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McKinsey on Finance

High tech’s coming consolidation 1

Perspectives on
Economic pressures to restructure high tech will eventually become
Corporate Finance
irresistible. More acquisitions loom.
and Strategy
When efficient capital and operations go hand in hand 7
Number 11, Spring
Olli-Pekka Kallasvuo, Nokia’s head of mobile phones and a former
CFO, discusses strategic organization, performance measurement, and
the value of financial transparency.

All P/Es are not created equal 12

High price-to-earnings ratios are about more than just growth.
Understanding the ingredients that go into a strong multiple can help
executives make the most of this strategic tool.

Putting value back in value-based management 16

Value-based management programs focus too much on measurement
and too little on the management activities that create shareholder value.
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High tech’s coming consolidation | 1

sector’s leading industries. The indicators

High tech’s coming we looked at included each industry’s
fragmentation levels, maturity (as measured
consolidation by growth rates), and profitability. We also
considered incentives for consolidation, such
as the need for scale to justify larger capital
expenditures and the importance of scope
to meet the customer’s changing needs.1

Where and how

We found strong signs of impending
Economic pressures to restructure high tech
restructuring in 11 of the industries we
will eventually become irresistible. More analyzed (Exhibit 1). These hot spots
acquisitions loom. account for more than two-thirds of the
sector’s revenues—a fact that speaks
volumes about its ripeness for consolidation.
Bertil E. Chappuis, For some time, the rules of economics In IT services, for example, professional and
Kevin A. Frick, and
appeared not to apply to the high- outsourcing services seem to be poised for
Paul J. Roche
technology sector. Growth slowed, profits an across-the-board restructuring. Software
shrank, and investors eagerly awaited the is vulnerable in particular areas, such as
billions of dollars in value likely to flow enterprise applications, network and systems
from mergers, acquisitions, downsizings, management and security, middleware, and
and liquidations. All signs pointed to an software for application servers. In
imminent restructuring, yet until recently hardware, the targets are PCs and notebook
little occurred. computers, networking gear, and storage
systems; in semiconductors, they are logic,
Today consolidation pressures are mounting memory, and semiconductor equipment. Our
fast, and some segments have already research also found many small and midsize
succumbed. Where operating systems for companies that are barely profitable, if at
PCs, midrange computers, and mainframes all, with cost structures more appropriate to
were once numerous, now only a few larger businesses (Exhibit 2).
remain. Ditto for database software. Niche
players in segments such as vertical-specific As economic forces take effect, companies
applications may remain fragmented, thanks will jockey for increased scale or scope or
in part to the unique nature of the value for some combination of both (Exhibit 3).
propositions they offer. As in any sector, scale-driven mergers,
which aim to streamline fixed costs over
To develop a sense of how imminent greater volumes and to satisfy the demand
consolidation really is, and to pinpoint the for bigger and more stable suppliers, will
segments within and outside high tech that mostly take place between companies
might encounter challenges or opportunities competing in the same industry. Customer
in the trend, we investigated the extent to needs will also influence mergers that are
which the economic forces driving undertaken to achieve advantages of scope.
consolidation were at play in 21 of the Indeed, deals of this nature have already
2 | McKinsey on Finance | Spring 2004

exhibit 1

Ripe for restructuring

Key IT industries and segments,1 2002, % of revenues

Ripe for restructuring
Software ($146 billion)

• Enterprise applications • Database

• Operating systems • Desktop applications

Semiconductors ($174 billion) • Vertical applications • Storage

• Logic • Network/systems • Middleware,

management, security application server
• Microcomponents

• Memory

• Analog
• Semiconductor equipment
• Discrete Hardware ($299 billion)
• PCs/notebooks

• Servers
• Networking

• Printers

• Storage

IT services ($243 billion) • Smart handhelds

• Professional and
outsourcing services

1 Metricsexamined include market growth rate, 2002–07 (industry maturity); Herfindahl–Hirschman Index (fragmentation levels); number of top 10
companies with negative earnings before interest and taxes in 2002 (industry profitability); qualitative assessment of scale, scope, changes in customer
buying behavior (incentives for consolidation).
Source: McKinsey analysis

taken place: in response to financial fabrication plants. Consolidation has

pressures and to the clamor of capital already taken place in certain pockets, such
markets, companies that manufacture as deposition, diffusion, and lithography,
technology products have been acquiring but the industry as a whole remains
service firms. We expect such mergers to fragmented; only a handful of companies,
proliferate as companies expand their including Applied Materials and Tokyo
breadth of product or service offerings to Electron, have significant positions in more
position themselves as preferred suppliers than one or two areas. The need to
for big customers, to chase new profit consolidate will therefore inspire scale deals
streams, and to hunt for cross-selling and in the few areas that are still fragmented
multichannel synergies. (automation, assembly, and packaging),
while demand for complete process-module
The semiconductor-equipment industry, for solutions means that scope deals are likely
one, is likely to see both scale and scope across industries. Vendors will thus capture
come into play as companies prepare to sales and marketing synergies by selling to
serve fewer and bigger semiconductor the same customer base. Moreover, an
manufacturers, only some of which will be integrated solution across related areas
able to finance next-generation research and (such as deposition and etching) can shorten
High tech’s coming consolidation | 3

exhibit 2


Average EBIT1 margin of public IT companies by revenues,2 2002, %

Revenues Software Hardware IT Services Semiconductors

<$50 million –320 –167 –29 –59

$50,000,000–$99,999,999 –1 –1 –3 –13

$100,000,000–$299,999,999 2 –1 4 –9

$300,000,000–$499,999,999 –2 2 5 –15

$500,000,000–$999,999,999 12 4 6 2

$1 billion–$5 billion 11 3 6 –4

>$5 billion 29 5 6 11

1 Earnings before interest and taxes.

2 Includes 2,121 companies worldwide in software (913), hardware (562), IT services (266), semiconductors (380).
Source: Bloomberg; Thomson Financial; McKinsey analysis

