Strategic Management and
Firm Performance
Chapter Two
© 2006 by Nelson, a division of Thomson Canada Limited.
2-1
Strategic
Inputs
Chapter 4
Internal
Environment
Strat. Intent
The Strategic
Strat. Mission
Strategy Formulation
Chapter 5
Bus. - Level
Strategy
Chapter 6
Chapter 7
Competitive Corp. - Level
Dynamics
Strategy
Chapter 9
Chapter 8
Acquisitions & International
Strategy
Restructuring
Strategic
Outcomes
Strategic Actions
Chapter 3
External
Environment
Chapter 2
Above Average
Returns
Chapter 10
Cooperative
Strategies
Chapter
Chapter 11
Strategic
Strategic
Competitiveness
Competitiveness
.
Management
Process
.
Strategy Implementation
Chapter 11
Corporate
Governance
Chapter 12
Structure
& Control
Chapter 13 Chapter 14
Strategic Entrepreneurship
Leadership & Innovation
Feedback
© 2006 by Nelson, a division of Thomson Canada Limited.
2-2
Strategic Management and Firm
Performance
Knowledge objectives:
1. Understand the ultimate goal of strategic
management – to impact organizational
performance.
2. Defining performance, particularly the
differences among above-average returns,
average returns and below-average returns.
3. Discuss the different ways in which
organizational performance is measured.
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2-3
Strategic Management and Firm
Performance
Knowledge objectives – continued…
4. Know the strengths and weaknesses of
different measures of organizational
performance.
5. Define corporate social responsibility,
sustainability, and the triple bottom line.
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2-4
Defining Performance
An organization is an association of
productive assets who have voluntarily come
together to accomplish a set of goals.
The goal is to gain an economic advantage.
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2-5
What Is Performance?
An important question in the study of firms.
What is performance?
In athletics, it’s straightforward:
• The person who runs 100 meters the fastest
• The person who jumps the highest
• The team who wins the Stanley Cup in the NHL
For firms, it’s when the company
successfully formulates & implements a
value-creating strategy.
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2-6
*
an
Levels of Performance
Below-normal
When the actual value
created is less than the
value owners expectations
Normal performance
Occurs when the actual
value created is equal to
the expected value
Above-normal
When the actual value
created is greater than the
expected value
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2-7
Defining Organizational Performance
The Concept of Value…
What is received for what is given.
?
For customers: ‘Did I receive more than I gave?’
• If the answer is yes, value was created.
• If the answer is no, value was destroyed.
For shareholders: Value creation means getting
more from an investment than could have been
received from another investment with similar
risk.
© 2006 by Nelson, a division of Thomson Canada Limited.
2-8
Firm Performance
• Above average returns: Returns in excess of
what an investor expects to earn from other
investments with similar risk.
• Average returns: Returns equal to an investor
expects from other investments with similar
amount of risk.
• Below average returns: Those that are less than
expected given a similar level of risk.
© 2006 by Nelson, a division of Thomson Canada Limited.
2-9
Approaches to Firm Performance
1.
2.
3.
4.
5.
6.
Firm Survival
Accounting Measures
Multiple Stakeholder Approach
Present Value
Market-based Measures
Market Value Added / Economic Value Added
7. The Balanced Scorecard
8. Corporate social responsibility
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2-10
Firm Survival & Firm Performance
Altman’s Z =
Working Capital
.012
Total Assets
Retained Earnings
+ .014
Total Assets
+ .033 Earnings Before Interest & Taxes
Total Assets
Market Value of Firm Equity
+ .006
Book Value of Firm Debt
Sales
+ .100
Total Assets
© 2006 by Nelson, a division of Thomson Canada Limited.
2-11
*
Firm Survival & Firm Performance
Altman’s Z
Likely Grey
to fail Area
-0
1.8
3.2
Likely to Survive
10
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2-12
*
Firm Survival & Firm Performance
+ It’s a simple and relatively obvious measure.
- It is sometimes difficult to know when a firm no
longer exists.
- Death of a firm can sometimes occur over a
relatively long period of time.
- It does not provide any information concerning
above average returns.
© 2006 by Nelson, a division of Thomson Canada Limited.
