Goals, Values and PerformanceGoals, 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 ProfitStrategy 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?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 21.4General Electric 6,573 9.4 22.2 4,370 285,320 45.3Exxon 6,370 6.3 14.6 -2,262 114,774 22.4 Philip Morris 5,450 10.3 39.0 5,180 98,657 64.8IBM 6,328 7.7 32.6 2,541 -5,878 77.5Coca-Cola 3,533 18.8 42.0 2,194 157,356 1.3Wal-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 37.5Hewlett-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 MaximizationValue Maximization

Maximizing the value of the firm:

Max. net present value of free cash flows :

max. V =

(1 + re)t

Ct

Where:

V market value of the firm.

Ct free cash flow in time t

re+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 UnitsValuing 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 ishazardous---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

OPTIONVALUE

Financial options Real options

Stock price

Exercise price

Uncertainty

Time to expiry

Dividends

Risk-freeInterest rate

Risk-freeinterest rate

Value lost over duration of option

Duration of option

Uncertainty

Investment cost

Present value of returns to theinvestment

=

=

=

=

=

=

The greater the NPV, thehigher the option value

The higher the cost, the lower the option value

Higher volatilityincreases option values

Time = opportunity tolearn about outcomes

Loss of cash flow to fully-committed competitors

lowers option value

Higher interest rate increases option valueby increasing value of deferring investment

Comments

The six levers of financial and real optionsThe six levers of financial and real options

ROCE

Return onSales

Sales/CapitalEmployed

COGS/Sales

Depreciation/Sales

SGA expense/Sales

Fixed Asset TurnoverSales/PPE

Inventory TurnoverSales/Inventories

Creditor TurnoverSales/Acct

Turnover of other items of working

capital

Disaggregating Return on Capital EmployedDisaggregating Return on Capital Employed

Shareholdervalue

creation

Shareholdervalue

creation ROCEROCE

Economic Profit

Economic Profit

MarginMargin

CapitalTurnover

CapitalTurnover

Sales Targets

Sales Targets

cogs/sales

cogs/sales

DevelopmentCost/Sales

DevelopmentCost/Sales

InventoryTurnover

InventoryTurnover

CapacityUtilization

CapacityUtilization

CashTurnover

CashTurnover

Order SizeCustomer MixSales/Account

Customer ChurnRate

Deficit Rates

Cost per DeliveryMaintenance cost

New productdevelopment time

Indirect/DirectLabor

Customer Complaints

Downtime

Accounts PayableTime

Accounts Receivable Time

CEO Corporate/Divisional Functional Departments & Teams

Linking Value Drivers to Performance TargetsLinking Value Drivers to Performance Targets

FINANCIAL

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

F1 Return on Capital EmployedF2 Cash FlowF3 ProfitabilityF4 Lowest CostF5 Profitable GrowthF6 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 OU MS ET 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

INTERNAL

* 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 GR RN O I WN TG 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 SpecOn time

Motivated and

Prepared

Balanced Scorecard for Mobil N. American Marketing & RefiningBalanced Scorecard for Mobil N. American Marketing & Refining

Shareholder ValueMeasures:• Market value of the firm•Market value added (MVA)•Return to shareholders

Intrinsic ValueMeasures:• Discounted cash flows•Real option values

Financial IndicatorsMeasures:• Return on Capital • Growth (of revenues & operating profits•Economic profit (EVA)

Value DriversSources:• Market share• Scale economies• Innovation• Brands

A Comprehensive Value Metrics FrameworkA Comprehensive Value Metrics Framework

The Paradox of ValueThe Paradox of Value

The companies that are most successful in creatinglong term shareholder value are typically those that:

a) Have a mission—They give precedence to goals 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 MissionValues 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.