development cycles and ramp-up times. The the long view and the need to prepare for
enterprise software market will restructure more hostile deals.
along similar lines.
Leaders and challengers
Restructuring could also be triggered by When industries consolidate, market leaders
companies that exit an industry altogether. and challengers can make acquisitions
This is likely to happen in the PC business if within their industries to create economies
some incumbents decide that the benefits of of scale or across industries to gain
merging are questionable in light of the economies of scope. To know what to do
industry’s deteriorating economics. Finally, and when, companies need to develop a
where mergers and acquisitions don’t make perspective on restructuring trends and the
sense, companies might forge alliances or way these affect their particular industry. To
transform themselves without resorting to envision the likely endgame, they should
alliances or M&A. consider shifts in customer behavior and the
factors required for success. And as they
Shape IT or leave IT make their moves, they must evaluate how
The economic rationale for consolidation competitors will probably respond.
might be similar in all sectors of the
economy, but restructuring unfolds in ways Market leaders. In restructuring sectors,
specific to each of them. In the same vein, market leaders aim to protect their position
our perspective on how to respond to from challengers while seizing opportunities
high-tech consolidation begins at a general to extend their dominance; they therefore
level (Exhibit 4), then tackles specifics. make acquisitions to head off those
We’ll examine the two classic roles— challengers and to increase their scale. In
market leader and challenger—before the high-tech sector as a whole, market
discussing the advantages for M&A of leaders should defend the customer base by
4 | McKinsey on Finance | Spring 2004

exhibit 3

Scale, scope, or skedaddle

Restructuring activity Drivers Examples

Scale: peer consolidation • Improved fixed-cost structures (SG&A,1 R&D, • Logic
• Memory
• Customer preference for bigger suppliers
• Network/systems management, security
• Network, platform effects
• Storage hardware

Scope: strategic cross- • Customer preference for broader-reaching suppliers • Database: middleware, application server
segment moves • Channel, cross-selling synergies • Hardware: IT services
• Technological synergies (such as those between • Networking hardware: storage
networking and storage) hardware, software
• Value migration from hardware to software, services • Semiconductor equipment
• Maturing core businesses; capital market pressures
for growth
Exit • Desire to limit losses, free up capital • Logic
• Refocusing resources on other businesses • PCs/notebooks

1 Selling, general, and administrative.

Source: McKinsey analysis

tightening their control of the value chain scope acquisitions, and the company swiftly
and customer relationships or by creating used its distribution capabilities to stake out
scale advantages in R&D and sales. Oracle, strong positions in access solutions and
for instance, is pursuing a broader footprint security. Microsoft’s purchase of Great
and new growth in its play for PeopleSoft. Plains Software and Navision extended its
reach into enterprise applications. EMC’s
Scale offers efficiencies in large fixed costs— acquisition of Legato Systems presaged a
essential in industries requiring massive move away from the slower-growth and
up-front capital investment (like memory rapidly commoditizing storage-disk-
chips) or expensive R&D (like software). It subsystem market and into the system-
also extends control over the value chain. management-software market—a core
Customers gain confidence in the vendor’s control point of an enterprise IT
ability to provide long-term support services infrastructure. The company’s decision to
and are more likely to choose it as a buy Documentum shows a similar move
preferred supplier. HP’s merger with into content management.
Compaq, for example, gave HP enhanced
control over its value chain, cost synergies, For companies in some segments,
and access to additional customers, to which such as IT services, scope deals offer
it could now sell more comprehensive an opportunity to become the prime
solutions. These factors should help HP integrator for customers’ needs; IBM’s
compete with IBM and Dell. acquisition of the consulting arm of
PricewaterhouseCoopers is a recent
Scope acquisitions can broaden the example. A few words of warning should
footprint of a leader and increase the be sounded, however: if the acquisition has
dependence of its customers. Cisco Systems’ a different revenue model (as in the case of
growth strategy in the 1990s was based on a hardware company acquiring a software
High tech’s coming consolidation | 5

exhibit 4
management. In semiconductors, several
The big picture companies could combine to form a large
Strategy chip maker focused on consumer
Type of company Scale Scope Exit electronics. (Beyond high tech, banks such
Market leaders Grow bigger; Cross-sell to as Morgan Stanley and UBS Warburg have
buy or block boost customer
challengers dependence used scope combinations to reposition
Challengers Merge with Buy adjacent themselves as financial-services providers.)
peers businesses Such deals challenge the acquirer to create a
Small companies Carve out Maximize compelling value proposition and to build a
sustainable niche sale value
sales force that can communicate it
Source: McKinsey analysis
forcefully enough to displace incumbents.

one), the buyer must avoid compromising If confronting the market leader directly is
the target’s underlying business model. too risky, companies can pair up to carve
out a defendable niche. IT service providers
Challengers. Typically, a challenger in a could take this approach in health care, say,
restructuring industry confronts industry if they found themselves unable to compete
leaders by “rolling up” smaller companies more broadly. Aspiring niche players must
to achieve scale or by merging with another assess whether they can create sustainable
challenger, thereby driving radical cost- entry barriers based on proprietary
structure changes through operational technology, innovation, industry knowledge,
integration and redesigned business or locked-up customer ties.
processes. PeopleSoft’s acquisition of
J. D. Edwards in enterprise applications Selling out. Finally, the best way to recoup
provides a good example of a challenger value is sometimes to sell part or all of a
buying a peer to reduce operating costs. company. In this case, it is often wise to
The combined company can use its larger move sooner rather than later to get the
scale to become a preferred supplier to highest value for shares and to position the
key customers. company in the most attractive light, which
may mean shedding noncore assets. Such
Alternatively, a challenger can attempt to moves sometimes unlock resources that can
extend its scope by acquiring players in be reinvested to make a company stronger
adjacent industries and combining the in more strategic segments.
offerings into solutions, with the eventual
aim of changing the basis of competition. The long view
BEA Systems, for example, started with a Market reactions to merger announcements
transaction-processing product and then, by tend to favor the target; fewer than half of
acquiring companies such as WebLogic, high-tech acquirers see their shares rise after
gained leadership in the application server disclosing their plans. No wonder boards
and middleware market, where we expect and executives are wary of acquisitions. But
further consolidation. Second-tier storage the most successful high-tech companies—
and networking vendors could also benefit those averaging more than 39 percent
from teaming up in this way, as might annual growth in returns to shareholders
companies in middleware and network from 1989 to 2001—were serious deal
6 | McKinsey on Finance | Spring 2004

