The Essence of Portfolio Effects and Value

Magnus Ytterstad recently posted a paper on LinkedIn that uses the concept of portfolio value in determining the wisdom of a set of investments. It’s an interesting paper, and I encourage you to read it.

But what is portfolio value? The appendix in Strategic Business Portfolio Management on Portfolio Specific Value (PSV) is extremely insightful. It explains the concepts behind using optimization to determine a portfolio value and why the Portfolio Value of an opportunity is different from its standalone value.

Portfolio value is a great concept that has been around for some time. It means the value of an investment within the context of the overall portfolio. In most cases, the portfolio value of an investment is less than its standalone value. This is because, in most organizations, bringing in a new investment necessarily delays or eliminates other potential investments due to limited capital and human capacity. While a new opportunity may look like it will add value, the value may be partially or completely offset by the portfolio effects. I presented this at the INFORMS Annual Conference in 2017.

Starting with an inventory of real investment opportunities and a nuanced view of what success means for the firm, you can generate a much better view of portfolio value.

At the simplest level, Portfolio value of an opportunity = Vportfolio with new opportunity - Vportfolio with base inventory. We can look at it with a little more granularity though.

VOpp is the standalone value.

VPortfolio with new opportunity = Vportfolio with base inventory + VOpp + PSV.

Where PSV is the net effect of the changes required to incorporate the new opportunity into the portfolio. PSV is usually negative, but it can be positive.

Ultimately, the PSV is a function of three factors: the characteristics of the opportunity in question, the firm’s inventory of potential investments, and the portfolio requirements and constraints (CRs).

It is best not to treat CRs as givens initially. In fact, understanding the envelope of possible performance and tradeoffs is a critical aspect of portfolio analysis. So the portfolio value of an individual opportunity will depend on the targets and goals of the firm, not just its own characteristics.

In the image, the blue dots represent the difference in value on the y-axis between the base set of investments and the inventory with Opportunity A. The x-axis values are different capital constraints. Note that the Delta NPV decreases as the capex decreases. In this case, the portfolio value depends on what you believe the capital program will be. If you believe the capital program will be larger than 82.5, it adds value. If smaller, it is a drag on the firm.

Strategic Business Portfolio Management includes an appendix with a working paper co-authored by Peter Val Kranak, Mal Wright, and me, which lays out the above framework in more detail.