The ‘market-to-equity’ algorithm

When thinking about a suitable approach for creating value, the attractiveness of a market (including adjacent growth opportunities) – ideally a ‘limitless’ market (Kutcher et al. (2014)) – with its momentum seems critical to success. It is a different but valid notion of the commonly used phrase ‘You can’t beat the market.’:

I.e. that it is rather challenging to be successful in an unattractive market by means of size, profit pool, growth and cyclicality/volatility.[1] However, Porter (2008) rightly views it as a common pitfall to declare an industry attractive or unattractive without taking into account that the industry structure drives competition, profit pool and its distribution, “not whether an industry is emerging or mature, high tech or low tech, regulated or unregulated”. Considering that market attractiveness closely intertwined with industry structure and its dynamics (be it modest adjustments or abrupt changes) decides about the business opportunity (chances, risks, limitations) marks the starting point for any performance dialogue (cf. Porter (2008)). If a market allows for profitable growth (over the cycle), it is in the company’s own hands to achieve this profitable growth as well, and vice versa the headwind to excel increases over-proportionally when the market attractiveness is declining or the industry dynamics show an unfavourable momentum. In conclusion, stressing the paramount importance of defining a company’s target market (segments), a ‘market-to-equity’ algorithm is proposed as economic approach for corporate governance.


Naturally it is rather challenging to find the balance between not formulating the approach in too general a manner and aspiring broader relevance, and furthermore not to give rise to immediate contradiction regarding completeness and overlaps. As initial basis for industry and company specific adaption, a set of corporate governance indicators based on proven KPIs and management concepts could help to link MIS (decision-making) with P&L, B/S and treasury (financial management) as a causal value driver model in the first place while also pointing at business model performance (organizational execution).


The management topics (value creation levers) addressed with the ‘market-to-equity’ algorithm are (1) understanding industry dynamics, (2) creating portfolio momentum, (3) limiting capital intensity, (4) increasing productivity, and (5) providing debt capacity.


In order to express the ‘algorithm’ while using common business figures, the key value driver formula serves to derive an approximate. The key value driver formula is (cf. Koller et al. (2010)):


EV = FCF / (WACC – g) = NOPLAT x (1 – g/ROIC) / (WACC – g)


      EV  –  Enterprise Value
      FCF   –   Free Cash-Flow
      WACC  –  Weighted Average Cost of Capital
      g  –  Revenue growth
      NOPLAT  –  Net Operating Profit Less Adjusted Taxes
      ROIC  –  Return On Invested Capital


Excluding non-operating items and goodwill amortization[2], expressing revenues through market share[3] and using the CAGR as average growth rate for a defined period, leads to the proposed ‘market-to-equity’ algorithm:


EV = [ M x SoM x EBITDA margin x (1 – Tax rate) – ∆ Invested Capital ] / [ WACC – CAGR ]


      M  –  Market size
      SoM  –  Share of Market
      EBITDA  –  Earnings Before Interest Depreciation Amortization
      Tax rate  –  Average operating tax rate
      ∆ Invested Capital  –  Increase/decrease in working capital plus in capital expenditure (above /below depreciation)
      WACC  –  Weighted Average Cost of Capital
      CAGR  –  Compound Annual Growth Rate


The granularity of applying the ‘market-to-equity’ algorithm for parts of the sum of an enterprise, e.g. for business or product/service lines and/or market segments or even micro markets, or to which extent management can lead the performance dialogue on a blended basis depends on the homogeneity of the value drivers. While market share per se – e.g. compared to improving profits – often is overrated as performance indicator and furthermore is rarely related to the profit pool of the industry (and not its volume), here it is nevertheless used as it reflects the knowledge of the market and the momentum of the company-specific customer portfolio. Interpreted in this sense, market share reflects also market penetration with the opportunities to size a market through product and market development concentrating on a corresponding marketing mix.[4]


The ‘market-to-equity’ algorithm, which includes one level deeper supplementary corporate governance indicators for the three introduced management dimensions decision-making, organizational execution, and financial management, provides the facts that bring to life the performance code and that define the agenda of the board of directors.


Frankfurt, 27 December 2016


[1] “McKinsey research suggests that about two-third of a company’s growth is determined by the momentum – the underlying growth, inflation, income and spending power – of the markets where it competes. Harnessing market momentum in the years ahead will require covering more geographies, more industries, and more types of competitors, prospective partners, and value-chain participants – as well as more governmental and nongovernmental stakeholders. … All this will place a premium on agility …” (Dobbs et al. (2014)). This observation made on a market level applies similarly to a company’s market segments and finally to its customer portfolio.
[2] FCF ~ EBITDA – Taxes – ∆ Invested Capital when excluding non-operating items and amortization
[EBITDA = NOPLAT + Non-operating Income + Operating Taxes + Depreciation + Amortization, FCF = NOPLAT – Investment in Invested Capital]
[3] Revenues = Market size x Share of Market, EBITDA = Market size x Share of Market x EBITDA margin
[4] The marketing mix comprises the 4 Ps product, price (contracting), place (distribution) and promotion (communication) respectively 7 Ps when supplemented by people (staff), processes and physical evidence.