2-13
Accounting Measures
& Firm Performance
Ratio
Profitability
Ratios 1 / 2
Calculation
What the Ratio Means
Sales–Cost of goods sold
Sales
Measures the revenue left to
cover operating expenses
after taking out the cost of
procurement
Operating
Profit Margin
Profit before interest & taxes
Sales
Assesses firm profitability
without regard to interest
charges as a result of the
capital structure
Net Profit
Margin
Profits after taxes
Sales
After tax profits per dollar of
sales
Gross Profit
Margin
(Return on Sales)
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2-14
Accounting Measures
& Firm Performance
Ratio
Calculation
Profitability
Ratios 2 / 2
What the Ratio Means
Return on Total Profit after taxes+interest
Assets
Total assets
Measures the return on the
total investment in the firm
Return on
Profit after taxes (PAT)
shareholders
Total shareholders’ equity
equity
Rate of return to shareholders given their
investment in the firm
Return on investment
PAT–Preferred stock dividends common shareholders have
Return on
common equity Total shareholders’ equity
made in the firm
Earnings per PAT–Preferred stock dividends #
share
common shares outstanding
Earnings available to
common shareholders
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2-15
Accounting Measures
& Firm Performance
Ratio
Current ratio
Liquidity
Ratios
Calculation
What the Ratio Means
Current Assets
Current Liabilities
Ability to cover ST debt with
assets convertible to cash in the
period ST debt matures
Quick ratio
Current assets-Inventory
(Acid-Test Ratio)
Current liabilities
Ability to pay off short-term
debt without relying on
inventory
Measure to which firm’s
Inventory to
Inventory
net working Current assets-current liabilities working capital is tied up
in inventory
capital
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2-16
*
Accounting Measures
& Firm Performance
Leverage
Ratios 1 / 2
Ratio
Calculation
What the Ratio Means
Debt-toassets ratio
Total debt
Total assets
Measures use of debt to
finance operations
Debt-toequity ratio
Total debt
Total shareholders equity
Use of debt relative to
shareholders’
investment in firm
Long-term
debt to
equity ratio
Long-term debt
Total shareholders equity
Balance between debt &
equity in long-term capital
structure of firm
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2-17
Accounting Measures
& Firm Performance
Ratio
Calculation
Leverage
Ratios 2 / 2
What the Ratio Means
Times
Profits before interest & taxes
interest earned Total interest charges
Measures how much profits
can decline before firm is
unable to meet its interest
obligations
Fixed- chargeProfits before interest & taxes +
Lease obligations
coverage
Interest charges
+ Lease obligations
More inclusive measure of
ability of firm to handle all
of fixed-charge
obligations
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2-18
Accounting Measures
& Firm Performance
Ratio
Dividend
yield on
common stock
Calculation
Shareholder Returns
What the Ratio Means
Annual dividends per share Measures return to common
Current market price per
shareholders
share
Current market price per
share
Price/Earning
After-tax earnings per share
ratio
Dividend
payout ratio
Misc. Ratios -
Annual dividends per share
After-tax earnings per share
Market perception of firm
Faster-growing / less risky firms
tend to have higher P/E ratios
Indicates dividends paid
out as a % of profits
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2-19
Accounting Measures
& Firm Performance
Ratio
Cash Flow
per Share
Break-even
analysis
Miscellaneous
Ratios
Calculation
What the Ratio Means
After-tax
profits+depreciation
# of common shares
outstanding
Measures total cash per
share available to firm
Fixed costs
Contribution margin
Measures the number of
units that need to be sold to
begin to make a profit on
that product or service
Contribution margin = (Selling price/unit) – (variable price/unit)
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2-20
Accounting Measures
& Firm Performance
$$$
Accounting Measures are Popular in Analysis
+ Easily available for publicly traded firms
+ Stock exchanges stress quality accounting data
.
as a tool for investor decisions
Broad support for use as a performance measure
+
+ May provide insights into economic rates of return
However, they
- May have a built in short-term bias
- Are subject to manipulation by managers
- Undervalue intangible assets
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2-21
Multiple Stakeholder Approach
& Firm Performance
(The firm must maintain performance at an adequate level in order to
maintain the participation of key groups affected by the firm.)
