within five days of receiving an order. This allowed the company to avoid large in-
ventories of parts and assembled computers. Low inventories allowed Dell to save
working capital costs; it also reduced costly write-offs of obsolete inventories, a
significant risk in the fast-changing computer industry.
ā¢ Third-party service. Dell used two low-cost approaches to after-sales service: tele-
phone-based service and third-party maintenance service. Dell had several hundred
technical support representatives accessible to the customers by phone any time of
the day. Using a comprehensive electronic maintenance system, the service repre-
sentatives could diagnose and help the customer to resolve problems in the vast ma-
jority of cases. In the rare case where on-site maintenance was required, Dell used
third-party maintenance contracts with office equipment companies such as Xerox.
Through this service strategy, Dell was able to avoid investing in an expensive field
service network without compromising on service quality.
ā¢ Low accounts receivable. Dell was able to reduce its accounts receivable days to an
industry minimum by encouraging its customers to pay by credit card at the time of
the purchase, or through electronic payment immediately after the purchase.
2-13 Part 2 Business Analysis and Valuation Tools
ā¢ Focused investment in R&D. Dell recognized that most of the basic innovations in
the personal computer industry were led by the component suppliers and software
producers. For example, Intel and Microsoft, two key suppliers, invested billions of
dollars in developing new generation processors and software, respectively. Dellā™s
innovations were primarily in creating a low-cost, high-velocity organization that
can respond quickly to these changes. By focusing its R&D innovations, Dell was
able to minimize these costs and get high return on its investments.
As a result of the above strategy, Dell achieved a signiļ¬cant cost advantage over its
competitors in the personal computer industry. This advantage resulted in a consistent
pattern of rapid growth, increasing market share, and very high proļ¬tability in an indus-
try that is characterized by rapid technological changes, signiļ¬cant supplier and buyer
power, and intense competition. Further, because the strategy involved activities that are
highly interrelated and involved continuous organizational innovations, Dellā™s business
model was difļ¬cult to replicate, making Dellā™s competitive advantage sustainable. In
fact, Dellā™s success inspired several of its competitors, including Compaq and IBM, to
attempt to replicate parts of its strategy. However, no competitor to date has been able to
replicate Dellā™s business model. The extraordinarily high earnings and book value mul-
tiples at which Dellā™s stock has been trading in recent years is evidence that investors are
betting that Dellā™s competitive advantage and its superior proļ¬t performance is likely to
be sustained for the foreseeable future.
CORPORATE STRATEGY ANALYSIS
So far in this chapter, we have focused on the strategies at the individual business level.
While some companies focus on only one business, many companies operate in multiple
businesses. For example, the average number of business segments operated by the top
500 U.S. companies in 1992 is eleven industries.12 In recent years, there has been an
attempt by U.S. companies to reduce the diversity of their operations and focus on a rel-
atively few ācoreā businesses. However, multibusiness organizations continue to domi-
nate the economic activity in most countries in the world.
When analyzing a multibusiness organization, an analyst has to not only evaluate the
industries and strategies of the individual business units but also the economic conse-
quencesā”either positive or negativeā”of managing all the different businesses under
one corporate umbrella. For example, General Electric has been very successful in cre-
ating signiļ¬cant value by managing a highly diversiļ¬ed set of businesses ranging from
aircraft engines to light bulbs, but Sears has not been very successful in managing retail-
ing together with ļ¬nancial services.
Sources of Value Creation at the Corporate Level
Economists and strategy researchers have identiļ¬ed several factors that inļ¬‚uence an or-
ganizationā™s ability to create value through a broad corporate scope. Economic theory
46 Strategy Analysis
suggests that the optimal activity scope of a ļ¬rm depends on the relative transaction cost
of performing a set of activities inside the ļ¬rm versus using the market mechanism.13
Transaction cost economics implies that the multiproduct ļ¬rm is an efļ¬cient choice of
organizational form when coordination among independent, focused ļ¬rms is costly due
to market transaction costs.
