Roger L. Martin

<article-ideainbrief class="article-ideainbrief">
 <h4 class="ideainbrief-title">Idea in Brief</h4>
 <div class="ideainbrief-contents">
  <h5>The Problem</h5>
  <p>Large public corporations frequently off-load business units they believe are underperforming—only to see the private equity firms that buy the units reap a handsome profit by turning them around and selling them.</p>
  <h5>Why It Happens</h5>
  <p>Managers at large corporations are wedded to a valuation model anchored in the amount of cash invested in a business rather than in expectations of value to be created. PE firms can exploit this serious misvaluation.</p>
  <h5>The Solution</h5>
  <p>Managers should recognize that any investment in an asset presupposes that value will be created or destroyed in the future—and that should immediately be reflected in the valuation of the capital represented in the asset.</p>
 </div>
</article-ideainbrief><p>In 2013 Ellen Kullman, then the CEO of the chemicals giant DuPont and under pressure from shareholders to improve results, decided to sell the company’s performance coatings business, a low-growth, low-profit part of the portfolio. Carlyle Group, a private equity firm, paid $1.35 billion to gain full ownership of the business and renamed it Axalta. Carlyle immediately embarked on a major overhaul of the unit, which involved fairly aggressive investment, especially in developing markets.</p>

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<p>Why do large corporations sell off business units to PE firms that make a fortune by selling them a few years later? The author, a former Rotman School dean, argues that the answer is rooted in the way many corporations value their businesses and projects. Their basic mistake is to compare estimates of future cash flow with the amount of cash put into a business as a capital investment. Although this sounds perfectly reasonable (and largely follows conventional practices for measuring economic value added, or EVA, and its equivalents), it can anchor performance measurement in a historical number that very quickly loses its relevance.</p>
<p>As Martin explains, once an investment has been made in an asset, the company&#8217;s expectations about the value that investment will create are, in effect, publicized. Thus a company assessing the performance of its investment should base its measures not on the cash put in but on the current value of the asset or capability in question, which&#8212;and this is the critical point&#8212;<em>includes the value that the market already believes the company will create or destroy with that asset or capability.</em> Martin describes an approach that is grounded in market expectations about future value.</p>

What Managers Get Wrong About Capital

Why do large corporations sell off business units to PE firms that make a fortune by selling them a few years later? The author, a former Rotman School dean, argues that the answer is rooted in the way many corporations value their businesses and projects. Their basic mistake is to compare estimates of future cash flow with the amount of cash put into a business as a capital investment. Although this sounds perfectly reasonable (and largely follows conventional practices for measuring economic value added, or EVA, and its equivalents), it can anchor performance measurement in a historical number that very quickly loses its relevance. As Martin explains, once an investment has been made in an asset, the company’s expectations about the value that investment will create are, in effect, publicized. Thus a company assessing the performance of its investment should base its measures not on the cash put in but on the current value of the asset or capability in question, which—and this is the critical point— includes the value that the market already believes the company will create or destroy with that asset or capability. Martin describes an approach that is grounded in market expectations about future value.

What Managers Get Wrong About Capital

Summary.

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