makers, undertaking almost twice as many Furthermore, as companies reach for scale
acquisitions as their competitors.2 History and scope, they will attempt larger deals.
also shows that companies with active While a hostile takeover is rarely the
M&A agendas tend to outperform their preferred approach, these deals are likely to
peers during and after industry downturns.3 become more common, especially when the
Companies that avoid acquisitions often run target’s management has strong incentives
out of steam, whereas enterprising acquirers to resist an acquisition that has real
renew and refocus themselves. economic logic. For acquirers with deep
pockets, cash offers may be more attractive
Companies should be cognizant of, but not in hostile situations, when cash can give
overly concerned with, investors’ short-term shareholders a low-risk way to take money
reactions. Instead, they need to ensure that out of their investments.
the long-term returns from their acquisition
plans maximize shareholder value. Take
Intel, which in recent years has acquired
several suppliers of communications chips. The scale and extent of the coming shifts in
Not all of the deals have been applauded as the high-tech sector promise to unlock
successful by observers (for example, the tremendous value for companies that
acquisition of Level One Communications), survive the consolidation. However quickly
but together they helped Intel establish a change comes, those that act wisely can
new communications growth platform on position themselves as the shapers of high
which the company has built a multibillion- tech’s next era. MoF
dollar business.
The authors wish to acknowledge the contributions of
High valuations can sometimes make Jukka Alanen and Jean-Francois Van Kerckhove,
alliances more enticing than M&A, consultants in McKinsey’s Silicon Valley office.
especially if synergies wouldn’t justify a full
Bertil Chappuis (
acquisition. Dell’s recent alliances with
and Paul Roche ( are
EMC and Lexmark are examples of how
principals in McKinsey’s Silicon Valley office, where
these arrangements can be used as a low-
Kevin Frick ( is an
risk step to broaden a company’s scope into
associate principal. Copyright © 2004 McKinsey &
new segments.
Company. All rights reserved.

More hostile deals

Most technology mergers have been small, 1
To measure the strength of each driver, we used qualitative
friendly affairs financed by the acquirer’s and quantitative metrics such as the Herfindahl-Hirschman
stock, but we expect that picture to change. Index (a common metric established by the US
Department of Justice and the US Federal Trade
Oracle’s attempt to acquire PeopleSoft is an Commission) to assess the current degree of
early example of what could become the fragmentation.
new reality in high-tech restructuring. 2
Kevin A. Frick and Alberto Torres, “Learning from high-tech
Executives and boards should thus prepare deals,” The McKinsey Quarterly, 2002 Number 1,
pp. 112–23.
for hostile takeovers, cash deals, and the 3
Richard F. Dobbs, Tomas Karakolev, and Francis Malige,
greater involvement of private equity “Learning to love recessions,” The McKinsey Quarterly,
firms—all common in other sectors. 2002 special edition: Risk and resilience, pp. 6–9.
When efficient capital and operations go hand in hand | 7

mobile-phones group after serving as chief

When efficient capital financial officer from 1992 to 1996 and
1999 to 2003. A lawyer by training,
and operations go hand Kallasvuo, 50, sees his move from finance
to the leadership of the business group
in hand responsible for most of Nokia’s profits as
perfectly natural. In an interview conducted
at Nokia headquarters outside Helsinki,
Kallasvuo spoke to Fredrik Lind and
Olli-Pekka Kallasvuo, Nokia’s head of mobile Risto Perttunen of McKinsey about Nokia’s
strategy, communicating with markets, and
phones and a former CFO, discusses strategic
the CFO’s mind-set when operational and
organization, performance measurement, and capital efficiencies go hand in hand.
the value of financial transparency.
McKinsey on Finance: What long-term
trends in the handset business do you see,
Fredrik Lind and Nokia’s transformation from a Finnish and how are they affecting Nokia’s strategy?
Risto Perttunen
conglomerate with its roots in pulp and
paper to the world’s leading mobile-phone Kallasvuo: The biggest long-term trend is
supplier has earned it a reputation as a our customers’ increasing mobility and, as a
model of innovation, brand building, and result, their demands for ever more
operational efficiency. Even during the sophisticated handsets. In one sense, it’s a
severe downturn in the telecommunications kind of convergence of businesses into a
industry the company maintained strong new business domain defined by mobility.
margins on its sales of mobile phones. The result is that we’ll continue to see a
Today Nokia runs 16 manufacturing very simplistic entry-level phone, with no
facilities in 9 countries, conducts R&D in bells and whistles, on one hand, and on the
11 countries, and has more than 51,000 other hand we’ll see a multipurpose device
employees around the world that has all sorts of capabilities, like mobile
gaming or mobile imaging. This is what we
Nokia is reorganizing itself yet again as it need to tackle at Nokia, and hence the
anticipates increased demand for high-tech reorganization to align our structure to
phones and other mobility products. different segments of this market.
A base of four business groups—mobile
phones, networks, multimedia, and MoF: How do you think about measuring
enterprise solutions—will exploit scale performance?
advantages across common functions such
as finance, marketing, and operations to Kallasvuo: The thinking over the years
provide maximum flexibility for business has definitely changed. We’ve learned to
units. The goal: “to go after every market understand that for us, traditional measures
in this industry and take share.” of performance like working capital, for
example, are financial matters, yes, but
So says Olli-Pekka Kallasvuo, who in more important they’re indicators of how
January of this year was named head of the a company is performing operationally.
8 | McKinsey on Finance | Spring 2004

