Contemporary Strategy Analysis PDF

CONTEMPORARY STRATEGY ANALYSIS Eleventh Edition Robert M. Grant Chapter 2 Goals, Values, and Performance Wiley 1  Goals, Values, and Performance OUTLINE S...

CONTEMPORARY STRATEGY ANALYSIS Eleventh Edition Robert M. Grant Chapter 2 Goals, Values, and Performance Wiley 1  Goals, Values, and Performance OUTLINE Strategy as a quest for value Putting performance analysis into practice Beyond profit: values and corporate social responsibility Beyond profit: strategy and real options Copyright © 2022 John Wiley & Sons, Inc.  STRATEGY AS A QUEST FOR VALUE What is Business For?  Every business has a unique purpose—often reflecting the motives of the founder(s) E.g. Henry Ford (Ford Motor Company), Steve Jobs (Apple), Jack Ma (Alibaba) were each motivated by a distinct vision.  Common to every business enterprise: the desire/need to create value  Value is the monetary worth of a product. Hence, the purpose of business is 1)to create value for customers 2)to appropriate some of that value in the form of profit—in order to ensure the survival of the firm Copyright © 2022 John Wiley & Sons, Inc. STRATEGY AS A QUEST FOR VALUE Value Creation A. Profit = B. Value created = Revenue Consumer surplus minus Cost plus Producer surplus Consumer Surplus Price paid Profit Profit by $ “Rents” to Producer customers input surplus providers Total revenue Real cost of Accounting production cost Units of output Units of output Copyright © 2022 John Wiley & Sons, Inc.  STRATEGY AS A QUEST FOR VALUE Value for Whom? Shareholders vs Stakeholders The shareholder approach The stakeholder approach The firm exists to maximize the wealth The firm is a coalition of interest groups of its owners —it must create value for them all To simplify strategy analysis we assume that the primary goal of the firm is maximizing profit over its lifetime Rationale: 1) Competition: To survive a firm must earn return on capital > cost of capital. This is difficult when competition is strong. 2) Acquisition: Firms that do not maximize profits are vulnerable to acquisition. 3) Convergence of interests: long run profitability requires satisfied customers, motivated employees, and good relations with governments and communities. Primary concern of strategy analysis: to identify and access the sources of profit available to the firm Copyright © 2022 John Wiley & Sons, Inc.  PROFIT, CASH FLOW, AND ENTERPRISE VALUE What is Profit? Different Measures Give Different Rankings (data for 2020) Market Return to capitalization Net income ROS ROE ROA shareholders Company ($ billion) ($ billion) (%) (%) (%) (%) Apple 2150 57.4 23.8 73.7 17.3 +185 Amazon 1580 21.3 5.9 27.4 7.8 +107 Alibaba 655 21.5 18.7 23.9 13.1 +24 JPMorgan Chase 459 29.0 28.7 10.7 0.9 +27 Roche Holding AG 281 15.6 30.4 41.4 16.9 +34 Wal-Mart Stores, Inc. 371 13.5 4.0 17.3 5.5 +25 Toyota Motor Corp. 208 19.6 7.9 10.3 4.0 +18 Copyright © 2022 John Wiley & Sons, Inc.  PROFIT, CASH FLOW, AND ENTERPRISE VALUE Linking Profit to Enterprise Value Profit maximization an ambiguous goal: – Total profit vs. Rate of profit – Over what time period? – What measure of profit? – Accounting profit versus economic profit Maximizing enterprise value is clearer: Enterprise value (V) = Net present value of free cash flows: = Σt Ct (1 + WACC)t Where: Ct = free cash flow in time t WACC = weighted average cost of capital Copyright © 2022 John Wiley & Sons, Inc.  PROFIT, CASH FLOW, AND ENTERPRISE VALUE Value Maximization and Strategy Choice In principle, DCF approach to enterprise value maximization is the correct approach to choosing a strategy:  Identify strategy alternatives  Estimate cash flows and cost of capital for each strategy  Select the strategy which generates the highest NPV. But in practice:  Difficult to estimate cash flows more than 2 or 3 years ahead  Hence, value maximization may encourage short-termism. Implications for strategy analysis:  Simple guidelines can approximate value maximization, e.g. a) On existing assets—maximize rate of return b) On new investment—ensure rate of return > cost of capital  Use qualitative strategy analysis to evaluate future profit potential. Copyright © 2022 John Wiley & Sons, Inc.  