Goals, Values and Performance

1. 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

2. 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: • Boards of directors legally obliged to pursue shareholder interest • To 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

3. 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 lesscost of capital Maximizing the value of the firm: Max. net present value of free cash flows: max. V = StCt (1 + r)t Where: V market value of the firm. Ct free cash flow in time t r weighted average cost of capital

4. The World’s Most Valuable Companies: Performance Under Different Profitability Measures

5. 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 • On existing assets—maximize after-tax rate of return • On new investment—seek rate of return > cost of capital • Utilize qualitiative strategy analysis to evaluate future profit potential

6. 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

7. Financial options Real options Comments Present value of returns to the investment The greater the NPV, the higher the option value Stock price = Exercise price The higher the cost, the lower the option value = Investment cost OPTION VALUE Uncertainty Uncertainty Higher volatility increases option values = Time = opportunity to learnabout outcomes Time to expiry Duration of option = Loss of cash flow to fully -committed competitors lowers option value Dividends Value lost over duration of option = Risk-free Interest rate Risk-free interest rate Higher interest rate increases option value by increasing value of deferring investment =

8. The six levers of financial and real options Financial options Real options Comments Present value of returns to the investment Higher NPV raises option value Stock price = Exercise price Higher cost lowers option value Investment cost = OPTION VALUE Uncertainty Uncertainty Higher volatility increases option value = More time allows more information to be taken into account Time to expiry Duration of option = As profit is lost to rivals, option value is lowered Dividends Value lost over duration of option = Risk-free Interest rate Risk-free interest rate A higher interest rate increases option value by increasing the value of deferring investment =

9. Performance Diagnosis: Disaggregating Return on Capital Employed COGS/Sales Margin (Return on Sales) Depreciation/Sales SGA expense/Sales ROCE Fixed asset turnover (Sales/PPE) Inventory Turnover (Sales/Inventories) Asset productivity (Sales/Capital Employed) Creditor Turnover (Sales/Receivables) Turnover of other items of working capital

10. Linking Value Drivers to Performance Targets Order Size Customer Mix Sales Targets Sales/Account Customer Churn Rate Margin cogs/ sales Deficit Rates Cost per Delivery Development Cost/Sales Maintenance cost Shareholder value creation ROCE New product development time Indirect/Direct Labor Inventory Turnover Customer Complaints Economic Profit Capital Turnover Downtime Capacity Utilization Accounts Payable Time Cash Turnover Accounts Receivable Time CEO Corporate/Divisional Functional Departments & Teams

11. Balanced Scorecard for Mobil N. American Marketing & Refining Strategic Objectives Strategic Measures 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 * ROCE * Cash Flow * Net Margin * Full cost per gallon delivered to customer * Volume growth rate Vs. industry * Risk index Financially Strong C O U M S E T 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 survey Delight the Consumer Win-Win Relationship I N T E R N A L 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 * 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 Safe and Reliable Competitive Supplier Good Neighbor On Spec On time 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 * Employee survey * Strategic competing (?) availability * Strategic information availability Motivated and Prepared

12. 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

13. The Paradox of Value The companies that are most successful in creating long term shareholder value are typically those that: • Have a mission—They 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, HP • 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