Goals, Values and Performance
OUTLINE
• Strategy as a quest for value
• What is profit?
• The shareholder value approach
• The shareholder value and strategy
formulation
• Mission and values
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 (= max. present value of profits over the life of the firm)
For the purposes of strategy analysis we assume that the primary goal
of the firm is profit maximization.
Rationale:
1) Boards of directors legally obliged to pursue shareholder interest
2) To replace assets firm must earn return on capital > cost of capital
(difficult when competition strong).
3) Firms that do not max. stock-market value will be acquired
Hence: Strategy analysis is concerned with identifying and accessing
the sources of profit available to the firm
From Profit Maximization to Value Maximization
• Profit maximization an ambiguous goal
–
–
–
–
Total profit vs. Rate of profit
Over what time period?
What measure of profit?
Accounting profit versus economic profit (e.g. Economic
Value Added: Post-tax operating profit less cost of capital
Maximizing the value of the firm:
Max. net present value of free cash flows: max. V = St
Where:
V
Ct
r
market value of the firm.
free cash flow in time t
weighted average cost of capital
Ct
(1 + r)t
The World’s Most Valuable Companies:
Performance Under Different Profitability Measures
COMPANY
MARKET
CAP.
($BN.)
NET
INCOME
($BN)
RETURN
ON
SALES
(%)
RETURN
ON
EQUITY
(%)
RETURN
ON
ASSETS
(%)
RETURN
TO
SHAREHOLDERS
(%)
Exxon Mobil
372
36.1
19.9
34.9
17.8
11.7
General Electric
363
16.4
10.7
22.2
14.7
(1.5)
Microsoft
281
12.3
40.3
30.0
18.8
(0.9)
Citigroup
239
24.6
22.0
21.9
1.5
4.6
BP
233
22.3
9.9
27.9
10.7
10.2
Bank of America
212
16.5
27.0
14.1
1.2
2.4
Royal Dutch Shell
211
25.3
14.7
26.7
11.6
11.8
Wal-Mart
197
11.2
5.5
21.4
8.1
(10.3)
Toyota Motor
197
12.1
10.7
13.0
4.8
(22.1)
Gazprom
196
7.3
28.1
9.8
7.1
n.a.
HSBC
190
15.9
23.0
16.3
1.0
(11.8)
Procter & Gamble
190
8.7
17.3
13.7
6.4
7.2
Shareholder Value Maximization and Strategy Choice
The Value Maximizing Approach to Strategy Formulation:
•
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
Problems:
•
•
Estimating cash flows beyond 2-3 years is difficult
Value of firm depends on option value as well as DCF value
Implications for strategy analysis:
•
•
Some simple financial guidelines for value maximization
a) On existing assets—maximize after-tax rate of return
b) On new investment—seek rate of return > cost of capital
Utilize qualitiative strategy analysis to evaluate future profit
potential
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
Financial options
OPTION
VALUE
Real options
Comments
Present value of
returns to the
investment
The greater the NPV, the
higher the option value
Stock price
=
Exercise price
=
Investment cost
The higher the cost, the
lower the option value
Uncertainty
=
Uncertainty
Higher volatility
increases option values
Time to expiry
Dividends
= Duration of option
=
Time = opportunity to
learn about outcomes
Loss of cash flow to fully
Value lost over
duration of option -committed competitors
lowers option value
Risk-free
Interest rate
=
Risk-free
interest rate
Higher interest rate
increases option value
by increasing value of
deferring investment
The six levers of financial and real options
Financial options
OPTION
VALUE
Real options
Comments
Stock price
=
Present value of
returns to the
investment
Exercise price
=
Investment cost
Higher cost
lowers option value
Uncertainty
=
Uncertainty
Higher volatility
increases option value
Higher NPV raises
option value
Time to expiry
=
Duration of option
More time allows more
information to be taken
into account
Dividends
=
Value lost over
duration of option
As profit is lost to rivals,
option value is lowered
Risk-free
Interest rate
=
Risk-free
interest rate
A higher interest rate
increases option value by
increasing the value of
deferring investment
Performance Diagnosis: Disaggregating
Return on Capital Employed
COGS/Sales
Margin
(Return on
Sales)
ROCE
Depreciation/Sales
SGA expense/Sales
Fixed asset turnover
(Sales/PPE)
Inventory Turnover
Asset
productivity
(Sales/Capital
Employed)
(Sales/Inventories)
Creditor Turnover
(Sales/Receivables)
Turnover of other items
of working capital
Linking Value Drivers to Performance Targets
Sales
Targets
Margin
Shareholder
value
creation
Development
Cost/Sales
ROCE
Economic
Profit
cogs/
sales
Inventory
Turnover
Capital
Turnover
Capacity
Utilization
Cash
Turnover
CEO
Corporate/Divisional
Functional
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
Departments & Teams
Balanced Scorecard for Mobil N. American Marketing & Refining
Strategic Objectives
Financially
Strong
Delight the
Consumer
Win-Win
Relationship
Safe and
Reliable
Competitive
Supplier
Good Neighbor
F
I
N
A
N
C
I
A
L
CO
UM
SE
TR
-
On Spec
On time
Motivated
and
Prepared
F1 Return on Capital Employed
F2 Cash Flow
F3 Profitability
F4 Lowest Cost
F5 Profitable Growth
F6 Manage risk
*
*
*
*
*
*
C1 Continually delight the targeted consumer
* Share of segment in key markets
* Mystery shopper rating
C2 Improve dealer/distributor profitability
* Dealer/distributor margin on gasoline
* Dealer/distributor survey
I1 Marketing
1. Innovative products and services
2. Dealer/distributor quality
I
N
T
E
R
N
A
L
&
G
R
O
W
T
H
ROCE
Cash Flow
Net Margin
Full cost per gallon delivered to customer
Volume growth rate Vs. industry
Risk index
* Non-gasoline revenue and margin per square foot
* Dealer/distributor acceptance rate of new programs
* Dealer/distributor quality ratings
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
Delivered cost per gallon .Vs. competitors
* Trading margin
* Inventory level compared to plan & to output rate
I4 Improve health, safety, and environmental performance
* Number of incidents
* Days away from work
I5 Quality
L
E
A
R
N
I
N
G
Strategic Measures
ROCE on refinery
Total expenses (per gallon) Vs. competition
Profitability index
Yield index
* Quality index
L1 Organization Involvement
* Employee survey
L2 Core competencies and skills
* Strategic competing (?) availability
L3 Access to strategic information
* Strategic information availability
A Comprehensive Value Metrics Framework
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
The Paradox of Value
The companies that are most successful in creating
long term shareholder value are typically those that:
a)
Have a mission—They give precedence to goals
other than profitability and shareholder return;
b)
Have strong, consistent, ethical values.
Examples:
a) “Visionary” companies studied by Collins & Porras,
e.g. Merck, Wal-Mart, Procter & Gamble, Disney, HP
b) Boeing — Focus pre-1996: “to build great planes,” weak
financial controls—yet high profitability
— Focus 1997-2003 : “creating shareholder
value”—Outcome: loss of market leadership,
declining profitability