The trouble is that each
group seldom has the
same goals in mind
Capital Market
Firm
Product Market
Primary Customers
Suppliers
Stock market/Investors
Debt suppliers/Banks
Organizational
Employees
Managers
Non-Managers
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2-22
Present Value & Firm Performance
Avoid short-term bias by measuring cash flows
over time.
Value all resources made available to a firm by
using the discount rate concept.
(Estimate net cash flows and expected discount rates for
several years into the future.)
Allow assessment of firm and/or project’s
performance on a forward-looking basis.
Net Present Value < 0 Below average returns
Net Present Value = 0 Average returns
Net Present Value > 0 Above average returns
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2-23
Present Value & Firm Performance
+s
Strengths
+ Close link between present value
& the conceptual definition of performance
+ Positive net present-value strategies
should maximize the wealth of shareholders
.
In doing so they
will likely generate
enough cash to
satisfy other
stakeholders
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2-24
Present Value & Firm Performance
-s
Weaknesses
- Misjudging prediction of cash flow
patterns several years into the future.
- Cash flows on projects worth billions &
lasting decades may be a problem.
- Measuring the discount rate is a problem.
- Hard to assess the firm’s systematic risk.
- (Beta) & such risk may change over time.
But, researchers question the adequacy of the
economic model on which the beta estimation is
based. (Capital Asset Pricing Model: CAPM)
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2-25
Present Value & Firm Performance
The use of net present-value (NPV) must
be done with it’s limitations in mind.
But using Present Value
may allow for a deeper
understanding of firm
performance.
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2-26
Market - Based Measures
& Firm Performance
Stock Market measures in essence:
Risk-free rate of return for firm’s stock
+
% change in
Systematic risk in the stock market [Beta]
stock price *
X
= % change in daily
Risk free rate
–
closing value of the of return *
Risk free rate of
stock
market
index
*
.
return *
+
Residual obtained when estimating risk free
rate and systematic risk
S* - RFR* = a + b ( M–RFR*) + e
* For 250 trading days
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2-27
Market - Based Measures
& Firm Performance
We can thus derive some essential formulas:
1
Sharpe’s Measure is used to assess return
per unit of total risk.
Sharpe’s = % change in stock price*- Risk free rate of return*
.
2
.
Standard Deviation of % change in stock price*
Treynor’s Measure is used to assess return
per unit of systematic risk.
.
Treynor’s = % change in stock price*- Risk free rate of return*
.
Systematic risk in the stock market [Beta]
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2-28
Market - Based Measures
& Firm Performance
3
Jensen’s Alpha is used to assess return
relative to risk free return.
.
Jensen’s Alpha = Risk-free rate of return for firm’s stock*
Appraisal Ratio is used to measure the risk
free return per unit of unsystematic risk.
.
.
4
Appraisal Ratio = Risk-free rate of return for firm’s stock*
.
Residual obtained when estimating
.
risk free rate and systematic risk
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2-29
+s
Market - Based Measures
& Firm Performance
+ Strategy researchers have increasingly relied on
market-based measures of firm performance.
This increased use may partially be a response to the
criticisms of accounting-based measures.
+ These measures may more accurately reflect econ.
performance than accounting based measures.
.
.
.
Useful for assessing econ. value of a given strategy or
choosing between strategies that could be implemented.
+ Market-based measures focus on the present
value of future streams of income, (e.g., expected
value of future cash flows) not past performance.
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2-30
-s
Market - Based Measures
& Firm Performance
- These measures were not originally designed for
-
measurement of firm performance but portfolios.
Sharpe’s & Treynor’s measures implicitly use the
risk-free rate as cost of capital & is thus a problem
when assessing smaller firms.
- Treynor Measure assumes unsystematic risk is
fully
diversified away. While appropriate for investment
portfolios it may not be so for firms.
- The need to use Market indexes like the TSE300
means heavily weighted firms like Nortel Networks
over-influence the index.
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2-31
Market - Based Measures
& Firm Performance
! Although the four measures have limitations, they
provide insight into the ability of a firm to achieve
above-average returns, average returns or belowaverage returns.