And if there were just one single thing to

do to improve performance, it would have
been done already. Improvement is usually
Olli-Pekka Kallasvuo not about making a quantum leap; it’s
Vital statistics
about taking small steps, improving a little
• Born July 13, 1953, in Lavia, in western Finland bit every day. Nor is this about pushing
Education responsibility off to individual departments
• Holds a Master of Laws degree from the University of Helsinki and saying, “You look at working capital,”
Career highlights or, “You look at inventory.” These are the
• Nokia, Inc. (1980 to present)
– Assistant vice president of the legal department (1987)
responsibility of everyone at Nokia because
– Assistant vice president of finance (1988) efficiency is the core of the business—
– Senior vice president of finance (1990)
– Executive vice president and chief financial officer (1992 to 1996) and then working capital becomes a
– Corporate executive vice president, Nokia Americas (1997 to1998)
– Chief financial officer (1999 to 2003) reflection of how efficient we are, and
– Executive vice president and general manager of mobile phones at
Nokia (2004–present)
that’s why it’s such an important indicator
that remains very high on our agenda even
Fast facts
• Served as chair and board member of Helsinki Stock Exchange from if financially it’s not critically relevant at
1991 to 1996 the moment.
• Serves on the boards of:
– Sampo, a Finnish full-service financial group
– Nextrom Holding, a Swiss machine manufacturer
– F-Secure, a Finnish company specializing in data security solutions MoF: Can the corporate team and the CFO
• In spare time, enjoys golf, tennis, and reading about political history
team contribute to and lead the different
divisions and businesses on the working
capital dimension?
When I look at working capital, I really
see it first as a reflection of efficiency and Kallasvuo: No; this is exactly the point.
then as a reflection of where our capital is Efficiency is so intricately entwined in the
invested, which is the reverse of the usual system that everyone has a stake in it,
way of thinking. everyone is helping out. So if you were to
start some big push for working capital at
MoF: So how do you track the company’s Nokia, with a big headline saying, “Now we
performance over time? are going to emphasize working capital,” or
announce that suddenly financial concerns
Kallasvuo: A more capital-intensive will drive everything, no one would
business would probably look much more understand what you’re talking about.
closely at its returns on investment, but Everyone understands that working capital is
ROI just is not as useful a measure for a everyone’s job—by taking those little steps
company that makes its money by investing to get logistics working even better. This is
in people, in research and development, and one of our key competitive areas.
in brand marketing. Measures of efficiency
are much more helpful—operational MoF: Are there any particular structures
efficiencies, production efficiencies, and yes, or processes at Nokia to make this
financial efficiencies—and they really all go cooperation work?
hand in hand. Production efficiencies and
capital efficiencies are very relevant for Kallasvuo: In the end, it really comes down
every finance person at Nokia. to a company’s business infrastructure and
When efficient capital and operations go hand in hand | 9

how it operates in general. As we have system, in accordance with your accounting

grown from a small, flexible player to such principles, those are your results.
a large company, we’ve put considerable
effort into combining flexibility and MoF: What is your view of the emergence
economies of scale, which has an impact on of companies over the past year or so that
how we operate. The emphasis has been on are minimizing their financial transparency
doing everything we can to take advantage to the markets?
of economies of scale where we can and
where it makes sense, but not to centralize Kallasvuo: Of course, I can’t speak on
anything that is business specific. We’ve behalf of other companies, but I feel that
drawn that line very carefully. If something our investor base wants quarterly guidance.
is business specific, it gets maximum It’s very much a matter of providing the
flexibility, empowerment, decentralization. markets with the information they want,
If it’s not business specific, then let’s take rather than telling them what we think they
the economies of scale. The result has been should want. This isn’t brain surgery. If the
an increasing platformization, if you will, of markets want information, you give them
the business infrastructure. And here the information.
business infrastructure means other than IT,
so it’s a wider concept. The question has to be, how can we better
understand what our investors want? The
MoF: What have been the special challenges mind-set really needs to be that we must
of communicating the results of a very fast- listen and communicate in terms of what is
growing company to financial markets? expected. This is very relevant coming from
a small market and growing into one of the
Kallasvuo: Communicating results is easy. most traded shares in the world. We come
Giving estimates is more of a challenge, from a context where we really didn’t have
because in this type of fast-moving business the benefit of the doubt when it came to
no one can really know what will happen our existence and our ability to deliver over
over three months—no one. No system in the long-term. It really was an imperative to
this world can make that prediction in a listen to what investors expected—if we did
way that is certain. The best you can do is not have that mind-set, we never would
communicate your best understanding to have become one of the most widely held
the market at the time, which is actually shares in the United States.
pretty simple.
MoF: What is the optimal way to distribute
At Nokia, we have been simply communi- value back to the shareholders—for example,
cating our best possible understanding to through share buybacks or dividends?
the market. We have not been playing
games. I was personally criticized by some Kallasvuo: I don’t think there is a big
investors for not playing games—for not difference between dividends and buybacks.
giving an estimate and then exceeding it by In the end it’s a pragmatic choice, very
one penny, which so many companies were much driven by tax questions and the
doing. Now, of course, everyone feels this shareholder base. Otherwise they’re both
way. Whatever numbers come out of the pretty equal from the financial perspective.
10 | McKinsey on Finance | Spring 2004

MoF: How important is it for a company to That became a real priority. For example,
be listed in the United States? instead of having our US investor relations
(IR) staff report to an IR executive in
Kallasvuo: It’s really not possible to Helsinki, we located the IR head office for
become a major name among US investors the entire company in the United States—and
if you’re not represented in the US market then of course allocated a lot of resources
in a major way. Being listed supports the and everything to make it work. Even the
business, and the business supports the Helsinki-based IR office reported for many
listing—which Nokia’s experience in the years to the US office. When it came to
1990s illustrates very well. Indeed, I communications, we said to ourselves, we
would claim that without its listing in need to communicate like a US company.
New York, Nokia would not have become Even today, if some capital-markets-related
the market leader in the United States. legislation or other comes out of the United
Furthermore, if it had not become a States that isn’t necessarily applicable to
market leader in the United States, the non-US companies, we comply anyway, even
share story would have been a lot less well- if the legislation does not, strictly speaking,
known. When we first issued our IPO in apply. There is no other way for us.
the United States, it wasn’t really that we
needed US capital but rather that the listing Other companies have chosen exactly the
would support the business, which is how other way: to be domestic first and
it worked out. The result was a positive foremost, abiding primarily by their own
spiral, if there is such a thing, each one government’s practices and legislation and
supporting the other. domestic shareholders. Which one is wrong
or right I can’t say.
MoF: And how has that transformation
changed your relationship with shareholders— MoF: And how comfortable are you with
on both sides of the Atlantic? Nokia’s current level of transparency?

