Product portfolio analysis: a tool for a more informed

corporate strategy

A sly rabbit
will have three
openings to
its den
Chinese Proverbs

Introduction
Companies that have several product
lines often struggle to understand how
a single product line interacts with other
products and the resulting impact on
their businesss profitability and risk
profile. This is an important corporate
strategy consideration, as a full account
of the risk and return profile of each
product line can guide a more informed
decision-making process around:
Sales and marketing campaign
strategy. Product-line sales volatility
and margins are two key factors that
drive profitability and marketing
strategy as they represent the risk
and return of each business line,
respectively. Insights on product
line margins and sales volatility
inform the company of the actual
returns for each business unit as
opposed to the risks faced. This
will help to assess the businesss
best sales and marketing terms.
Inventory management strategy.
Sales volatility is a serious challenge
to a companys ability to manage
inventories cost effectively. Its
profitability is threatened as it causes
revenue volatility and has a significant
impact on inventory costs. The worstcase scenario would be serious risk
of cash shortfall that would affect
the companys financial stability.
Cost-cutting decisions. Companies
often use profit margins as a key
reference point in decisions about
product-line divestments. However,
choices based only on an assessment

54

Performance

of margins may lead to less efficient

outcomes, if the risks associated with
the margins are overlooked. Risk and
return have a positive relationship;
ideally, product lines with low margins
and high volatility should be divested
as they clearly overexpose the
company to a high level of risk without
sufficient returns. However, lowmargin, low-volatility product lines do
not expose the company to excessive
risks, but they may still be considered
if profitability can be improved.
Investment decisions. The risk/
return profile analysis of a companys
product lines is a useful guide to
assessing future investment decisions
and how they may impact the overall
level of risk facing the company, as
well as the cost of financing via an
increase in the cost of capital.
Investment appraisals. As different
product lines tend to have different risk/
return profiles, to apply a common cost
of capital in an investment evaluation
of all of the product lines would result in
biases in the assessment of the projects.
The risks facing some product-line
projects would be overestimated which
would result in a project that would
potentially lead to companys value
being overlooked. At the same time, the
level of risk for the product lines in other
projects would be underestimated,
which could lead to a decision to embark
on projects with risk profiles that are
too high. Projects based on this premise
could lead to value erosion rather than
creation, or may simply be not aligned
with the corporate strategy for risk.

Companies have traditionally focused

on the profitability of product lines only.
However, the measurement of product-line
risk is crucial for an accurate comparison

serious concerns about the ability of

the product line to generate value to
the firm without increasing the overall
risk profile. Figure 1 is an analysis of a
company that has several asset classes
and depicts the sales margin versus
sales volatility for seven product lines.

Figure 1: Portfolio analysis

1

Grow

Tight inventory control

.8

Product_line 5
Product_line 4

.6

Product_line 1

Product_line 3
Product_line 6

Divest

.4

Improve terms

.2

Not optimal

Product_line 2

Not optimal
Product_line 7

Sales and marketing campaign,

and inventory management

of product-line portfolios. High returns

are usually associated with high risk; this
maxim is at the core of basic financial
theory as high returns are the incentive
for taking higher risks. An ideal situation
would be to have high returns associated
with low volatility. On the contrary, low
returns and high volatility would create

Sales margin

Product portfolio analysis

Product portfolio analysis has proven
value as a tool for assessing the risk/
return profile of several product lines and
for guiding a better-informed decisionmaking process on which to base corporate
strategy. Companies often have in
several product lines and, as such, can
be viewed as portfolios of several assets,
with the assets being the product lines.
Each asset has its own features in terms
of risk (sales volatility) and return. The
latter can be represented by several
financial metrics according to the reason
for the analysis. Commonly suggested
metrics are: sales margin, inventory
stock margin; ROA; profit margin; etc.
The ability to analyze a product line
not only from a return perspective, but
also from a risk perspective, provides
a further dimension that is extremely
valuable in corporate strategy. This
approach has several implications
that inform various CEO decisions.

5,000

10,000

15,000

20,000

Sales volatility

Performance

55

Figure 1 shows that product lines 4 and

5 are the best performers in terms of
their risk and return profiles. Their sales
volatility (risk) is relatively low, while their
margins (return) are very high, compared
with the companys other product lines.
This is an ideal situation and the company
should grow its market share in these two

product lines. Product lines 1, 3 and 6 are

consistent with the general risk/return
profile. High sales volatility is matched
by high returns. However, the high sales
volatility may raise some concerns about
inventory management. Therefore,
tight inventory control is recommended.
Product line 2 is not optimal: the high sales

Figure 2: Product lines cash analysis

1

Prot driver

Stars

.8

Product_line 5
Product_line 4
Product_line 3

.6

Product_line 6

Cash driver

Dog

.4

Sales margin

Product_line 1

.2

Product_line 2

Product_line 7

2,000

4,000

6,000

8,000

Total sales in 000s

56

Performance

volatility similar to product lines 1, 3 and 6,

is not matched by the same margins. The
company should divest from product line 2
as it only increases the overall risk profile,
without providing an adequate return.
Product line 7 is not optimal either. Despite
having the lowest margin relative to all
other product lines, its low sales volatility is
a positive feature. Therefore, the company
should explore the opportunity to improve
sales terms to increase profitability.
The stock margin is another useful
financial matrix that can be used to
analyze the risk/return profile of product
lines. This represents the sales margin
given the overall investment in inventory,
and it helps to assess the efficiency of
the inventory management policy.
Another aspect worth considering is the
product lines ability to generate cash. This
is particularly relevant in current market
conditions, where credit availability is
limited and the ability to generate cash is
a key challenge for companies in meeting
their outstanding debt obligations and
avoiding the financial distress that would
result from an increase in the cost of

