Goals, Values and PerformanceStrategy as a quest for valueWhat is profit?The shareholder value approachThe shareholder value and strategy formulationMission and valuesOUTLINE

Strategy as a Quest for ProfitThe stakeholder approach : The firm is a coalition of interest groupsit 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:Boards of directors legally obliged to pursue shareholder interestTo replace assets firm must earn return on capital > cost of capital (difficult when competition strong).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 MaximizationProfit maximization an ambiguous goalTotal profit vs. Rate of profitOver what time period?What measure of profit? Accounting profit versus economic profit (e.g. Economic Value Added: Post-tax operating profit less cost of capitalMaximizing the value of the firm: Max. net present value of free cash flows: max. V = St Ct(1 + r)t Where:V market value of the firm. Ct free cash flow in time t r weighted average cost of capital

The Worlds Most Valuable Companies: Performance Under Different Profitability Measures

COMPANYMARKET CAP. ($BN.)NET INCOME ($BN) RETURN ON SALES (%)RETURN ON EQUITY (%)RETURN ON ASSETS (%)RETURN TO SHARE-HOLDERS (%)Exxon Mobil 37236.119.934.917.8 11.7General Electric36316.410.722.214.7(1.5)Microsoft28112.340.330.018.8(0.9)Citigroup23924.622.021.91.54.6BP23322.39.927.910.710.2Bank of America21216.527.014.11.22.4Royal Dutch Shell21125.314.726.711.611.8Wal-Mart19711.25.521.48.1(10.3)Toyota Motor19712.110.713.04.8(22.1)Gazprom1967.328.19.87.1n.a.HSBC19015.923.016.31.0(11.8)Procter & Gamble1908.717.313.76.47.2

Shareholder Value Maximization and Strategy ChoiceThe Value Maximizing Approach to Strategy Formulation:Identify strategy alternativesEstimate cash flows associated with cash strategyEstimate cost of capital for each strategySelect the strategy which generates the highest NPVProblems: Estimating cash flows beyond 2-3 years is difficultValue of firm depends on option value as well as DCF valueImplications for strategy analysis: Some simple financial guidelines for value maximizationOn existing assetsmaximize after-tax rate of returnOn new investmentseek rate of return > cost of capitalUtilize qualitiative strategy analysis to evaluate future profit potential

Valuing Companies and Business UnitsIf 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

OPTIONVALUEFinancial optionsReal optionsStock priceExercise priceUncertaintyTime to expiryDividendsRisk-freeInterest rateRisk-freeinterest rateValue lost over duration of optionDuration of optionUncertaintyInvestment costPresent value of returns to theinvestment ======The greater the NPV, thehigher the option valueThe higher the cost, the lower the option valueHigher volatilityincreases option valuesTime = opportunity tolearn about outcomesLoss of cash flow to fully-committed competitorslowers option valueHigher interest rate increases option valueby increasing value of deferring investmentComments

OPTIONVALUEFinancial optionsReal optionsStock priceExercise priceUncertaintyTime to expiryDividendsRisk-freeInterest rateRisk-freeinterest rateValue lost over duration of optionDuration of optionUncertaintyInvestment costPresent value of returns to theinvestment ====== Higher NPV raises option valueHigher cost lowers option valueHigher volatilityincreases option valueMore time allows more information to be taken into accountAs profit is lost to rivals,option value is loweredA higher interest rate increases option value by increasing the value of deferring investmentCommentsThe six levers of financial and real options

ROCEMargin(Return onSales)Asset productivity(Sales/CapitalEmployed)COGS/SalesDepreciation/SalesSGA expense/SalesFixed asset turnover(Sales/PPE)Inventory Turnover(Sales/Inventories)Creditor Turnover(Sales/Receivables)Turnover of other items of working capital Performance Diagnosis: DisaggregatingReturn on Capital Employed

Shareholdervalue creationROCEEconomic ProfitMarginCapitalTurnoverSales Targetscogs/salesDevelopmentCost/SalesInventoryTurnoverCapacityUtilizationCashTurnoverOrder SizeCustomer MixSales/AccountCustomer ChurnRate Deficit RatesCost per DeliveryMaintenance costNew productdevelopment timeIndirect/DirectLaborCustomer ComplaintsDowntimeAccounts PayableTimeAccounts Receivable Time CEO Corporate/Divisional Functional Departments & TeamsLinking Value Drivers to Performance Targets

Balanced Scorecard for Mobil N. American Marketing & RefiningFINANCIAL

F1 Return on Capital EmployedF2 Cash FlowF3 ProfitabilityF4 Lowest CostF5 Profitable GrowthF6 Manage risk

Strategic ObjectivesFinanciallyStrong* ROCE* Cash Flow* Net Margin* Full cost per gallon delivered to customer * Volume growth rate Vs. industry* Risk indexStrategic MeasuresC OU MS ET R- 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 surveyDelight the ConsumerWin-Win RelationshipI1 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 QualityINTERNAL* 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 indexL E & A GR RN O I WN TG HL1 Organization Involvement

L2 Core competencies and skills

L3 Access to strategic information* Employee survey

* Strategic competing (?) availability

* Strategic information availabilitySafe and ReliableCompetitive SupplierGood NeighborOn SpecOn timeMotivated and Prepared

Shareholder ValueMeasures: Market value of the firmMarket value added (MVA)Return to shareholders Intrinsic ValueMeasures: Discounted cash flowsReal option values

Financial IndicatorsMeasures: Return on Capital Growth (of revenues & operating profitsEconomic profit (EVA) Value DriversSources: Market share Scale economies Innovation Brands 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:Have a missionThey give precedence to goals other than profitability and shareholder return;Have strong, consistent, ethical values.Examples: Visionary companies studied by Collins & Porras, e.g. Merck, Wal-Mart, Procter & Gamble, Disney, HPBoeing Focus pre-1996: to build great planes, weak financial controlsyet high profitability Focus 1997-2003 : creating shareholder valueOutcome: loss of market leadership, declining profitability

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