! Correlations between the accounting measures &
market measures are only 0.15 to 0.30.
This suggests that market measures tell us something different
about performance than accounting measures.
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2-32
Market Value Added / Economic
Value Added & Firm Performance
Market Value Added (MVA) is:
The difference between the cash investors expect to
receive given the firm’s current market value and the
amount of cash that debt & equity holders have
invested in the firm since inception.
$75 billion Current total market value of the firm
- $20 billion Given by firm debt holders
- $15 billion Given by firm equity holders
- $30 billion Retained from operations
$10 billion MVA
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2-33
Market Value Added / Economic Value
Added & Firm Performance
Economic Value Added (EVA) is:
An internal measure of a firm’s ability to generate
MVA in the future.
The amount of operating capital at the beginning of
each year times the difference between the rate of
return on capital & the weighted average cost of the
debt & equity capital employed.
The present value of all projected EVAs = MVA
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2-34
Market Value Added / Economic
Value Added & Firm Performance
Economic Value Added (EVA)
To create shareholder value, any or all of these will
increase EVA:
1. Improve return on capital already employed.
(generate more profits without employing more capital)
2. Invest more capital in strategies having a greater
rate of return than the cost of the capital employed.
3. Withdraw capital from strategies/projects having a
cost of capital greater than their rate of return.
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2-35
The 2003 Stern Stewart 1000 MVA Rating
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2-36
Market Value Added / Economic Value
Added & Firm Performance
+s
+ MVA - a good measure of shareholder wealth creation or
destruction that also captures the ability of the firm’s
senior leaders to manage the firm’s capital.
MVA is considered an estimate of the NPV of all the firm’s
capital projects, both ongoing & anticipated by investors.
+ Positive EVA/MVAs suggest that firms are maximizing
shareholder wealth and that these firms are efficiently
allocating the resources flowing to them.
+ Changes over time should be examined closely by a
firm’s stakeholders. This may be a more effective
measure than absolute EVA/MVA at one point in time.
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2-37
Market Value Added / Economic Value
-s
Added & Firm Performance
- EVA does not assess econ. profit (the difference in econ.
value at 2 points in time) but accounting income.
- There is a lack of consistent definitions for EVA,
capital, and net operating profit after taxes.
- EVA is too complex, requiring 160 adjustments under
Generally Accepted Accounting Principles.
- EVA is an inadequate single measure for decisions
in that it only measures short-term profitability.
- Given EVA is a short-term measure, it may be wrong
to reward managers based only on EVA.
- EVA is not appropriate for capital budgeting.
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2-38
Market Value Added / Economic Value
Added & Firm Performance
-s
MVA/EVA is easy for managers to manipulate
and it may create undesirable impacts:
- EVA requires capitalization of R&D even if such
-
expenditures may have no future value.
Managers could develop a short-term bias.
Managers could decide to spend little or no time on
quality improvement.
EVA permits capitalization of restructuring charges &
may lead to unnecessary restructuring.
EVA permits the holding back of expenditures as
assets even if they have no future value.
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2-39
Market Value Added / Economic Value
Added & Firm Performance
An educated approach to the required
160 adjustments is needed.
Less than 20 adjustments
may be needed but which
20 will vary between each
firm and be based on the
industry in which it
operates.
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2-40
Market Value Added / Economic Value
Added & Firm Performance
Assessing future direction of a firm’s EVA & knowing its
value-creating / destroying capabilities allows one to derive
likely scenarios for future stock prices.
EVA methodology, applied appropriately, may be very
valuable in unveiling hidden investment opportunities &
over-valued projects and strategies.
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2-41
The Balanced Scorecard
• Brings financial measures of previous
performance together with measures of
the drivers of future performance.
• The Balanced Scorecard translates a
business units mission into tangible
objectives and measures.
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2-42
The Balanced Scorecard
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2-43
Sustainability
and the Triple Bottom Line
• Sustainability:
The capability of present generations to meet
their needs without compromising the capability
of future generations to meet their needs.
• The Triple Bottom Line:
A framework for measuring and reporting firm
performance against economic, environmental
and social parameters.
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2-44
Best Corporate Citizens Rankings
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2-45