To accompany contemprory strategy analysis concepts techiniques application chapter02slides

Goals, Values and Performance• Strategy as a quest for value • What is profit?. • The shareholder value approach • The shareholder value and strategy formulation • Mission and values OU

Goals, Values and Performance

• Strategy as a quest for value

• What is profit?

• The shareholder value approach

• The shareholder value and strategy formulation

• Mission and values

OUTLINE

Strategy as a Quest for Profit

• The stakeholder approach : The firm is a coalition of interest groups—it seeks to balance their

different objectives.

• The shareholder approach : The firm exists to maximize the wealth of its owners.

• Why is profit maximization a reasonable goal?

(1) Boards of directors legally obliged to pursue shareholder

interests.

(2) To replace assets, firm must earn return on capital > cost of

capital (difficult when competition intense).

(3) To avoid acquisition, firm must achieve stock-market

value > break-up value.

What is Profit?

• Profit maximization an ambiguous goal

– Total profit vs Rate of profit

– Over what time period?

• Accounting profit versus Economic profit

• Economic Value Added (EVA) as a measure of economic profit:

— Post-tax operating profit less cost of capital

• From profit maximization to value maximization

—Net present value of firm = Discounted future profits

over the life of the firm

Net Inc ROS ROE EVA Market Return to

Value Added Shareholders ($m) (%) (%) ($m) ($m) (%)

General Motors 2,956 1.8 19.7 -5,525 -17,943 21.4

General Electric 6,573 9.4 22.2 4,370 285,320 45.3

Exxon 6,370 6.3 14.6 -2,262 114,774 22.4 Philip Morris 5,450 10.3 39.0 5,180 98,657 64.8

IBM 6,328 7.7 32.6 2,541 -5,878 77.5

Coca-Cola 3,533 18.8 42.0 2,194 157,356 1.3

Wal-Mart 4,430 3.2 21.0 1,159 159,444 107.7 Procter & Gamble 3,780 10.2 12.2 61,661 102,379 15.9 Microsoft4,490 31.0 27.0 3,776 328,257 37.5

Hewlett-Packard 2,945 6.3 17.4 -593 45,464 10.7

How U.S Companies Perform Under Different Profitability Measures, 1998

How U.S Companies Perform Under Different Profitability Measures, 1998

Value Maximization

Maximizing the value of the firm:

Max net present value of free cash flows :

max V =

(1 + r e ) t

C t

Where:

V market value of the firm

C t free cash flow in time t

r e+d weighted average cost

of capital

t

Applying Shareholder Value Maximization to Strategy Choice

Applying Shareholder Value Maximization to Strategy Choice

• Identify strategy alternatives

• Estimate cash flows associated with cash strategy

• Estimate cost of capital for each strategy

• Select the strategy which generates the highest NPV

Valuing Companies and Business Units

Valuing Companies and Business Units

If net case flow growing at constant rate (g)

V = C1 ( r - g )

With varying cash flows which can be forecasted

for 4 years:

V = C0 + C1 + C2 + C3 + VH

(1 + r ) (1 + r )2 (1 + r )3 (1 + r )3

where: VH is the horizon value of the firm after 4 years

Problems of DCF Approaches to

Strategy Approach

Problems of DCF Approaches to

Strategy Approach

• Net Present Value of the Firm depends on option values as well as discounted cash flow expectations

• Estimating cash flows beyond 2-3 year horizon is

hazardous -especially in dynamic markets

HENCE: Some simple guidelines for maximizing

the value of the firm—

• On existing assets maximize after-tax rate

of return

• On new investment seek after-tax rate of

return > cost of capital

VALUE

Financial options Real options

Stock price

Exercise price

Uncertainty

Time to expiry

Dividends

Risk-free Interest rate

Risk-free interest rate

Value lost over duration of option

Duration of option Uncertainty

Investment cost

Present value of returns to the investment

=

=

=

=

=

=

The greater the NPV, the higher the option value

The higher the cost, the lower the option value

Higher volatility increases option values Time = opportunity to learn about outcomes

Loss of cash flow to fully -committed competitors lowers option value

Higher interest rate increases option value

by increasing value of deferring investment

Comments

The six levers of financial and real options

Return on Sales

Sales/Capital Employed

COGS/Sales

Depreciation/

Sales SGA expense/

Sales Fixed Asset Turnover

Sales/PPE Inventory Turnover Sales/Inventories Creditor Turnover

Sales/Acct Turnover of other items of working

capital

Disaggregating Return on Capital Employed

value

creation

Shareholder

value

creation ROCE

Economic Profit

Economic

Profit

Margin

Capital Turnover

Capital Turnover

Sales Targets

Sales Targets

cogs/

sales

cogs/

sales

Development Cost/Sales

Development Cost/Sales

Inventory Turnover

Inventory Turnover

Capacity Utilization

Capacity Utilization

Cash Turnover

Cash Turnover

Order Size Customer Mix Sales/Account Customer Churn

Rate Deficit Rates Cost per Delivery Maintenance cost New product development time Indirect/Direct Labor Customer Complaints Downtime Accounts Payable