Figure 3: Portfolio analysis cost-cutting and investment decisions

40%
35%

Efcient frontier
Product_line 1

High
margin

Product_line B

Margin

30%
25%

Product_line D

Medium
margin

Product_line A

Product_line E

20%
15%

Product_line C

Low
margin

10%
0.00

0.05

0.10

0.15

0.20

0.25

0.30

0.35

Revenues volatility

funding. Figure 2 represents the same

product lines analyzed from a different
perspective. Here, the sales margin and
total sales of the product lines are the
key variables. These help to identify the
product lines that could generate more
cash and drive profitability in the company.
Product lines 4 and 5 indicate low total
sales. However, these two product
lines are profit drivers because of the
high margins they are able to generate.
Product lines 1, 3 and 6 are the best
performers stars - in terms of their
ability to generate cash. Large sales
volumes are matched with reasonably high
sales margins and, as such, these product

lines are generating most value for the

company. Product line 2 has low margins.
However, large sales volumes make this
product line a cash driver. Finally, product
line 7 has low sales margins, which are
associated with low sales volumes.
Cost-cutting and investment decisions
Cost-cutting and investment strategy
are crucial as they affect a companys
profitability in the medium to long term.
Several factors affect these types of
corporate strategy decisions. Therefore,
portfolio analysis is another valuable tool
to assist the decision-making process.

Performance

Figure 3 illustrates a potential scenario

for a company that has several product
lines. The product lines have been divided
into three categories: low, medium and
high margin. Product lines A and E have
similar margins. Therefore, from a pure
margin perspective, they seem to be
similar and bring the same value to the
company. However, product line E has
much higher sales volatility. Product line
A is preferred as, for the same margin
(return), the sales volatility (risk) is much
lower. The company should divest product
line E and consider divesting product
line C as it features similar volatility to
product lines A and D, but lower margins.
An ideal situation for the company would
be to reach a performance level illustrated
by the orange line, which represents
the efficient frontier. This is the best
achievable risk/return trade-off for this
companys product-line portfolio. The
companys corporate strategy needs to
take account of the existing risk/return
profile and assess whether new decisions
about its product-line investment are
likely to lead to significant changes in
its overall risk exposure leading to a
rise in cost of its funds. The decision to
invest in a product line that has both
high margins and volatility, for instance,
is likely to bring the companys overall
risk toward the efficient frontier.

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Investment appraisals
Appropriate investment valuation is the
main route to value creation for most
companies. However, many companies
often fail to fully assess the level of risk
associated with the various product
lines. Instead, they use their common
cost of capital to evaluate different
investments in different product lines.
The main danger with this approach is
that it may either under or overestimate
the true product-line risk. Investments
that are not aligned with the corporate
strategy and policy, because the level of
risk and cost of capital attached are too
low, or projects that have the potential to
generate value, may be rejected because
they are evaluated using too high a risk
factor and consistent cost of capital.
An extension of portfolio analysis is to
apply econometric techniques to assess

the level of risk associated with various

product lines. The companys beta is the
most widely used measure to assess its
risk. Taking the view that a company
with several products is a portfolio of
assets, each asset will have a risk profile
that can be measured by the beta. This
implies that the companys beta is the
weighted average of the product lines
beta. The weights are represented by
the share of revenues generated by each
product line, or the share of company
assets invested in each product line.
Historical data on the companys beta
and product-line weights can be used to
estimate the beta for each product line.
Figure 4 illustrates the security market line
for the company and all of its product lines.
The security market line plots the beta
and the attached return. The companys
beta is the weighted average of the beta of

Figure 4: Security market line

40%
Product_line F, 2.0

Return on equity

35%
Product_line B, 1.7
30%
Company 1.26

25%

Product_line D, 1.4

Product_line A, 1.1
Product_line E, 1.1

20%

several product lines, where the weights

are represented by the revenue share
each product line is able to generate.
Figure 4 also shows how applying the same
risk (beta) to the investment appraisal
project or all product lines would lead
to biased results as an erroneous cost
of capital would be used. A low level of
risk would be attached to product lines
A, F and G leading to the acceptance of
the project with a higher risk profile than
permitted under the companys strategy
and policy. On the contrary, a high risk
profile would be attached to product lines
C, D and E, leading the company to reject
projects that may actually deliver value
because it used too high an estimated
cost of capital. Portfolio analysis and
beta disaggregation, however, would
help to guide a more informed and
robust investment decision process, and
limit the risk to pursue investments not
aligned with the companys policy.
Conclusion
Portfolio analysis is a powerful
and quick tool that can be used to
improve the decision-making process
in several areas of a companys
corporate strategy. Its flexibility to
be applied to various challenges that
CEOs face on a daily basis makes it
an essential tool to inform corporate
strategy. Our experience suggests that
many successful organizations have
achieved higher value using this tool
to guide their strategic decisions.

Product_line C, 0.7
15%
0.5

0.7

0.9

1.1

1.3

1.5

1.7

Beta

58

Performance

1.9

2.1

Author
Fabrizio Jacobellis is a Manager in the
Valuation & Business Modeling Practice,
Ernst & Young UK

Performance

59