Transaction costs can arise out of several sources. They may arise if the production
process involves specialized assets, such as human capital skills, proprietary technology,
or other organizational know-how that is not easily available in the marketplace. Trans-
action costs also may arise from market imperfections such as information and incentive
problems. If buyers and sellers cannot solve these problems through standard mecha-
nisms such as enforceable contracts, it will be costly to conduct transactions through
For example, as discussed in Chapter 1, public capital markets may not work well
when there are signiļ¬cant information and incentive problems, making it difļ¬cult for en-
trepreneurs to raise capital from investors. Similarly, if buyers cannot ascertain the qual-
ity of products being sold because of lack of information, or cannot enforce warranties
because of poor legal infrastructure, entrepreneurs will ļ¬nd it difļ¬cult to break into new
markets. Finally, if employers cannot assess the quality of applicants for new positions,
they will have to rely more on internal promotions, rather than external recruiting, to ļ¬ll
higher positions in an organization. Emerging economies often suffer from these types
of transaction costs because of poorly developed intermediation infrastructure.14 Even
in many advanced economies, examples of high transaction costs can be found. For ex-
ample, in many countries other than the U.S., the venture capital industry is not highly
developed, making it costly for new businesses in high technology industries to attract
ļ¬nancing. Even in the U.S., transaction costs may vary across economic sectors. For
example, until recently electronic commerce was hampered by consumer concerns
regarding the security of credit card information sent over the Internet.
Transactions inside an organization may be less costly than market-based transac-
tions for several reasons. First, communication costs inside an organization are reduced
because conļ¬dentiality can be protected and credibility can be assured through internal
mechanisms. Second, the headquarters ofļ¬ce can play a critical role in reducing costs of
enforcing agreements between organizational subunits. Third, organizational subunits
can share valuable nontradable assets (such as organizational skills, systems, and
processes) or nondivisible assets (such as brand names, distribution channels, and
There are also forces that increase transaction costs inside organizations. Top man-
agement of an organization may lack the specialized information and skills necessary to
manage businesses across several different industries. This lack of expertise reduces the
possibility of realizing economies of scope in reality, even when there is potential for
such economies. This problem can be remedied by creating a decentralized organization,
hiring specialist managers to run each business unit, and providing them with proper in-
centives. However, decentralization will also potentially decrease goal congruence
among subunit managers, making it difļ¬cult to realize economies of scope.
2-15 Part 2 Business Analysis and Valuation Tools
Whether or not a multibusiness organization creates more value than a comparable
collection of focused ļ¬rms is, therefore, context dependent.15 Analysts should ask the
following questions to assess whether or not an organizationā™s corporate strategy has the
potential to create value:
ā¢ Are there significant imperfections in the product, labor, or financial markets in the
industries (or countries) in which a company is operating? Is it likely that transac-
tion costs in these markets are higher than the costs of similar activities inside a well
ā¢ Does the organization have special resources such as brand names, proprietary
know-how, access to scarce distribution channels, and special organizational pro-
cesses that have the potential to create economies of scope?
ā¢ Is there a good fit between the companyā™s specialized resources and the portfolio
of businesses in which the company is operating?
ā¢ Does the company allocate decision rights between the headquarters office and the
business units optimally to realize all the potential economies of scope?
ā¢ Does the company have internal measurement, information, and incentive systems
to reduce agency costs and increase coordination across business units?
Empirical evidence suggests that creating value through a multibusiness corporate
strategy is hard in practice. Several researchers have documented that diversiļ¬ed U.S.
companies trade at a discount in the stock market relative to a comparable portfolio of
focused companies.16 Studies also show that acquisitions of one company by another,
especially when the two are in unrelated businesses, often fail to create value for the
acquiring companies.17 Finally, there is considerable evidence that value is created when
multibusiness companies increase corporate focus through divisional spinoffs and asset
There are several potential explanations for the above diversiļ¬cation discount. First,
managersā™ decisions to diversify and expand are frequently driven by a desire to maxi-
mize the size of their organization rather than to maximize shareholder value. Second,
diversiļ¬ed companies suffer from agency problems leading to suboptimal investment
decisions and poor operating performance. Third, capital markets ļ¬nd it difļ¬cult to mon-
itor and value multibusiness organizations because of inadequate disclosure about the
performance of individual business segments.
In summary, while companies can theoretically create value through innovative cor-
porate strategies, there are many ways in which this potential fails to get realized in prac-
tice. Therefore, it pays to be skeptical when evaluating companiesā™ corporate strategies.
Applying Corporate Strategy Analysis
Let us apply the concepts of corporate strategy analysis to Amazon.com, a pioneer in
electronic commerce. Amazon started operations as an online bookseller in 1995 and
48 Strategy Analysis
went public in 1997 with a market capitalization of $561 million dollars. The company
grew rapidly and began to pose a serious threat to the dominance of leading traditional
booksellers like Barnes & Noble. Investors rewarded Amazon by increasing its market
capitalization to a remarkable $36 billion dollars by April 1999.