Kallasvuo: Sometime in 1995 or 1996, Kallasvuo: I can say that every time we have
we became the first company in the world had a discussion internally about whether
with a major market cap that had the we should go into this more transparent
majority of its market capitalization coming reporting, and every time we have made a
from outside its home country, as domestic decision to report instead of holding back,
Finnish share dipped below 50 percent. the decision to report has been the right
That happened very suddenly and decision, eventually. It’s what I feel. Not
continued at a rapid pace. Other once have I looked back and thought, “Why
companies have since found themselves in did we have to tell this?” But here again,
similar positions, but not to the same I would suggest that theories aside, in our
extent. So we basically said to ourselves, case it’s been a necessity. You are foreign.
“Now we have to see ourselves as a You are an ADR.1 You don’t have the option
US company and we have to do things in of not listening to what the market wants.
the same way a US company would,
because that’s what a majority of our MoF: Is there any risk, as Nokia begins
investors will expect.” reporting separately for multimedia
When efficient capital and operations go hand in hand | 11

handsets and enterprise solutions? What if MoF: In many companies, the role of the
one unit doesn’t achieve very good results? CFO has been expanding on the traditional
role in two directions: the first is a more
Kallasvuo: No, definitely not. As I said, strategic-architect or strategic-planning type
every time we’ve increased our transparency of role, even to the point of having M&A
it was the right decision, so it must be the or strategy divisions; the second is moving
right decision here too. And you have to also toward a more involved operations role,
remember that external pressure is good for enhancing some business-controlling
you. It makes you run even harder. The activities or leading corporate-pricing or
people running those operations have even working-capital programs. What are your
more reason to perform if external pressure thoughts on the evolution of the CFO role
is there also. That’s been our experience. in general?

MoF: Has the CFO been a part of the Kallasvuo: If you assume a traditional sort
strategic decision-making process in Nokia, of controller role as the starting point, then
and do you see that role being strengthened yes, those are the two natural directions for
in the future? the role to evolve. But because it varies
depending on how the company operates,
Kallasvuo: I don’t really think there is one it’s also possible that both of those roles
and only one role for a CFO. Of course, the might even be combined. The latter role—
role of a CFO has to be aligned with the way the more involved operations role—is
the company operates, and it also depends particularly apt for the CFO of a major
very much on the size of the company. But it business unit, which is very much an
really can’t be the same in every company, in operational role in an operational unit.
every business situation, and in every type of The former, more strategic role is more apt
business a company is in. for a corporate, head-office CFO who
operates, supervises, and oversees several
At Nokia, being CFO has meant being business units. And both are quite relevant
very much a part of the management at Nokia, too, because of how we operate
team, looking at matters from a financial and how the roles of the business units or
perspective but really not taking the role even business groups have been defined.
of a finance guy who primarily becomes And I would also claim that the role of the
the voice of that department. Instead of CFO must be aligned to the approach of
defining the role in one way and taking the CEO. Without alignment, success is
that into the management team, the CFO difficult. MoF
at Nokia has a responsibility for the same
decisions as everyone else on the Fredrik Lind ( is a
management team. Yes, of course, you principal in McKinsey’s Stockholm office, and
might look at those decisions from a Risto Perttunen (
certain perspective, but that doesn’t have is a director in the Helsinki office. Copyright © 2004
to mean that you always take the same McKinsey & Company. All rights reserved.
sort of role. You have to be more versatile
than that, which makes the role a very
strategic one. 1
American depository receipt
12 | McKinsey on Finance | Spring 2004

yield an adequate return over the cost of

All P/Es are not capital, it won’t create shareholder value.
That means no boost to share price and no
created equal increase in the P/E multiple. Executives who
do not pay attention to both growth and
returns on capital run the risk of achieving
their growth objectives but leaving behind
the benefits of a higher P/E and, more
important, not creating value for
High price-to-earnings ratios are about more shareholders. They may also discover that
they have confused their portfolio and
than growth. Understanding the ingredients that
investment strategies by treating some high-
go into a strong multiple can help executives P/E businesses as attractive growth
make the most of this strategic tool. platforms when they are actually high-
returning mature businesses with few
growth prospects.3 Better understanding of
Nidhi Chadda, When it comes to price-to-earnings ratios, the way growth and returns on capital
Robert S. McNish,
most executives understand that a high combine to shape each business’s multiple
and Werner Rehm
multiple enhances a company’s strategic can produce both better growth and better
freedom. Among other benefits, strong investment decisions.
multiples can provide more muscle to
pursue acquisitions or cut the cost of Doing the math on multiples
raising equity capital. Unfortunately, in The relationship between P/E multiples and
their efforts to increase their P/E, many growth is basic arithmetic:4 high multiples
executives reflexively try to crank up can result from high returns on capital in
growth. Too many fail to appreciate the average or low-growth businesses just as
important role that returns on capital easily as they can result from high growth.
play in channeling growth into a high or But beware: any amount of growth at low
low multiple. returns on capital will not lead to a high
P/E, because such growth does not create
Simply put, growth rates and multiples don’t shareholder value.
move in lockstep. For instance, the retailer
Williams-Sonoma has a P/E multiple of exhibit 1
about 21, based on earnings growth over
Companies can have identical P/E multiples
15 percent in the past three to five years for dramatically different reasons
and low returns on capital.1 By contrast,
Coca-Cola has a slightly stronger P/E at 24,
Expected Expected Implied P/E
despite its lower growth rate.2 Coke’s ROIC growth multiple1

secret? Returns on capital over 45 percent Growth, Inc 14% 13% 17

Returns, Inc 35% 5% 17
relative to a 9 percent weighted average cost
of capital.
1 Assuming 10% cost of equity, no debt, and 10 year’s excessive growth
followed by 5% growth at historic levels of returns on invested capital.
It’s common sense: growth requires Source: McKinsey analysis
investment, and if the investment doesn’t
All P/Es are not created equal | 13

exhibit 2 Because Growth, Inc., and Returns, Inc.,

Sustaining high growth requires considerably take very different routes to the same
more reinvestment than sustaining high returns
P/E multiple, it would make sense for a
savvy executive to pursue different growth
Growth, Inc1 Returns, Inc1
Year 1 Year 2 Year 1 Year 2
and investment strategies to increase each
Operating profit less taxes 100 113 100 105 business’s P/E. Obviously, the rare company
Reinvestment 93 105 14 15 that can combine high growth with high
Free cash flow 7 8 86 90 returns on capital should enjoy extremely
Reinvestment rate Reinvestment rate
93% 14%
high multiples.

