IBM and Economic Value Added (EVA) - Research Paper Example

? IBM and Economic Value Added (EVA) Introduction IBM is one of the most successful firms in the world. IBM (International BusinessMachine) was among the pioneers in the information technology sector and became very famous for its desktop computers as well as server computers. As time went on, however, things have changed and the firm, which did not have much competition in the past, has faced stiff competition in the modern world. Upcoming of other computer hardware manufacturers such s Hewlett Packard (HP) and Dell has introduced much competition for a firm that once faced no competition. However, as IBM has faced competition in the computer hardware subsectror of the IT sector, it has diversified into other areas and become a big product in these areas. IBM has become more active today in the software sector as well as the cloud computing sector. In fact the area where the firm is most successful is the software sub-sector. IBM now has four main divisions which include Financing, Hardware, Services, and Software (Lines & Ambler, 2012). Each of the four departments in IBM has different profitability and this means that if the investors were to value each individually rather than valuing the firm one whole, they would have different a value in total. Economic Value Added (EVA) is the method of determining the value of a firm through calculating its value produced after return of capital invested and the cost of operation (Grant, 2003). Because of this when investors value each individual division as opposed to averaging the profits of each division and calculating the value firm of collectively, they would at a different value of the firm. In this regard, if investors were to demarcate IBM and each division valued individually, each of the division would have a different value and if these values were to be added together, they would have a higher value than the value calculated in a combination. Rationale Every firm intends to get the best and highest valuation, just like they want to make the highest profits. This is why it is necessary for a firm to find the best way to improve its value. The value of an organization can also be theoretical. One theoretical method of a valuing a firm is the EVA method and has been used in several firms. Warren Buffet showed that investors value a firm differently if the firm has different divisions with different values. By separating the less valuable parts of the business from the more valuable parts of the firm, it is possible to help the investors in a different light (Grant, 2003). Eliminating the negative aspect of the firm By separating the firm into different units, the investors are able to see the firm in a better light because the negative aspects of the firm can be separated from the firm. Warren Buffet used this in Coca Cola and separated the less profitable division from the rest of the firm. This led to the investors to be willing to value the firm higher. As a result, separating the firm into units and carrying out an EVA evaluation is not just an accounting process but also a psychological process, which help in lifting away the negative aspects of the firm. In this regard, it is necessary for a firm like IBM to separate the less effective aspects of the firm to let the investors to see the better aspect of the firm. This approach is more useful to IBM than almost any other firm because of the history of the firm. As already discussed, IBM was the leader in hardware manufacturing, both for retail and corporate customers. However, as new players came into the market, it became harder for the firm to deal with the competition, it has to diversify. In the modern day, IBM is no longer the giant it was in the hardware sector, but competitors such as HP and Dell have shrouded the firm. However, IBM is doing so well in its software division and it has become a leader in this new niche. However, it is very hard for investors to see this new opportunity unless and until IBM separates itself from the older IBM and to the new IBM. Until the managers separate the firm, most investors can only seen IBM as a failure who was scuttled down by new entrants. IBM, regardless of that new entrants pushed it out of the throne in the hardware sector, has managed to create a new niche for itself in the new sector of software and business services. IBM would be doing its self good if it separates these good aspects of the firm from the older negative aspects. The second issue has to do with accounting, in which case, the accounting formula being the Economic Value Added (EVA) will be used for individual divisions. Developed by Stern Stewart & Co., this model of valuing a firm is guided by the profitability of the firm and its ability to return capital invested as well as covering the cost of operation. IBM would benefit from this in one important way. This is because the firm has four divisions and each of these divisions has different ratios of cost and profit. However, the better and newer division in the firm would be worth more if investors valued them separately, and this would help in adding the value of the firm. As of now, the most profitable division of the firm and which has the least operating costs is the software division. Separating this division from the less profitable divisions, such as the hardware division would lead to the division becoming more valuable and in total increase the value of the firm. Separating these divisions will be easier because they already operate as two different and almost autonomous organizations. This will make sure that there are those issues that the managers must consider to make sure that the firm can get the highest value not only from investors, but also from within the internal accounting team. Dividing the firm into divisions will lead to at least four divisions that include the following; Financing Finance is another division in IBM. IBM started financing businesses and has been doing this as a way to boost