Where should CEOs of consumer-products companies look for growth?

More and more of them find it in categories close to those they already serve. The strategy is called adjacent diversification, and the logic behind it is that a company's capabilities can be exploited across related categories. Often accomplished through acquisition, adjacent growth can offer consumer-products companies major economies of scale and scope at a time when the retailers that distribute their products grow ever larger and more powerful. In fact, for the consumer-products makers, consolidation and diversification strategies are often linked: Companies seeking scale acquire competitors with dissimilar category footprints, while companies seeking diversified growth find the shortest route through acquisition - increasing scale in the bargain.

In the right combinations, diversification helps companies lower their functional costs per unit. It also frees resources for breakthrough product innovations, provides fuller assortment and service to demanding retailers and defends share through massive spot investment in contested markets or categories.

But moving into unfamiliar categories can be perilous. The growth potential of far-from-the-core expansion carries a higher risk as the new entrant takes on entrenched competitors. What's more, distraction from existing lines of business can kill the golden goose - the legacy business that funds new initiatives.

There's a lot to weigh if you're considering adjacent diversification and acquisition. We recommend a four-step process for assessing your options and charting your course.

1. Determine the growth path. Adjacent diversification should not be sought for its own sake. Its appropriateness depends on the basis for competition in your industry, your competencies and the availability of attractive combinations.

One durables manufacturer, for example, had a mix of broadly diversified and narrowly focused players in its category. It wanted to know if it needed to diversify to survive. Our analysis found that the shareholder return of diversified players was no better than that of focused ones. Furthermore, the manufacturer could realize few synergies across broad categories along the value chain because the categories had dissimilar gains from scale. Distribution advantages also differed, depending on the point of fabrication. Finally, major retailers didn't really care whether the supplier was diversified. Instead of diversification, we recommended that the company focus on a narrower set of related categories in which it had brand relevance and an advantage in materials science. The company is now profitably following that strategy.

2. Rank the attractiveness of adjacent categories. Once they've decided on adjacent diversification, most managers prefer to stay close to home, hoping to leverage existing knowledge and capabilities. But they often define proximity by the wrong variables. One diversifying food company, for example, focused on categories with similar manufacturing processes: "This is like making X, and making X is what we do best." A closer look revealed a more important lever: common locations within the store, and the associated merchandising, branding and selling capabilities the company possessed.

To be ready to assess the attractiveness of an adjacent category, you need to prepare three important profiles:

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• An understanding of your current consumer, including target definition, segment size, demographics, stated and unstated needs, purchase behaviors and pathways, and occasions of use.

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• An objective outline of your company's capabilities across the value chain, including innovation, conversion, distribution and branding.

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• A complete teardown of your core-category economics and requirements for success, including volume growth, velocity, assortment, cost per pound, distribution density and price realization.

Once armed with a map of your consumers, capabilities and category economics, you are ready to scan candidate categories. Consumer understanding will clarify your strengths and allow you to calculate the impact of expansion. By mapping your capabilities, you will identify points of competitive advantage and synergy as you enter a category, as well as risks in execution. Economic analysis will help you quantify the impact of profit, investment and risk on your business. At its conclusion, your review will give you a picture of the standalone and complementary attractiveness of relevant categories. When such data surface, the best adjacent categories are clear and sometimes surprising.

One packaged-foods company, for example, worried about one of its core businesses when a competitor decided to exit. Did the competitor know something it didn't? An analysis showed that participating in the raw-material ingredients stage of the industry was not very attractive. But a study of the end-use markets revealed an opportunity to build a premium ready-to-consume product line. Such a line would compete outside the company's current distribution mode. Therefore, the company acquired a small player with a position in the appropriate channels and also introduced the product line to its own established channels. The company then launched a second and third premium line. Each new line brought new technical benefits that meant higher prices. The business grew to more than $1 billion, bigger by far than the original ingredients business.

3. Assess the best entry means. Whether you mount an organic launch or acquire another company in an attractive category depends on the category's competitive dynamics, your capabilities and the availability of acquirable assets. Although much research has been devoted to understanding why acquisitions fail, it is also important to appreciate the relative difficulty of organic adjacent diversification. To that end, Boston Consulting Group studied nearly 600 food launches between 1997 and 2001. Among launches that represented organic entry into an adjacent category, only 9% achieved first-year sales in excess of $50 million, compared with a 17% success rate among launches in general. In many categories, mergers and acquisitions will represent the most attractive means of entry.

For the acquisition to succeed, however, it must capitalize on a unique advantage. As with other aspects of charting your course, you can predict the factors that contribute to a successful purchase.

4. Value candidates with high definition. If acquisition is the preferred entry vehicle, finding the right property and paying the right amount are the final (and sometimes fatal) hurdles. In most cases, you can narrow the field of properties with thorough research on strategic intent, regulatory barriers, the balance sheet and your targets' complementary strengths. Once you've done this, you can prepare detailed dossiers on the most likely candidates and develop a source book and game plan for active or reactive M&A moves downstream. At the heart of the dossier is an output we call high-definition valuation.