The hard part: Disaggregating

1 Assuming 10% cost of equity, no debt, and 10 year’s excessive growth
followed by 5% growth at historic levels of return on invested capital. multiples
Source: McKinsey analysis Not many executives and analysts work to
discern how much of a company’s current
value can be attributed to expected growth
To illustrate, consider two companies with or to returns on capital. Those who try
identical P/E multiples of 17 but with often fail. To see why, consider one widely
different mechanisms for creating value. used model to break down multiples as it
(Exhibit 1). Growth, Inc., is expected to might be applied to a large consumer goods
grow at an average annual rate of manufacturer and a fast-growing retailer
13 percent over the next ten years, while with similar P/E ratios (Exhibit 3).
generating a 14 percent return on invested
capital (ROIC) which is modestly higher The first step is to estimate the value of
than its 10 percent cost of capital. To current earnings in perpetuity, assuming no
sustain that level of growth, it must growth.6 The model then attributes the
reinvest 93 cents from each dollar of remaining value to growth. The
income (Exhibit 2). The relatively high interpretation from this simple two-part
reinvestment rate means that Growth, Inc., approach would be that the market assumes
turns only a small amount of earnings that the consumer goods manufacturer
growth into free cash flow growth. Many would have better growth prospects than
companies fit this growth profile, including the retailer.
some that need to reinvest more than
100 percent of their earnings to support But this reading misleads because it doesn’t
their growth rate. In contrast, take into account returns on capital.
Returns, Inc., is expected to grow at only Discount retailers fight it out primarily on
5 percent per year, a rate similar to long- price, which translates into lower margins
term nominal GDP growth in the United and relatively low returns on capital—similar
States.5 Unlike Growth, Inc., however, to Growth, Inc. In contrast, consumer goods
Returns, Inc., invests its capital extremely companies compete in an environment where
efficiently. With a return on capital of 35 brand equity can generate higher margins
percent, it needs to reinvest only 14 cents and returns on capital, making them more
of each dollar to sustain its growth. As its like Returns, Inc. In fact, the simple two-part
earnings grow, Returns, Inc., methodically model is wrong. The discount retailer is
turns them into free cash flow. actually expected to grow faster and to
14 | McKinsey on Finance | Spring 2004

exhibit 3

Traditional assessments of enterprise value can lead to a misinterpretation of where value

comes from

100% = operating enterprise value

Traditional decomposition ROIC1-growth decomposition

ROIC: 38%
Consumer goods manufacturer, P/E: 20 48% 52% 48% 50% 2%
Implied growth: 5.1%
Fast-growing retailer, P/E: 20 50% 50% ROIC: 12%
Implied growth: 9.5%2 50% 29% 21%

Value from current Value from future Value from current ROIC premium Value of
earnings in perpetuity earnings performance expected growth
with no growth

1 Return on invested capital.

2 From 2004 to 2018.

Source: Compustat; Zacks; McKinsey analysis

create more value from growth than the on capital and growth in shaping a
consumer goods company, whose high company’s P/E is to expand the simple
valuation would be primarily based on high two-part model and draw out a P/E
returns on capital. premium for high returns on invested
capital. This approach effectively
An executive relying on the faulty analysis disaggregates value into three easily
produced by such a simple model might flirt understood parts:
with trouble. The CEO of the consumer-
goods company Current performance. Current performance
The best way to understand might increase is still estimated in the usual manner, as the
investment or value of current after-tax operating earnings
the respective roles of returns
discount prices to in perpetuity, assuming no growth.
on capital and growth in drive growth, Intuitively, this is the value of simply
potentially maintaining the investments the company
shaping a company’s P/E is
destroying has already made.
to expand the simple two- shareholder value
in the long run. By Return premium. This is the value a
part model to draw out a
digging a little company delivers by earning superior
premium for high returns deeper and returns on its growth capital. In order to
appreciating the assess how a company’s return on
on invested capital.
role of returns on growth capital influences its P/E multiple,
capital, the CEO would more likely focus on we recommend discounting a company’s
protecting high returns and market share. cash flows as if they grew in perpetuity at
some normalized rate, such as nominal
Accounting for the ROIC premium GDP growth.7 Through repeated analyses,
How can we avoid these misinterpretations we have found that the result is a good
and still keep the analysis relatively simple? proxy for the premium a company enjoys
In our experience, the best way to in the capital markets because of its high
understand the respective roles of returns returns on future growth capital. In our
All P/Es are not created equal | 15

example, the consumer goods manufacturer even determine that a top management
would enjoy a large return premium, priority is to redirect some attention from
consistent with its high historical returns growth to operations improvement.
on capital.

Value from growth. This value represents

High P/E multiples can serve as a powerful
how much a company delivers by growing
strategic tool. Executives who understand
over and above nominal GDP growth. It can
the complex chemistry of growth, returns,
be calculated as that portion of the
and P/E multiples will be better positioned
company’s current market value that is not
to make strategic and operating decisions
captured in current performance or the
that increase shareholder value. MoF
return premium.8 While more sophisticated
and time-consuming analyses are sometimes
Nidhi Chadda (
appropriate, in our experience executives
and Werner Rehm (
can learn a lot about their P/E multiple with
are consultants in McKinsey’s New York office.
this simple three-
Rob McNish ( is a
While more sophisticated part model.
principal in the Washington, DC, office.
analyses are sometimes Copyright © 2004, McKinsey & Company.
How might an
All rights reserved.
appropriate, executives can executive change
his or her insights
learn a lot about their P/E
about the consumer 1
Adjusted for operating leases, Williams-Sonoma’s ROIC
multiple with this simple goods company and has historically averaged about 10 percent, the same as its
cost of capital.
the discount retailer
three-part model. 2
Coke reports earnings around 3 percent over the past
using this three-part seven years.
model? The consumer goods company 3
Likewise, stock market investors can make the same
would be seen to enjoy a large premium for mistake by thinking they are investing in high P/E “growth
its return on capital. In the consumer goods stocks” when in fact some of these stocks are high-
returning “value” investments.
sector, preserving that return premium must 4
For instance, assuming perpetuity growth for a company
be paramount, but anything the company without any financial leverage, P/E = (1 – growth/return on
can do to increase its organic growth rate capital)/(cost of capital – growth).
while preserving its return premium would 5
Real GDP growth over the past 40 years in the United
translate directly into shareholder value and States was 3.5 percent.

the possibility of a very high multiple.

