linkage that really matters

It's different at the top. While your subordinates are in the product or service markets and measure success in sales and profits, the board has to think differently. You are in the capital market and success is measured in shareholder value created. Shareholder value is not the same as profit; it is a function of both returns and risks. So main board directors concern themselves with the risk-adjusted return on capital, a worry their subordinates are generally free of.

Unfortunately, the tools for assessing business risk are inadequate. They are either uncomfortably qualitative, based on vague assessments of intangibles, or hopelessly general, based on broad extrapolations of industry rather than company performance. What business leaders need is a way of assessing business risk both quantitatively and specifically. We need a tool that can objectively assess the probability of a business plan delivering the profits it promises. Moreover, we need a process that can be applied specifically to any business.

Just such a process has recently emerged from years of research at Cranfield, one of Europe's top business schools. It has been described in a new book, Marketing Due Diligence, which is summarised in this article.

In short, 'Marketing Due Diligence' is a process that assesses the probability of a business plan delivering its promises. It then adjusts the promised profit to reflect that probability and calculates if, for the firm's cost of capital, the plan would create or destroy shareholder value. It is a sophisticated process built on years of detailed research, but it can be understood in quite simple terms. In the following description the Marketing Due Diligence process is described for a single, simple, strategic business unit but the same principles work for a complex global business.

WHAT IS A STRATEGY AND WHAT MAKES IT RISKY?

Once the hype and jargon is cleared away, all business plans say the same thing: 'We're going to do these things in this market and make this much profit'. Digging deeper, we can discern three fundamental assertions that lie at the root of all business plans:

1. the market we are going for is this big
2. our strategy will achieve this much share
3. that share will result in this much profit.

It is these three assertions that give rise to the three components of business risk.

1. Market risk: the risk that the market is not as big as you think it will be.
2. Share risk: the risk that your strategy will not deliver the share it promises.
3. Profit risk: the risk that you will not make the margins you promised.

Cumulatively, these three component risks add up to business risk. If all three are certain, then there is no risk and the plan will deliver what it promises. To the extent that there is some uncertainty in one or more areas, the plan is risky and the promised returns must be higher to compensate for the risk. If we could objectively assess business risk, using data in a specific and systematic way, it would help us to create shareholder value in two ways. First, it would allow us to identify the main areas of risk in our strategy and act to reduce that risk. Second, it would give us a tool to sell our strategy to investors, demonstrating in detail that our plan is well thought out and creates shareholder value. The challenge lies in accurately assessing each of those three areas of risk.

MARKET RISK

It takes little business sense to appreciate that a minority of strategies have very high market risk (for instance, a brand new market and a novel product), while others have very low market risk (for instance, well-established, mature markets and established products). The test for Marketing Due Diligence is to differentiate between the large mass of strategies in the middle; to compare the market risk of two or more strategies of moderate market risk. The Cranfield research found that market risk itself was made up of five sub-component risks, as shown in Table 1.

The business plans studied showed that each of these five sub-components of market risk could be measured on an objective scale using data related to the plan. For instance, strategies that assume a much higher market price than the competition with little substantiation in the way of new product claims are riskier than those with some evidence, while the lowest pricing risk of all is to plan for me-too or lower pricing. In an article of this length, it is impossible to describe all the scales, but in practice they prove both accurate and effective at identifying actions to reduce business risk. Low market risk was not found to be synonymous with success, but a good appreciation of the true level of market risk is a prerequisite to creating shareholder value.

SHARE RISK

Once the risk associated with the business plan's assertions of market size are accurately assessed, the next key question concerns whether or not the intended strategy will deliver the promised share of that market. Share risk is inversely proportional to strategy strength, the likelihood that the strategy will create a more compelling proposition than that of the competitors' strategies. In the blizzard of promotional hype and detailed product claims, this is not easy to discern. However, our research revealed five key tests that could be applied to any strategy to reveal its strength and therefore the share risk associated with it. Just as with market risk, share risk has five sub-component risks, as show in Table 2.

The assessment of share risk proved to be an especially useful tool for separating strong strategies from weaker, high-risk ones. This was because it uncovered that failure to win the desired market share was most often due to how we apply resources to the market, rather than to do with product features and benefits. Companies that were found to destroy shareholder value tended to attack broadly defined markets (e.g. all high net-worth individuals for financial services) with a single proposition and offered much the same thing to the same customers as the competition. Such strategies both depended on brawn, not brains, and failed to use distinctive organisational strengths. By contrast, shareholder value-creating strategies defined novel segments, based on unmet customer needs and focused tightly on those segments with distinctive propositions. In doing so, they used their strengths and avoided head-on competition.

PROFIT RISK

Profit risk is the third component of business risk and arises during the implementation of strategy. It is the risk that the planned margins are not realised either because of higher than anticipated costs or lower than anticipated prices. By contrasting cases in which the planned profit was realised and those in which it was not, our research identified a number of key factors that were indicative of profit risk. Usefully, these risk factors could be looked for and found prior to strategy implementation, enabling modification of the strategy to reduce implementation risk. As with market risk and share risk, profit risk can best be described in terms of five sub-components, as described in Table 3.

As with market and share risk, profit risk can be assessed by the objective judgement of each of its five sub-components against a graduated scale. The practicality of the tests lies in the fact that they use available data, such as internal costs from other products or readily available market research. Using the profit risk tests allowed companies that were entering shrinking profits pools with the intention of severely damaging a major competitor to see that they were naively assuming no competitor response.

Equally, the tests illuminated the unrealistic cost assumptions often built into plans in order to get funding or approval. The flaws in the strategy revealed by the profit risk tests allowed the plan to be revised on the basis of an objective knowledge and reduced the subjectivity of much business planning activity.

KNOWLEDGE IS POWER

The Marketing Due Diligence process does not end with the objective assessment of each of the components of business risk. The three assessments are used to revise the plan's three principal assertions of market size, share and profit. Simply put, low-risk assessments leave the assertions unchanged while high-risk assessments lead to a reduction in the promised numbers. This combination of revised business plan promises leads to a revised calculation for the return on capital employed. Importantly, this calculation uses the firm's own cost of capital and counts both tangible assets and intangible assets, such as brands.

The end result is a statement of Marketing Due Diligence; this plan either will or will not create shareholder value. The board can then either revise the strategy, armed with knowledge of where the plan is weak, or use positive results to help manage investor relations. Where the process shows different businesses having different risks, the board can make more informed decisions about how to fund those businesses, thus avoiding the lethal combination of high business risk and high financial risk.

Marketing Due Diligence is a new, well-founded and much needed tool for those who are responsible for creating shareholder value. In time, we expect it will become as commonly used as financial due diligence. Until then, however, it will be a source of competitive advantage to the early adopters who use it first.

This article featured in Market Leader, Autumn 2006.

NOTES & EXHIBITS

TABLE 1: COMPONENTS OF MARKET RISK

TABLE 2: COMPONENTS OF SHARE RISK

TABLE 3: COMPONENTS OF PROFIT RISK