Concepts of OverviewDeck #1

Professor Sonia Marciano

Qualitative Analysis is Critical to Valuing Projects and Firms

• Historical cashflows provide some information about future cashflows – qualitative analysis tells us some of what we can learn from the past.

• Qualitative analysis also informs us about critical factors that affect cashflows going forward.

• Qualitative and quantitative analyses are highly complementary and often “siloed” in practical and academic contexts.

Firm Advantages Leave Financial Footprints

Size)Market ( ShareMarket Sales

Capital

Sales

A&SG

Sales

COGS)- (Salesrate)tax 1(

WACC

EconomicProfit

EconomicProfit

SuperiorEconomic Profit

SuperiorEconomic Profit

Higher Gross Margin

Higher Gross Margin

Lower SG&A toSales Ratio

Lower SG&A toSales Ratio

Higher Market Share

Higher Market Share

Lower Capital to Sales Ratio

Lower Capital to Sales Ratio

COGS advantage

Price premium due to benefitadvantage

Superior efficiencies in marketing or administration

Greater ability to spread fixed portion of SG&A due to larger volumes

CapitalNOPAT WACC

Superior management of working capital

Efficiencies in use of fixed assets

Benefit advantage

Lower prices due to cost advantage

Financial Footprints

StrategicDrivers

Ability to dominate niches competitors cannot serve

Concepts• Industry Analysis (Strategy Essentials)• Positioning (Strategy Essentials)• Resource Based View (Strategy Essentials)• Value Creation vs. Added Value (Strategy Essentials)• Key Success Factors (This slide deck)• Firm Boundaries (Strategy Essentials)• Game Theory (Slide Deck #3)• Real Options (Slide Deck #4)• Corporate Social Responsibility (Strategy Essentials)• Preemption /Sustaining Advantage (Strategy Essentials)

Strategy Concepts

The “Value Creation” describes how a wedge is driven between the customer’s WTP and the firm’s cost generally in a particular industry or industry segment.

The “Value Chain” depicts where and how a particular firm creates value

“Added Value” indicates the source of a particular firm’s leverage over its trading partners

These three concepts are useful for articulating the uniqueness of the firm’s product or production process (or both).

Although not shown here, firms can enjoy added value on the cost side – firm’s B’s cost could be lower b/c of production efficiencies or superior trading terms with suppliers or tied to some locational advantage.

Return on Invested Capital, Average of 1985 – 2002

Note: ROIC calculated as EBIT divided by Average Invested Capital (Total Assets less Excess Cash less Current Operating Liabilities)Source: Compustat and author’s calculations

Variance Across Industries

Average ROIC of the U.S. Economy: 11.6%

Copyright Michael E. Porter 2006

Variance Across Firms

Pharmacia-Upjohn 1.60%

Nucor 1.35%

Market Economics

Company’s Position in its Market

Attractive

Unattractive

Disadvantage Advantage

Pharma.2.16%

Steel-5.55%

Merck10.36%

BethlehemSteel

-12.25%

Source: Stern Stewart Performance 1000 database

Strategy FrameworksWTP Drivers:

Cost Drivers:

Positioning Analysis: Describes the nature of the firms cost or product market position. Positions are often more valuable over a subset of the market – hence there is often a “trade off” – firm creates value but also faces a more limited market potential.

Industry Analysis: Any firm’s ability to sustain profits is impacted by the attractiveness of the industry in which that firm competes. This framework identifies constituents best (and least) able to constrain industry profits.

The best positions exploit industry opportunities and avoid industry constraints.

In the case of some firms, particular resources generate a high fraction of value – the key to retaining those resources is cospecialization.

Resource Based View

Consider Nonmarket Factors Such As Demographics…

Baby Boomers

Baby Boomers

…And Politics

Industry or more generally context attractiveness reflects the accumulated “thoughtfulness” of the

“players” (firms, customers, suppliers). By thoughtful, we mean game theoretic…

•Utilities• Cloud services (?)

• These industries have much higher MES• Examples: Commodity metals, chemicals, oil tankers after the 1990 Oil Pollution Act

• Cola• Automobiles

• Think of microeconomics:•Price is the only thing that differentiates•Industry is not capacity constrained, but each firm is small relative to total demand•Oil tankers before 1990

• Customers demand for features is heterogeneous, production has low MES •Restaurants in a local market, Local car insurers, small music labels

• PC operating systems• Search (?)

