Goals, 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 Profit
The 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.

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?
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 21.4
General Electric 6,573 9.4 22.2 4,370 285,320 45.3
Exxon 6,370 6.3 14.6 -2,262 114,774 22.4
Philip Morris 5,450 10.3 39.0 5,180 98,657 64.8
IBM 6,328 7.7 32.6 2,541 -5,878 77.5
Coca-Cola 3,533 18.8 42.0 2,194 157,356 1.3
Wal-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
Microsoft 4,490 31.0 27.0 3,776 328,257 37.5
Hewlett-Packard 2,945 6.3 17.4 -593 45,464 10.7

How U.S. Companies Perform Under
Different Profitability Measures, 1998
Value Maximization
Maximizing the value of the firm:

Max. net present value of free cash flows :


max. V =


(1 + r
e
)
t
C
t
Where:
V market value of the firm.
C
t
free cash flow in time t
r
e+d
weighted average cost
of capital
t
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 Units
If net case flow growing at constant rate (g)

V = C
1

( r - g )

With varying cash flows which can be forecasted
for 4 years:

V = C
0
+ C
1
+ C
2
+ C
3
+ V
H

(1 + r ) (1 + r )
2
(1 + r )
3
(1 + r )
3


where: V
H
is the horizon value of the firm after 4 years
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 is
hazardous---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
OPTION
VALUE
Financial options Real options
Stock price
Exercise price
Uncertainty
Time to expiry
Dividends
Risk-free
Interest rate
Risk-free
interest rate
Value lost over
duration of option
Duration of option
Uncertainty
Investment cost
Present value of
returns to the
investment
=
=
=
=
=
=
The greater the NPV, the
higher the option value
The higher the cost, the
lower the option value
Higher volatility
increases option values
Time = opportunity to
learn about outcomes
Loss of cash flow to fully
-committed competitors
lowers option value
Higher interest rate
increases option value
by increasing value of
deferring investment
Comments
The six levers of financial and real options
ROCE
Return on
Sales
Sales/Capital
Employed
COGS/Sales
Depreciation/
Sales
SGA expense/
Sales
Fixed Asset Turnover
Sales/PPE
Inventory Turnover
Sales/Inventories
Creditor Turnover
Sales/Acct
Turnover of other
items of working
capital
Disaggregating Return on Capital Employed
Shareholder
value
creation
ROCE
Economic
Profit
Margin
Capital
Turnover
Sales
Targets
cogs/
sales
Development
Cost/Sales
Inventory
Turnover
Capacity
Utilization
Cash
Turnover
Order Size
Customer Mix
Sales/Account
Customer Churn
Rate
Deficit Rates
Cost per Delivery
Maintenance cost
New product
development time
Indirect/Direct
Labor
Customer
Complaints
Downtime
Accounts Payable
Time
Accounts
Receivable Time
CEO Corporate/Divisional Functional
Departments & Teams
Linking Value Drivers to Performance Targets
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

Strategic Objectives
Financially
Strong
* ROCE
* Cash Flow
* Net Margin
* Full cost per gallon delivered to customer
* Volume growth rate Vs. industry
* Risk index
Strategic Measures
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
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
I
N
T
E
R
N
A
L
* 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 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
Safe and
Reliable
Competitive
Supplier
Good Neighbor
On Spec
On time
Motivated
and
Prepared
Balanced Scorecard for Mobil N. American Marketing & Refining
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

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:
a) Have a missionThey 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 Boeings 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 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.