The Marakon model was developed by Marakon Associates, a management consulting firm known for its work in the field of value-based management. According to Marakon model, a firm’s value is measured by the ratio of its market value to the book value. An increase in this ratio depicts an increase in the value of the firm, and a reduction reflects a reduction in the firm’s value. The model further states that a firm can maximize its value by following these four steps:
- Understand the financial factors that determine the firm’s value
- Understand the strategic forces that affect the value of the firm
- Formulate strategies that lead to a higher value for the firm
- Create internal structures to counter the divergence between the shareholders goals and the management’s goals.
1. Financial Factors
The first step in this model is to identify the financial factors that affect the value of the firm. The model states that a firm’s market value to book value ratio, and hence, its value depends on three factors – return on equity, cost of equity, and growth rate. This conclusion is drawn indirectly from the constant growth dividend discount model.
The constant growth dividend discount model says that
P/B = M/B = (rxb) / (k-g)
where,
- M, be the current market price of the firm’s share
- k, be the cost of equity
- g, be the growth rate in earnings and dividends
- r, be the return on equity
- B, be the current book value per share
- b, be the dividend pay-out ratio.
Thus, a firm’s market value to book value ratio can be derived from its return on equity, its cost of equity and its growth rate. It can be observed from the formula that;
- A firm’s market value will be higher than its book value only if its return on equity is higher than its cost of equity. This is supported by the other theories of valuation of equity.
- When the return on equity is higher than the cost of equity, the higher a firm’s growth rate, the higher its market value to book value ratio.
Hence, a firm should have a positive spread between the return on equity and the cost of equity, and a high growth rate in order to create value tor its shareholders.
2. Strategic Forces
The financial factors that affect a firm’s value are in turn affected by some strategic forces. The two important strategic factors that affect a firm’s value are market economics and competitive position. The market economics determines the trend of the growth rate and the spread between the return on equity and cost of equity for the industry as a whole. The firm’s competitive position in the industry determines its relative rate of growth and its relative spread.
Market economics refers to the forces that affect the prospects of the industry as a whole. These include:
- Level of entry barriers
- Level of exit barriers
- Degree of direct competition
- Degree of indirect competition
- Number of suppliers
- Kinds of regulations
- Customers influence.
Competitive Position refers to a firm’s relative position within the industry, A firm’s relative position is affected by its ability to produce differentiated products and its economic cost position. A product can be referred to as a differentiated product when the consumers perceive its quality to be better than the competitive products and are ready to pay a premium for the same. The firm can benefit from a differentiated product in two ways. It may either increase its market share by pricing it competitively, or can command a higher price for its product than its competitors, and forego the higher market share. Thus, the ability to produce differentiated products improves a firm’s relative position vis-a-vis its competitors. The other factor that helps a firm enjoy a strategic advantage over its competitors is a low per unit economic cost. Economic costs include operating costs and the cost of capital employed. A low economic cost may result from a number of factors like:
- Access to cheaper sources of finance
- Access to cheaper raw material
- State-of-the-art technology resulting in better quality control
- Better management
- Strong dealer network
- Exceptional labor relations.
3. Formulation of Strategies
Once a company has identified its potential growth prospects and analyzed its strengths and weaknesses, it needs to develop strategies that would help it utilize its strengths and underplay its weaknesses, thus achieving the maximum possible growth and creating value. For achieving this objective two kinds of strategies are required – participation strategy and competitive strategy.
A company, to create value for its shareholders, has to either operate in an area where the market economies are favorable, or has to produce those products in which it can enjoy a highly competitive position. The strategy that specifies the broad product areas or businesses in which a firm is to be involved is referred to as its participation strategy. At the level of a business unit, this strategy outlines the market areas (in terms of the geographical areas, the high-end market or the low-end market, the level of quality and differentiation to be offered) to be entered.
The strategy on the preferred markets is followed by the competitive strategy, which specifies the plan of action required for achieving and maintaining a competitive advantage in those markets. It includes deciding the way of achieving product differentiation, the method for utilizing the differentiation so created (i.e. by increasing the price of the product or the market share) and the means of creating an economic cost advantage.
4. Creation of Internal Structures
The separation of ownership and management in the traditional manner results in the management bearing all the risks associated with value-adding decisions, without their enjoying any of the benefits. This often results in the management taking sub-optimal decisions. A firm needs internal structures which can control this tendency of the management. These may include
- The management’s compensation being linked to the company’s performance.
- Corporate governance mechanisms that specify responsibilities and holds managers accountable for their decisions.
- Resource allocation among projects guided by the specific requirements of the projects rather than the past allocations and capital rationing.
- A mechanism for making sure that the various projects undertaken form part of a strategy, rather than being disjointed, discrete projects.
Plans being made in accordance with the long-term goals and target performance being fixed in accordance with these plans, rather than the level of achievable targets determining the plans. Performance targets should be a function of the plans, rather than being the base for the plans.
Target performance, when achieved, should be rewarded with promised incentives. Non-fulfillment of such promises affects the future performance.