its revenue. In regard to the rationale for this project, this division will not receive much consideration due to a number of issues. First, finance cannot be considered as IBM’s area of competence because IBM is not in the finance services industry. At the same time, the finance division is to the most profitable for IBM and, this would lead to many issues with regard to valuation. Hardware The hardware division is one of the oldest businesses that IBM has been doing since the early days. It was the original business for IBM, as the name of the firm suggests. However, as the IT sector grew and other business opportunities came up, IBM has taken over other forms. The hardware division of the IBM business is the one least profitable, due to a decline in sales as well as increased competition in the industry. In fact, this decline in the hardware sector has led to the need to divide the firm into divisions to let the more profitable divisions to get better valuation. Services IBM also offers business services that relate to IT and IS. IBM realized the opportunities coming up as the IT sector was growing and in this regard started offering IT and IS services to businesses. This is a high opportunity sector, however, it is not the most profitable division of IBM, and this would mean that investors would be value it lowly when they use EVA to value it. However, for the sake of this assignment, it would be necessary to look at his division because IBM has a strategic advantage in this area of business, and this may add the value of the firm. Software As Jakobsen and Torp (2001), business software has become the new cash cow for the IT sector. With advanced systems such as enterprise software becoming more popular with big firms, the opportunities are many, and the possibilities are endless. Regardless of this IBM has curved a very strong niche in the world market for business systems. IBM is not only competitive in this area but also very well established in this area. The software business in IBM is the best and most successful, and this means that this division on it own would be valued highest in the EVA method. Strategic analysis of the software division in IBM Competency From a competence point of view, IBM has the highest hand in this due to the fact that IBM is one of the oldest computer and software firm in the world. IBM has been producing software for computers and developing business systems for more than five decades. In fact, IBM was at the dawn of computing era, and this gives it high competence. Unlike computer hardware production, software is a very sensitive process and experience is very important. Because of this, new hardware manufacturing can manage to compete with the older business but not in software development. This means that the IBM can continue to enjoy its competence because nothing can replace experience in software development. Strategic advantage In terms of strategic advantage, IBM is very well placed in the area of business software development. IBM is well placed in terms of geographical advantage. IBM was among the firms that distributed their business around the world. For instance, the software development is in the East, and this gives the form high advantage due to the availability of the affordable and quality labor. With the high experience in this area, IBM has the advantage to command the market for business software. Future business Profitability The business software division in IBM is the most profitable, and this means that this is the most useful. The software division is not only profitable; it also has the least costs (Lines, 2012). The most experience costs in the software division is the labor for research and development, which is still lower compared to the other division such as the hardware. In a nutshell, the software division is likely to be worth more when analyzed alone because of the following factors; More profits The division is the most profitable, and according to the EVA model of valuation, this is a big advantage and would lead to increased value. While valuating IBM as a whole, it means that the wide profit margins are absorbed by the less profitable division and this means that the firm is not able to have the high value it should be having. The software division is the most profitable in the IBM Corporation and this is important tin raising the value of the firm. it is also the main business in IBM which means that the other divisions are not the focus of the firm. In this regard, in trying to use the EVA model, it would be necessary to consider separating this division from the rest of the firm. Lower costs The software division is not only the most profitable but also the one of the least expensive. Unlike hardware development, software development does not need expensive infrastructure to develop, and this means that the software development division would fare well when valued using the on the EVA scale. Hardware manufacturing however requires expensive infrastructure in terms of big factories, machinery, raw material, etc. this would fare badly when investors use EVA to measure the value of the hardware division. This is because the capital and the profits are the main variables considered in the EVA mode of valuing a firm. In this regard, the hardware division can be seen to able dragging the software division down in terms of the valuation of the firm. Separating the two would be most useful for the sake of the firm. Low risk Apart from low costs and high profits, the software division also faces the lowest risks. Unlike the hardware division, the software division in most cases only deals with existing customers. IBM’s software customers are not likely to change their supplies as easily as the hardware customers. Hardware customers can easily choose to change their hardware supplier by the next hardware upgrade processes. However, the already existing software customers for IBM are not likely to easily change. This is because software of a firm always integrates with the history