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Economic Foundations Economic Foundations of Strategyof Strategy

Power Point Set #3

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The First Rule of Strategy:The First Rule of Strategy:A Good Strategy Is “Coherent.”

Functional pieces of strategy support the whole (Michael Porter)

Oper.

Strategy

Finance

Acctg. H.R.

Mktg.

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Strategic CoherenceStrategic Coherence

The Logic of How the Business Fits Together:Southwest Airlines

Low PriceShort Routes

No FrillsPoint-to-PointOne Aircraft - Boeing 737High # of Aircraft per RouteNo MealsFlexible/ Lower Staffing

American AirlinesPremium PricedShort, Long, & Int’lVariety

Hub & SpokeMultiple AircraftLow # of Aircraft per RouteMeals & ServiceHigher Staffing

4© 1999 Pankaj Ghemawat Source: Michael E. Porter “What is Strategy” Harvard Business Review, Nov-Dec 1966

Limitedpassengeramenities

Short-haul,point-to-pointroutes betweenmidsize cities

and secondaryairports

Highaircraft

utilization

Frequent,reliable

departures

Lean, highlyproductiveground andgate crews

Very lowticket prices

No meals

No seatassignments

No baggagetransfers

No connectionswith other

airlines

15-minutegate

turnarounds

Limited useof travelagents

Automaticticketingmachines

Standardizedfleet of 737

aircraft

Flexibleunion

contracts

High levelof employee

stockownership

“Southwest,the low-fare

airline”

Highcompensationof employees

Southwest Airlines’ Activity System

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A Basic Analytical FrameworkA Basic Analytical Framework

SWOT Analysis Strengths, Weaknesses, Opportunities, & Threats

Strengths &Weaknesses

Opportunities& Threats

Values OfManagement

Values OfStakeholde

rs

StrategyInternalFactors

ExternalFactors

Objectives

Drivers

6Copyright 1998 by Houghton Mifflin Company. All rights reserved.

2-20

Tradeoff Between Profitability Tradeoff Between Profitability and Growth Rate and Growth Rate

G0

P1

P2

PMAX

G1 G2

Growth Rate

Profitability

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Sustainable Competitive Advantage and the Measurement of Performance

While we have said that the objective of strategy is to “create competitive advantage,” specifically we have the goal to maximize economic return.Static Measures of Performance

Economic ProfitsROA, ROE, ROC

Dynamic Measures of PerformanceNPV Methods

Capital Market Measures of PerformanceMarket Value of the FirmMVA and EVATobin’s Q (James Tobin, Yale)

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4-2Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Ratio of Market Value to Book Value for Selected Companies

Annual Market Book Ratio of Sales Value Value Market to

Company ($ billions) ($ billions) ($ billions) Book Value

Exhibit 4.1 Ratio of Market Value to Book Value for Selected Companies

eBay 1.2 30.8 3.9 7.9

Microsoft 28.4 254.1 58.3 4.4

Intel 26.8 142.1 35.4 4.0

General Motors Corp. 182.1 20.0 9.4 2.1

Nucor (Steel) 4.8 3.9 2.3 1.7

J. C. Penney 32.3 5.0 6.4 .78

Note: The data on market valuations are as of June 16, 2003. All other financial data is based on the most recently available balance sheets and income statements.

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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 22.4Philip 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 15.9Microsoft 4,490 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

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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

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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

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The Four Perspectives of the Balanced ScorecardThe Four Perspectives of the Balanced Scorecard

© The McGraw-Hill Companies, Inc., 1998Irwin/McGraw-Hill

Slide 4-5Exh. 4.8

Financial

Customer

Operations

Organizational

EVAProfitabilityGrowth

DifferentiationCostQuick Response

Product DevelopmentDemand ManagementOrder Fulfillment

LeadershipOrganizational LearningAbility to Change

Perspective Assessed through analysis of:

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Problems With Shareholder Wealth MaximizationProblems With Shareholder Wealth Maximization

Under what conditions does “maximizing shareholder wealth” not make sense? When do we need to pay attention to other “stakeholders?”