At no growth, we assume that depreciation is equal to
capital expenditure, and therefore net operating profits less
adjusted taxes (NOPLAT) is equal to free cash flow for a
In contrast, the CEO of the discount retailer business that does not grow. In effect, the first contributor
would face a tiny premium for return on is calculated as NOPLAT divided by the company’s cost of
capital, since his or her company derives 7
This can be achieved without an explicit discounted cash
most of its value from the rapid growth flow model by using, for example, the value driver formula
prospects. Anything this company could do derived by Tom Copeland, Tim Koller, and Jack Murrin,
to increase its ROIC, possibly even reining Valuation: Measuring and Managing the Value of
Companies, third edition, New York: John Wiley & Sons,
in its growth rate, would add value. By 2000.
applying the model to calibrate the trade-off 8
For a company that grows more slowly than GDP, this
between growth and return, the CEO could value will be negative.
16 | McKinsey on Finance | Spring 2004

an anecdotal view of how the most

Putting value back successful practitioners push the principles
of VBM to achieve its real promise for
in value-based shareholders.

management Simply put, ailing VBM programs typically

settle for merely measuring value creation in
business initiatives, while successful
approaches push to link tightly the
Value-based management programs focus measurement to how the business can be
improved. For example, some companies
too much on measurement and too little on
mechanically measure historical
the management activities that create performance but then fail to apply what
shareholder value. they’ve learned to the strategies from which
value should flow. Most also neglect to
account for future growth and
Richard J. Benson- Value-based management (VBM) burst sustainability. Others make this important
Armer, Richard F.
onto the scene a decade ago with a link but then set targets in ways that fail to
Dobbs, and
Paul Todd revolutionary promise: a company that mobilize the troops needed to make VBM
traded in traditional management pay off. Still others go to great lengths to
approaches in favor of VBM could align its implement VBM programs but then relegate
aspirations, mind-set, and management them to the finance department, where they
processes with everyday decisions that truly languish without the commitment of senior-
add shareholder value. Name the initiative— level management.
investing in a new project, say, or spinning
off a subsidiary, or implementing new Troubled VBM programs do not necessarily
customer-service guidelines—and manifest all these symptoms at once. In our
management could not only pinpoint better experience, however, the vast majority
projects but also better understand the value suffer from at least one. Moreover, the best
they would create for shareholders. Indeed, practitioners have learned to overcome them
well-implemented VBM programs typically and can provide guidance about how to
deliver a 5 to 15 percent increase in push VBM to better fulfill its potential.
bottom-line results.
Missing the link between
Sadly, even as VBM has evolved, most measurement and value
programs are notable more for their The original breakthrough of value-based
implementation shortfalls than for their management was to draw attention to the
successes. In our ongoing work and failure of traditional accounting measures,
discussions with executives, we have begun such as net income and earnings per share,
to identify a few common pitfalls that have to account for the cost of capital.
repeatedly plagued underperforming Traditional managers focused far more
VBM programs going back years as well as intently on improving cost and gross
some newer wrinkles that stanch the benefits margin and paid little if any attention to
that VBM can deliver. We’ve also developed the capital invested in the business. As a
Putting value back in value-based management | 17

exhibit 1

Metrics designed to measure value have strengths—and weaknesses

Traditional P&L and balance sheet approaches Value creation: historical metrics Value: forward-looking metrics
• Revenues • Return ratios • DCF1-value
• EBITDA1 –ROE1 • Discounted EVA1
• Net income –ROCE,1 ROIC1 • IRR1
• Book value –ROA1 • CFROI1
• ROS1 • Economic profit or EVA1
• EPS1 (diluted or not)

• Relevance for management declining, but still • Widely used concepts orientated • Required for active management of
widely used by companies for communication to towards taking into account the company’s value
investors (e.g., EPS) economic cost of the capital in the • Explicit consideration of growth and
• Economic cost of the capital invested ignored business long-term impact of decisions
• Growth, long-term performance, and
• Growth, long-term performance, and sustainability • High correlation to market value of
not taken into account sustainability not taken into account company
• Much harder to measure accurately
and so can be gamed

1 EBITDA = earnings before interest, taxes, depreciation, amortization; ROS = return on sales; EPS = earnings per share; ROE = return on equity; ROCE =
return on capital employed; ROIC = return on invested capital; ROA = return on assets; EVA = economic value added; DCF = discounted cash flow; IRR =
internal rate of return; CFROI = cash flow return on investment
Source: McKinsey analysis

result, it was common to find projects in five years as measured by economic profit.
which much of the capital deployed in But because the company delivered its
businesses was wasted. growth by increasing prices, it ultimately
damaged its customer franchise and could
As managers focused on value creation and not sustain its growth rate.
the true economic cost of capital deployed
in the business, VBM proponents Companies that apply VBM at a more
introduced metrics to measure a business’s advanced level move beyond measurement to
or program’s value, including return on help the management team focus on the
invested capital (ROIC), economic profit, levers that can be used to improve the
cash flow return on investment (CFROI), or business. The best programs use value trees2
economic value added (EVA™).1 The to identify underlying drivers of operating
advantages of different measures vary value. These have long been at the core of
(Exhibit 1), but they all attempt to VBM theory, but we find that they are still
recognize the cost of capital in the conspicuously missing in many applications.
benchmarks managers use to gauge the
value their decisions create. Savvy VBM practitioners use these trees to
identify areas of improvement, pushing deep
Yet many companies fall into the trap of into a business’s operating performance and
focusing their measurement too much on comparing it with others to create clear
historical returns, which are easily benchmarks. These benchmarks can also be
quantified, and too little on more forward- pegged to the performance of peers outside
looking contributors to value: growth and the company, or to the performance of
sustainability. For instance, one consumer similar internal businesses. One particularly
goods company (Exhibit 2) was able to informative and credible internal benchmark
demonstrate strong economic returns for comes from analyzing the historical
18 | McKinsey on Finance | Spring 2004