Min

imu

m E

ffic

ien

t Scale

Low relative to market demand

High relative to market demand

Low

High

Industry Features Combine with Firm Reactions to Give Rise to Market Structures

•Interactions are non-strategic•Firms cannot shape their environment

Product Differentiation

•Interactionsstrategic•Firms canshape their environment

Natu

re o

f Firm

Inte

ractio

ns

Perfect competition Monopolistic competition

Free-Entry Free-Entry MarketsMarkets

Oligopoly Oligopoly MarketsMarketsHomogeneous product oligopolyDifferentiated product oligopoly

““Winner-Take-All” Winner-Take-All” MarketsMarkets

Traditional natural monopoly

Network industries

VERY high scale economies relative to market sizeNot Necessarily scale economies…unique market features

Where should we put large music labels?

Critical that a Firm Identify Its Key Success Factors – Taxonomize Success and Tie to Value Chain

• Product Portfolio: broad and deep in terms of product and price range

• Product Excellence and Innovation: High ratings in established rankings. Distinctness in desired attributes/image. Demonstrated technology leader.

• Brand Management: Clear brand positioning – nurtured and cultivated to create sufficiently broad appeal.

• Pricing and Incentives: Able to premium price to monetize the above. Rarely use incentives to boost volume.

• Channel Mgmt/Retail Environment: Appealing retail facility, right geography and coverage – professionally managed and consistent practices across locations. Highly profitable dealers – low intra-brand competition.

• Customer Relationship: Satisfying sales process and ownership experience. High customer loyalty.

• Lifecycle/Residual Value Management: Cradle to gave mindset. Higher residual value (price for used car) relative to competitors

Example: Luxury Car Segment

This slide adapted from analysis by Scott Corwin, Partner of Booz and Company

Sustainability/Preemption Analysis: Warren Buffet is Said to Ask “How Wide are the “Moats”?

Legal Barriers

One-of-a-Kind Strategic Assets

Information Gapsand Complexity

Economies of Scale, Market Size, and

Sunk Cost

Increasing Returns Advantages

• Patents• Copyrights• Trademarks• Operating Licenses

• Superior Locations• Human Talent• Trade secrets• Intellectual property• Brand names

• “Black magic”• Social complexity• Path dependence • Need to imitate on

numerous dimensions

• Cumulative experience along a learning curve

• Product performance track records and reputation

• Installed base in a network market

• Market big enough to support just one efficient-scale firm

Mos

t pow

erfu

lL

east

pow

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l

What do you do when they expire?Worth more to other firms?

Will they retain economic power?Gateways to profitable growth?

Often most enduring ... but will they prevent us from replicating our success

formula as we grow?

Will advantage be undermined as market grows?

Will advantage be undermined by shifts in technology or

customer priorities?

Back to the Cash FlowsGenerally a high fraction of the firms flow of value is derived from:– How attractive is the industry?

How “thoughtful” are the players in this business?– The firm’s “position” in the industry

Real optionsCSR

– Demographics and politics– The wisdom reflected in the firm’s value chain:

SupportActivities

Marketing& Sales

(e.g. Sales Force, Promotion, Advertising, Proposal Writing, Web site)

InboundLogistics

(e.g. Incoming Material Storage, Data Collection, Service, Customer Access)

Operations

(e.g. Assembly, Component Fabrication, Branch Operations)

OutboundLogistics

(e.g. Order Processing, Warehousing, Report Preparation)

After-Sales Service

(e.g. Installation, Customer Support, Complaint Resolution, Repair)

M

a

r

g

i

n

Primary Activities

Firm Infrastructure(e.g. Financing, Planning, Investor Relations)

Procurement(e.g. Components, Machinery, Advertising, Services)

Technology Development(e.g. Product Design, Testing, Process Design, Material Research, Market Research)

Human Resource Management(e.g. Recruiting, Training, Compensation System)

ValueWhat buyers are willing to pay

The value described above is fairly “ownable”

The Not All Sources of Cash Flows are Ownable

• In the case of some firms, particular people generate a notable share of the firm’s profits and if these people leave, value goes with them.

• We call individuals who contribute a notable share of the firm’s value “stars” or “jockeys”. A partial list of what makes jockeys special is:– Cannot “cast a wide net” to replace them– Their value they generate is “mobile”– They often matter when big information frictions are

present.

We will discuss implications using BMG case

Central Point of Strategy

If the firm offers something unique and that uniqueness is defensible, the firm may be able to sustain economic profits for at least some period.