Flush with his success in online book-selling, Jeff Bezos, the founder and chief exec-
utive ofļ¬cer of Amazon, moved the company into many other areas of electronic com-
merce. Amazon claimed that its brand, its loyal customer base, and its ability to execute
electronic commerce were valuable assets that can be exploited in a number of other on-
line business areas. Beginning in 1998, through a series of acquisitions, Amazon ex-
panded into online selling of CDs, videos, gifts, pharmaceutical drugs, pet supplies, and
groceries. In April 1999, Amazon announced plans to diversify into the online auction
business by acquiring LiveBid.com. Bezos explained, āWe are not a book company.
Weā™re not a music company. Weā™re not a video company. Weā™re not an auctions company.
Weā™re a customer company.ā19
Amazonā™s rapid expansion attracted controversy among the investment community.
Some analysts argued that Amazon could create value through its broad corporate focus
because of the following reasons:
ā¢ Amazon has established a valuable brand name on the Internet. Given that electron-
ic commerce is a relatively new phenomenon, customers are likely to rely on well
known brands to reduce the risk of a bad shopping experience. Amazonā™s expan-
sion strategy is sensible because it exploits this valuable resource.
ā¢ Amazon has been able to acquire critical expertise in flawless execution of elec-
tronic retailing. This is a general competency that can be exploited in many areas
of electronic retailing.
ā¢ Amazon has been able to create a tremendous amount of loyalty among its custom-
ers through superior marketing and execution. As a result, a very high proportion
of Amazonā™s sales comes from repeat purchases by its customers. Amazonā™s strat-
egy exploits this valuable customer base.
There were also some skeptics who believed that Amazon was expanding too rapidly,
and that its diversiļ¬cation beyond book retailing was likely to fail. These skeptics ques-
tioned the value of Amazonā™s brand name. They argued that traditional retailers, such as
Barnes & Noble, Wal-Mart, and CVS, who are boosting their online efforts, also have
valuable brand names, execution capabilities, and customer loyalty. Therefore, these
companies are likely to offer formidable competition to Amazonā™s individual business
lines. Amazonā™s critics also pointed out that expanding rapidly into so many different ar-
eas is likely to confuse customers, dilute Amazonā™s brand value, and increase the chance
of poor execution. Commenting on the fact that Amazon is losing money in all of its
businesses while it is expanding rapidly, Barronā™s business weekly stated, āIncreasingly,
Amazonā™s strategy is looking like the dim-bulb businessman who loses money on every
sale but tries to make it up by making more sales.ā20
2-17 Part 2 Business Analysis and Valuation Tools
Investor concerns about Amazonā™s corporate strategy began to affect its share price,
which dropped from a high of $221 dollars in April 1999 to $118 dollars by the end of
May 1999. Still, at a total market capitalization of about $19 billion dollars, many inves-
tors are betting that Amazonā™s corporate strategy is likely to yield rich dividends in the
Strategy analysis is an important starting point for the analysis of ļ¬nancial statements
because it allows the analyst to probe the economics of the ļ¬rm at a qualitative level.
Strategy analysis also allows the identiļ¬cation of the ļ¬rmā™s proļ¬t drivers and key risks,
enabling the analyst to assess the sustainability of the ļ¬rmā™s performance and make re-
alistic forecasts of future performance.
Whether or not a ļ¬rm is able to earn a return on its capital in excess of its cost of cap-
ital is determined by its own strategic choices: (1) the choice of an industry or a set of
industries in which the ļ¬rm operates (industry choice), (2) the manner in which the ļ¬rm
intends to compete with other ļ¬rms in its chosen industry or industries (competitive po-
sitioning), and (3) the way in which the ļ¬rm expects to create and exploit synergies
across the range of businesses in which it operates (corporate strategy). Strategy analysis
involves analyzing all three choices.
Industry analysis consists of identifying the economic factors which drive the indus-
try proļ¬tability. In general, an industryā™s average proļ¬t potential is inļ¬‚uenced by the de-
gree of rivalry among existing competitors, the ease with which new ļ¬rms can enter the
industry, the availability of substitute products, the power of buyers, and the power of
suppliers. To perform industry analysis, the analyst has to assess the current strength of
each of these forces in an industry and make forecasts of any likely future changes.
Competitive strategy analysis involves identifying the basis on which the ļ¬rm intends
to compete in its industry. In general, there are two potential strategies that could provide
a ļ¬rm with a competitive advantage: cost leadership and differentiation. Cost leadership
involves offering the same product or service that other ļ¬rms offer at a lower cost. Dif-
ferentiation involves satisfying a chosen dimension of customer need better than the
competition, at an incremental cost that is less than the price premium that customers are
willing to pay. To perform strategy analysis, the analyst has to identify the ļ¬rmā™s in-