Chapter 4: The Economic Filter

BUILDING A BRIDGE between strategy and finance requires an analysis of economic factors that affect a business. A macroview of market conditions provides the first level of validation of Strategic Alternatives. This chapter will discuss the economic filter in the Step-Wise Approach to Value (Exhibit 1-1). This filter tests whether Strategic Alternatives (SAs) create shareholder value based on future economic conditions. How do economic factors affect shareholder value? Economic factors impact shareholder value through their influence on market demand (MD). MD measures the total revenue stream for an industry.

We will examine the concept of MD, the economic factors that affect it, and how to vet a Strategic Alternative based on the future direction of MD. The economic factors that we will discuss are GNP, inflation, interest rates, and resource availability. Evaluation of Strategic Alternatives then involves analysis of two factors—MD alignment and equivalence of response. The alignment factor looks at how well the SA accommodates the expansion or contraction in MD. Equivalence of response vets an SA in terms of permanency of market change and market risk. On the basis of these factors, you can determine whether to dismiss the SA or move on to the next filter.

What Is Market Demand and Why Is It Important?

Estimating the growth rate for your business is an important part of your strategic plan. Pricing, product, and channel decisions are vastly different between high growth and mature industries. Investment decisions will require different assumptions and risk profiles as well as the level of resources required to execute an effective strategy. The growth in the technology marketplace is vastly different from the demand for cereal or other mature markets. As these technology markets mature, expansion will slow.

Market demand represents the total revenue stream for a particular product or service. As mentioned, market demand is simply calculated as follows:

Product Price Number of Buyers = Market Demand.

Market demand is a measure of the overall revenue generated by an industry. The value proposition of a Strategic Alternative must include ways to increase value-based shifts in market demand. If market demand is increasing, the value proposition of a Strategic Alternative must be able to capture the increase in potential revenue in the marketplace. If the market is contracting, the value propositions must protect existing demand and focus on efficiency. Alignment with the market requires careful thought. The importance of using this screen can be demonstrated through a consulting experience.

A number of years ago, a client asked for the results of a consulting study to be presented to the board of directors. The consulting team had created an operating unit to support lending to small businesses for a regional bank. Most of their customers were small businesses, and they wanted to apply small business-lending practices to their existing portfolio to increase efficiency as well as to attract new customers by processing loans faster. The value proposition for creating the unit was based on productivity, more specifically improving the bank's cost position. The bank was interested in improving their cost to process a loan and in reducing customer response time. In preparing for the presentation, the focus was on cost reduction and process reengineering. Prior to the board meeting, a separate meeting was conducted with the president and chief operating officer of the bank about the members of the board and their areas of interest. The board consisted of major shareholders and regional business leaders.

As consultants normally do, I worked throughout the night distilling months of work into a concise and focused presentation. The value proposition was clear, quantifiable, and aligned with my client's goals. I arrived at the bank's headquarters confident and excited about the work that had been done. I've always found the most gratifying aspect of my work to be the final presentation. It demonstrates the value of the work. I was the second presenter on the agenda and was instructed to sit at the front of the room next to a tall and thin man in his late fifties. Not having had the pleasure of knowing him, I introduced myself. He was an investor in the bank and asked me what I was presenting. After explaining the purpose of the engagement, he quickly shot back a question to me: "What is the market for the product? If there is no market for this product, then it does not make sense to go forward". This question took me by surprise after spending a month looking at productivity. Fortunately, I was able to respond with a U.S. market demand figure, a growth rate, and an industry profit margin relative to other products.

What can we learn from this experience? Whatever the value proposition, it should be validated with market demand. The value proposition needs to be aligned with the direction of the market demand. The logic behind the key issue in the investor's line of questioning was, "Why do something if there is no demand to support it?" What is unique about this story is that most executives would not associate productivity with market demand. Yet even in this case the line of inquiry was appropriate. Applying an economic filter to all value propositions is important to evaluate strategic alternatives of all types.