of a firm and changing the supplier can lead to either inability to have backward compatibility or increase the cost of achieving this backward compatibility (Cusumano, 2004). This makes it possible for IBM to maintain its customers, and this reduces the market risk. The other important issue that makes the software division to be least risky is the fact that the market for business software is definitely a ripe market without any uncertainties. The future of the hardware market is, however, shrouded with uncertainties, and this mean that the firm faces much risk in this area. Analysis Although IBM has at least for distinct divisions that could be separate for the purpose of EVA valuation, it is clear that the main contentious divisions are the software and the hardware division. In this regard, it is necessary for IBM to know how to separate these two divisions to make sure that the firm should be separate. In using the EVA to value IBM, one would have two options as follows: Value each of the four divisions separately This is an option that can be considered. There is, however, a number of difficulties that would have to be overcome in order to successfully achieve this. First, although it sounds easy on paper, achieving to divide the firm into four distinct divisions may be very difficult and complicated. This is because some of these divisions may be dependent on each other in very complicated ways and therefore drawing the lines to separate them would be difficulty. The other issue is that some of the divisions may not have any significance where the valuation of the firm is considered and separating them or keeping them intact would not have any impact. In this regard, it is necessary to consider the alterative scenario. The alternative scenario is in which the managers will only consider the two major divisions within IBM. In this case, the managers will divide the firm into the hardware and the software division. From there, they will place the other two divisions together with either the hardware or the software division. This would help in achieving the purpose of giving the firm the best value but at the same time reduce the work required to do so. The only challenge to consider in this scenario would be to look at where to place the other two divisions. This would help in making sure that the firm has the best value and the less effective division will not affect the value of the firm. Recommendations From the analysis done above, the best way to divide IBM would be to have three distinct divisions. This would be the hardware division, the finance division and the third division made of combination of the software and Services. This should help in making sure that the firm is has a high advantage for the EVA process. The software and the business services divisions are very similar and can function together, they also depend on each other to a very high degree that would mean that separating the two would be difficult and probably unrealistic. In this regard, dividing it into the three new divisions would have the firm valued in parts and increase its value. Investors should value the hardware division individually to make sure that high capital requirements and low profitability will not affect the value of the rest of the firm. The finance division would also be considered individually due to the fact that it does not have a bearing with the rest of the divisions. This would leave the firm to value the software and the business services division to be valued together. Conclusions The EVA model can be a very useful in helping to pinpoint the actual true value of a firm. However, one issue lies at the heart of the EVA valuation model. This issue is that in a firm consisting of different divisions, some divisions may lead to investors valuing the firm lowly. This happens when the said division has high operations costs, higher initial capital requirements and thinner profits margins. This is because the EVA model uses this as a way to measure the value of a business. However, this problem can be overcome by separating the various divisions to value them individually. Once separated and divided into distinct businesses, investors can use the EVA model to value each division and this means that the divisions that are not affected by the above issues can get high valuation. Many firms, such as Coca Cola have used this method to get a fairer valuation. In this regard, a firm like IBM that is composed of distinct divisions, some of which are not performing so well, would benefit from this strategy. This will help IBM to get a better valuation of its core business and leave the less profitable business, such as hardware to not affect the rest of the business. Dividing the business units and making them different businesses will also have other advantages that are not necessarily related to the EVA issues. These advantages are strategic rather than accounting advantages. For instance, when the better division of the firm is separated from the less successful ones, the public, and investors will see the firm in a better light. This will help in giving the firm a better market position. For instance, in the case of IBM, separating the software division from the hardware division will help in eliminating the negative image that the hardware division carries with it and help the software division to shine on its own. This will be above helping IBM to get a better valuation. References Cusumano, M. (2004). The Business of Software: What Every Manager, Programmer, and Entrepreneur Must Know to Thrive and Survive in Good Times and Bad. New York City, NY: Simon and Schuster. Grant, L. (2003). Foundations of Economic Value Added. Hoboken, NJ: John Wiley & Sons. Jakobsen, G. & Torp, J.E. (2001). Understanding Business Systems in Developing Countries. Thousand Oaks, CA: SAGE Publications . Lines, M. & Ambler, S.W. (2012). Disciplined Agile Delivery: A Practitioner's Guide to Agile Software Delivery in the Enterprise. Indianapolis, IN: IBM Press. Read More