exhibit 2 Consider the experience of one global

Financial measures alone are inadequate consumer goods company. When the
Economic profit went up, to a point . . . . . . but proved unsustainable, as market corporate technical manager ordered that all
Year 1 = 100 share steadily declined, % the company’s bottling lines should achieve
200 60 75 percent operating efficiency, regardless of
160 their current level, some plant operators
120 rebelled. Operators at one US plant,
Profit growth due 30
80 to price increases 20 concluding that at 53 percent their plant was
40 10 running as well as it had ever run, worked
1 2 3 4 5 6 7
1 2 3 4 5 6 7
only to maintain performance at historical
Year Year levels. Yet after the plant launched an
inclusive process to permit the operators to
Source: McKinsey analysis
set their own performance goals, they raised
performance levels above the 75 percent
performance of the same business over time. target over a period of only 14 months.
For example, one processing company’s
analysis found that daily performance alone The most effective VBM programs fine-tune
varied so widely that the management team this dynamic even more. As they set targets,
didn’t need to look for outside benchmarks. some build in a challenge from peers
Instead, they could improve the overall running similar businesses. This approach
performance of the company enough just by helps to stretch targets, to highlight
focusing their efforts on the levers that led accountability in view of peers, and to
to the most severe underperformance on create the sense of commitment and
bad days. purpose that comes from collaborating on
tough issues. Because colleagues running
The error in focusing on targets similar businesses will be familiar with all
rather than how they are set the opportunities for improvement, they
A second common VBM pitfall stems from will be much more effective than line
the way executives set performance targets managers at providing such challenges.
and hand them down to the individuals Companies that have excelled at VBM
responsible for meeting them. These targets programs arrange them not only on overall
may seem perfectly reasonable to the profitability but also on capital expenditure,
managers who set them, but they often growth, pricing, and costs—as well as
appear arbitrary and unrealistic and convey performance during the year. Others create
little sense of ownership to the teams that formal processes that encourage mutual
receive them. In our experience, only when support among colleagues to improve the
those assigned to meet the targets also performance of the business. At one of
actively help in setting them is a company Canada’s largest privately held companies,
likely to generate the understanding and for example, stronger performers are
commitment needed to deliver outstanding explicitly assigned to help their colleagues
performance (Exhibit 3). Indeed, we find who are not performing as well.
the process of setting targets to be the
single biggest factor in delivering superior Or consider how one chemical company
VBM performance. designed a more effective way to review
Putting value back in value-based management | 19

exhibit 3

Involve managers early in KPI1 definition process to ensure acceptance and accountability

Success factor This Not this

Guided self-discovery • Managers discover the key value drivers and KPIs for • External team (or a staff team) does
themselves the analysis and develops value drivers
and KPIs
• The process, rigor, and insights will be shared between

Strong senior management leadership • Management actions and messages emphasize value • Senior managers, publicly or privately,
creation and value-based shaping of the management communicate or act in ways that do not
agenda reflect the value drivers and KPIs

Inclusive and open communication • Relevant staff is involved both in analysis and rollout, • Staff is told what the new value drivers
with a clear understanding of the ultimate objective and KPIs are

Fact-based debate and challenge • Discussions and decisions are based on facts • Discussions and decisions are based on
personal preferences and past actions

Link to ‘real deliverables’ • KPI framework leads to clear assignment of • KPI work is done separately from the
accountabilities for targets and actions budget and targeting processes

1 Key performance indicator.

Source: McKinsey analysis

performance. A year after introducing a the meeting shifted away from individual
VBM approach to make reported data successes and failures to a combination of
more transparent, the company had yet to shared lessons and problem solving on
see the improvements it expected. Worse, future risks and opportunities.
nearly everyone in the organization
recognized that official discussions about Next the company introduced a series of
performance were something of a sham. peer meetings among unit leaders without
Some managers misrepresented reports the division heads present. These meetings
of their actual performance in order to aimed to review plans and identify risks and
create the appearance of meeting targets; opportunities in order to set priorities for
others built enough slack into future allocating capital and resources. In the first
performance targets to make sure they year of operating under the new processes,
would easily be met. capital outlays dropped 25 percent and
underlying profits, adjusted for the usual
The company’s response: change the review modulations of the business cycle, rose by
process. What had been a one-on-one 10 percent.
review involving the division head and unit
leader became a broader discussion between Not ingraining VBM in day-to-day
the division head and all unit leaders business processes
together. And rather than simply reviewing Setting targets and committing to meet them
the data, the meeting focused on the most is one thing. It’s another to make sure that
important lessons from the previous performance targets are acted upon. This
reporting period, as well as the greatest process happens by making certain that
risks and opportunities expected to appear specific individuals are accountable and
in the coming reporting period. Emphasis at responsible for making decisions and by
20 | McKinsey on Finance | Spring 2004

guaranteeing a link between performance individuals who fail to meet their targets
and an individual’s evaluation process. more than once. By tying performance
evaluation and compensation to individual
One energy company, for example, objectives, performance can also be aligned
implemented a VBM program that seemed with the objectives of the VBM program.
to have all the right parts. But management
then failed to carry it over from a discrete A rule of thumb: until a VBM program is
program in the finance department to an integral part of how a company
engage the manages, it will always be simply
Until a VBM program is an entire company. “something else to do” and will inevitably
This result was fail as employees continue to perform as
integral part of how a company
despite the fact they always have. Finance department input
manages, it will always be that the is essential, for example, but delegating
company’s VBM to the finance department as a
simply something else to do
finance team discrete, isolated program is a surefire way
and will inevitably fail. developed a to snuff its potential.
scorecard covering financial performance,
operating drivers, organizational health,
and customer service. Nearly a year later, Too few VBM programs have fulfilled their
there was no discernible impact. Beyond early promise. But recognizing common
top-level conversations, few of the patterns in programs that have gone awry is
company’s managers used the scorecard— a first step in moving VBM closer to its goal
some didn’t even know what it was. They to help line managers deliver better
had had no involvement in the program’s performance for shareholders. MoF
development, little understanding of why
the new scorecard was necessary, and no Richard Benson-Armer (Richard_Benson-
incentive to use it. The few that did use it is a principal in McKinsey’s
found that targets regularly were missed. Toronto office. Richard Dobbs (Richard_Dobbs is a principal in the London office,
Some companies overcome this pitfall by where Paul Todd ( is an
using a formal performance contract to associate principal. Copyright © 2004 McKinsey &
explicitly link the key performance Company. All rights reserved.
indicators—such as sales, profit margin,
return on investment, and customer The authors wish to acknowledge the valuable
satisfaction—with roles such as sales contributions of Joe Hughes, Tim Koller, and
manager, business unit manager, finance Carlos Murrieta to the development of this article.
manager, and call-center manager
respectively. This link forces an explicit
conversation to take place about whether 1
EVA is a registered trade mark of Stern, Stewart & Co.,
roles and decision rights are correctly lined New York, and is synonymous with the more generic term,
“economic profit.”
up. Other companies link their people- 2
Tom Copeland, Tim Koller, and Jack Murrin, Valuation:
evaluation system to hitting targets, with Measuring and Managing the Value of Companies, third
explicit rules about dismissals for edition, New York: John Wiley & Sons, 2000.
Copyright © 2004 McKinsey & Company