Time Accounts Receivable Time

CEO Corporate/Divisional Functional Departments & Teams

Linking Value Drivers to Performance Targets

F I N A N C I A L

F1 Return on Capital Employed F2 Cash Flow

F3 Profitability F4 Lowest Cost F5 Profitable Growth F6 Manage risk

F1 Return on Capital Employed F2 Cash Flow

F3 Profitability F4 Lowest Cost F5 Profitable Growth F6 Manage risk

Strategic Objectives

Financially

Strong

* ROCE

* Cash Flow

* Net Margin

* Full cost per gallon delivered to customer

* Volume growth rate Vs industry

* Risk index

* ROCE

* Cash Flow

* Net Margin

* Full cost per gallon delivered to customer

* Volume growth rate Vs industry

* Risk index

Strategic Measures

C O

U M

S E

T R

-

C1 Continually delight the targeted consumer

C2 Improve dealer/distributor profitability

C1 Continually delight the targeted consumer

C2 Improve dealer/distributor profitability

* Share of segment in key markets

* Mystery shopper rating

* Dealer/distributor margin on gasoline

* Dealer/distributor survey

* Share of segment in key markets

* Mystery shopper rating

* Dealer/distributor margin on gasoline

* Dealer/distributor survey

Delight the

Consumer

Win-Win

Relationship

I1 Marketing

1 Innovative products and services

2 Dealer/distributor quality

I2 Manufacturing

1 Lower manufacturing costs

2 Improve hardware and performance

I3 Supply, Trading, Logistics

1 Reducing delivered cost

2 Trading organization

3 Inventory management

I4 Improve health, safety, and environmental performance

I5 Quality

I1 Marketing

1 Innovative products and services

2 Dealer/distributor quality

I2 Manufacturing

1 Lower manufacturing costs

2 Improve hardware and performance

I3 Supply, Trading, Logistics

1 Reducing delivered cost

2 Trading organization

3 Inventory management

I4 Improve health, safety, and environmental performance

I5 Quality

I N T E R N A L

* Non-gasoline revenue and margin per square foot

* Dealer/distributor acceptance rate of new programs

* Dealer/distributor quality ratings

* ROCE on refinery

* Total expenses (per gallon) Vs competition

* Profitability index

* Yield index

Delivered cost per gallon Vs competitors

* Trading margin

* Inventory level compared to plan & to output rate

* Number of incidents

* Days away from work

* Quality index

* Non-gasoline revenue and margin per square foot

* Dealer/distributor acceptance rate of new programs

* Dealer/distributor quality ratings

* ROCE on refinery

* Total expenses (per gallon) Vs competition

* Profitability index

* Yield index

Delivered cost per gallon Vs competitors

* Trading margin

* Inventory level compared to plan & to output rate

* Number of incidents

* Days away from work

* Quality index

L

E &

A G

R R

N O

I W

N T

G H

L1 Organization Involvement

L2 Core competencies and skills

L3 Access to strategic information

L1 Organization Involvement

L2 Core competencies and skills

L3 Access to strategic information

* Employee survey

* Strategic competing (?) availability

* Strategic information availability

* Employee survey

* Strategic competing (?) availability

* Strategic information availability

Safe and

Reliable

Competitive

Supplier

Good Neighbor

On Spec

On time

Motivated

and

Prepared

Balanced Scorecard for Mobil N American Marketing & Refining

Shareholder

Value

Measures:

• Market value of the

firm

•Market value added

(MVA)

•Return to

shareholders

Intrinsic Value

Measures:

• Discounted cash

flows

•Real option values

Financial Indicators

Measures:

• Return on Capital

• Growth (of

revenues & operating profits

•Economic profit (EVA)

Value Drivers

Sources:

• Market share

• Scale economies

• Innovation

• Brands

A Comprehensive Value Metrics Framework

A Comprehensive Value Metrics Framework

The Paradox of Value

The companies that are most successful in creating

long term shareholder value are typically those that:

other than profitability and shareholder return;

a) Have strong, consistent, ethical values.

Examples:

a) “Visionary” companies studied by Collins & Porras,

e.g Merck, Wal-Mart, Procter & Gamble, Disney, HP

b) Boeing — Boeing’s focus pre-1996: “to build great planes”

with weak financial controls — post-1996 focus: creating shareholder value — after 2000, rapid decline in Boeing profitability

Values and Mission

The role of (ethical) values :

• Place constraints on the means by which the firm

will pursue shareholder value max.

• Increase the effectiveness with which the firm builds

competitive advantage though reinforcing strategic intent and building internal consensus and

commitment.

The role of mission:

• Foundation for strategy Statement of what the

firm seeks to achieve and what it intends to become.