What are the social responsibilities of business to:

Employees?Communities?Customers?

The Issue: What are the “externalities,” and who bears the costs?

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Dynamic Measures of Performance: NPV or DCF AnalysisDynamic Measures of Performance: NPV or DCF Analysis

Competitive Advantage doesn’t happen over night; it evolves over time - So Profits may not be the best way to measure performanceFinance vs. Strategy

-

+

0

Cash Flow

Time

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Dynamic Measures of Performance Dynamic Measures of Performance NPV or DCF Analysis:NPV or DCF Analysis:

The principle of discounted cash flow (DCF) analysis that firms apply to their individual projects can also be applied to the firm as a whole.

Maximizing the net present value of the firm’s cash flow (“sustainable competitive advantage”) corresponds to maximization of its stock market valuation and hence maximizes the wealth of its shareholders.

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Net Cash FlowNet Cash FlowEBT - t (EBT) EBT (1-t) = NET INCOMEEBT (1-t) + depreciation - capital expenditures = NET CASH FLOW

• (note we are assuming no change in accounts receivable, no change in net working capital, no change in inventory)

Equivalent concepts:Maximize NPVDCF ApproachMaximize Economic Profits (EVA)Sustainable Competitive Advantage (SCA)

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Limitations of Present Value MeasuresLimitations of Present Value Measures

Projections are only as good as the ability of managers to measure accurately the financial consequences of actions.

An implicit assumption of value-based strategy was that business units and all investment proposals were self-contained. It was usually expected that divesting a business or curtailing an investment project would have no financial repercussions elsewhere in the corporation (e.g., ignores knowledge transfers).

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Limitations of Present Value MeasuresLimitations of Present Value Measures

Strict financial measurement of many long-term investments, particularly in intangible assets, is virtually impossible.

Investments in R&D typically do not offer direct returns; their value is an option to invest in new products and processes that may arise from R&D. Narrowly- defined DCF does not accurately value investments where there is significant options value.

(Note: Merck has been at the forefront of applying options theory to analyze investments in R&D).

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Capital Market Approaches To Measuring PerformanceCapital Market Approaches To Measuring Performance

Market Value Added (MVA)Market Value less Total Investment

Economic Value Added (EVA)Operating Profit (after tax) less annual capital costs; basically, this is economic profit

Tobin’s q (Market Value/Book Value)a firm’s market value divided by its “replacement” cost

The Market Value of the Firm -Current Value of all securities issued by the firm

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Economic Value Added (EVA)

Anheuser-Busch

Operating profit $1,756 million - taxes $617 million = $1,139 million

WACC : 67% equity at 14.3%

33% debt at 5.2%

11.3% WACC

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Economic Value Added (EVA)Economic Value Added (EVA)

WACC = 11.3%Capital of $8 billion

11.3% * $8billion = $904 million

$1,139 - $904 = $235 million is the EVA

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Economic Value Added (EVA)Economic Value Added (EVA)

Former CEO Roberto Goizueto introduced EVA to Coca-Cola in 1987. Its impact has been to encourage:

Divestment (e.g., pasta, wine, instant tea) where returns failed to cover the cost of capital

Increased leverage (i.e., cost of equity far exceeded the cost of debt. Their WACC fell from 16% to 12%)

Increased efficiency (e.g., inefficient plants shut down)

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The Context Of Strategy FormulationThe Context Of Strategy Formulation

Continuous Monitoring Of Strategic Situation

Decisive Moments In The Company’s History

Boeing and the 747

Nucor and the Continuous Strip Mill

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Key Characteristics Of Strategic DecisionsKey Characteristics Of Strategic Decisions

Important

Not Easily Reversible

Significant Commitment Of Resources

Involves Alternatives, Consequences, and Choice

Some Level of Uncertainty Typically Involved