Typical valuation approaches run something like this: Comparable transactions and industry multiples are observed. A discounted cash-flow model is built on the basis of the target's standalone value and trajectory, with overlays for projected cost and revenue synergy. Cost synergies are estimated using scale-economy rules of thumb. Revenue synergies emerge through consensus. The seller's data room is mined, site visits are made and the valuation is revised and agreed upon.

Such an approach falls short because information that materially affects value lies outside its scope; the devil is indeed in the details. Many companies, of course, are sophisticated acquirers, and master those details. Still, it's worthwhile to review the two main aspects of an effective valuation approach, one both broad and deep.

A wide field of view. An acquirer needs an encompassing view of the value that might be created or lost. We quantify all of the external aspects of a transaction and its indirect consequences. These include:

• Resource diversion. In theory, any project with a positive net present value justifies incremental investment. In practice, time and resources are often constrained, and acquisitions rob other initiatives. For this reason, we recommend a review of internal projects. On the basis of an estimate of required acquisition and integration resources, internal projects are eliminated, discounted or delayed - with the penalty subtracted from the transaction upside. Thus only unique, incremental transaction value is paid for, and the deal isn't credited with false synergy. Costly errors are avoided.

• Plan impairment. The cost of inaction is often missed in traditional valuation. Forfeiting a property to a competitive bidder not only closes off potential upside, it exposes existing plans to a strengthened competitor. Recently, we fielded a team to look at where and how a likely bidder would attack after it completed an acquisition. What markets would be at risk given the combined footprint of the two companies? What launches might they pre-empt with strengthened R&D? How would their new cost position pressure prices? Where should a competitor increase brand support to stave off attack?

Such an effort minimizes damage. It also reveals the true value of winning the target.

Deep, detailed research. Many standalone and upside analyses base their assumptions on rules-of-thumb and rudimentary extrapolations. Such looseness can skew valuations, especially when compounded in terminal values. Instead, we advocate:

• A standalone analysis. Rather than base projections on historical or category average performance, you should examine consumer purchase data on the brand level. You should research recent launch performances; interview subjects with knowledge of the target's business, including blind interviews of important customers or retail buyers; conduct deep dives on heavy-user segments and their consumption trends; and analyze differences among competitors to understand the performance of consolidated subsidiaries or private companies.

• Upside scrutiny. Acquisition upsides must be thoroughly tested. If, for example, certain brands are to be transplanted to new locations or extended, test the concept and commission original consumer research. That includes interviewing retail buyers on the benefits of the combination to substantiate the estimated revenue.

You should also determine physical overlap and opportunities for rationalization by investigating plants and facilities - down to the detail of line output and square footage. Patent footprint overlap and teardowns of recent launches can point to combined innovation potential.

• Premerger integration. Postmerger integration, of course, involves assembling a team to plan operational integration and set detailed performance targets. Pre-merger integration exercises are an advance simulation of that process, conducted well before a deal is likely. Same team, same issues, same objectives. The outputs are a set of cost and revenue projections (showing the probabilities of different outcomes) and an implementation plan showing the resources required to achieve the benefits. When conducted under tough management expectations of accountability, this exercise builds realism into the valuation.

Even the most painstaking evaluation of upside is meaningless if it is given away in bidding. A structured approach to setting opening and walkaway price points can ensure that identified value is brought back to your shareholders. And it can inoculate management against the contraction of "deal fever." Opening bids should be established on the basis of precedent transactions, a conservative estimate of value creation and an understanding of the transaction upside and funding constraints of competing bidders. Walkaway bids should be established (and adhered to) by an aggressive but achievable estimate of upside as well as of funding, dilution, and earnings-per-share accretion thresholds.

In addition, a clear-eyed view of possible competitive bidders and their bidding potential is needed. If your upsides are unique, competitors should be unable to match them in their bids.

The real power of high-definition valuation is in the timing. Every aspect can be accomplished well ahead of a transaction, across a number of worthy properties, without an offering memorandum and without a data room. This type of early valuation provides a commanding view of options for expansive growth - making it especially useful for consumer-products companies with multiple adjacent categories to assess. It ensures that when the time is right, you can move swiftly, value accurately, and bid intelligently. - Jeff Gell, Marin Gjaja, Kermit King and Michael Silverstein

Jeff Gell is a manager in the Chicago office of The Boston Consulting Group. Marin Gjaja and Kermit King are vice presidents and directors in the firm's Chicago office. Michael Silverstein is a senior vice president and director in BCG's Chicago office. He has been head of the firm's global consumer practice since 1996, and is now the executive officer in charge of BCG's Office of the CEO.

A longer account of BCG's thinking on adjacent growth is available on the firm's Web site.

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