PROFIT, CASH FLOW, AND ENTERPRISE VALUE Profitability Ratios Ratio Formula Notes Return on Capital Operating profit, before The return on the capital invested in a Employed (ROCE) interest and tax business. ROCE is also known as return on Equity + Debt invested capital. The numerator can be operating profit or earnings (EBIT). Return on Equity Net income Measures the firm's success in using (ROE) Shareholders’ equity shareholders’ capital to generate profits that are available to remunerate investors. Return on Assets Operating profit The numerator should be the return on all the (ROA) Total assets company’s assets—e.g. operating profit, EBITDA (earnings before interest, tax, depreciation, and amortization), or EBIT (earnings before interest and tax). Gross margin Sales – cost of material inputs Gross margin measures how much value a firm Sales adds value to the goods and services it buys in. Operating margin Operating profit / Sales Operating margin and net margin measure a firm's ability to extract profit from its sales, but influenced by differences in capital intensity Net margin Net income / Sales between different types of business. Copyright © 2022 John Wiley & Sons, Inc.  PROFIT, CASH FLOW, AND ENTERPRISE VALUE Enterprise Value and Shareholder Value Enterprise value = Market capitalization of equity + Market value of debt Reasons for preferring maximization of enterprise value over maximization of shareholder value: Not always easy to distinguish debt from equity Shareholder value maximization has become discredited by its misapplication by managers (e.g. in emphasizing short-term profits and in seeking to manipulate reported earnings). Copyright © 2022 John Wiley & Sons, Inc.  PUTTING PERFORMANCE ANALYSIS INTO PRACTICE Profitability Ratios Ratio Formula Notes Return on Capital Operating profit, before The return on the capital invested in a Employed (ROCE) interest and tax business. ROCE is also known as return on Equity + Debt invested capital. The numerator can be operating profit or earnings (EBIT). Return on Equity Net income Measures the firm's success in using (ROE) Shareholders’ equity shareholders’ capital to generate profits that are available to remunerate investors. Return on Assets Operating profit The numerator should be the return on all the (ROA) Total assets company’s assets—e.g. operating profit, EBITDA (earnings before interest, tax, depreciation, and amortization), or EBIT (earnings before interest and tax). Gross margin Sales – cost of material inputs Gross margin measures how much value a firm Sales adds value to the goods and services it buys in. Operating margin Operating profit / Sales Operating margin and net margin measure a firm's ability to extract profit from its sales, but influenced by differences in capital intensity Net margin Net income / Sales between different types of business. Copyright © 2022 John Wiley & Sons, Inc.  PUTTING PERFORMANCE ANALYSIS INTO PRACTICE Performance Diagnosis: Disaggregating ROA COGS/Sales Sales Depreciation/Sales Margin SGA expense/Sales ROA Fixed asset turnover (Sales/PPE) Inventory Turnover (Sales/Inventories) Sales/Assets Creditor Turnover (Sales/Receivables) Turnover of other items of working capital Copyright © 2022 John Wiley & Sons, Inc. PUTTING PERFORMANCE ANALYSIS INTO PRACTICE Why UPS (U) earns Labor costs/Sales U: 52.7% F: 37.2% a higher ROA than Fuel costs/Sales and Fedex (F) U: 3.7% F: 5.8% Operating Maintenance/Sales Margin U: 2.7% F: 4.1% U: 13.4% F: 6.3% Depreciation/Sales U: 3.7% F: 7.0% ROA U: 13.2% Other costs/Sales F: 7.1% U: 18.4% F: 21.2% PPE turnover U: 2.44 F: 2.03 Sales/Assets U: 1.35 Receivables turnover F: 1.13 U: 7.33 F: 7.29 Cash turnover U: 17.3 F: 19.6 Copyright © 2022 John Wiley & Sons, Inc. PUTTING PERFORMANCE ANALYSIS INTO PRACTICE Linking Value Drivers to Order Size Performance Targets Sales Customer Mix Targets Sales/Account Customer Churn cogs/ Rate Margin sales Deficit Rates Cost per Delivery Development Maintenance cost Shareholder New product value Cost/Sales ROCE development time creation Indirect/Direct Labor Inventory Customer Economic Turnover Complaints Profit Downtime Capital Capacity Turnover Accounts Payable Utilization Time Cash Accounts Turnover Receivable Time CEO Corporate/Divisions Functions Depts. & Teams PUTTING PERFORMANCE ANALYSIS INTO PRACTICE Balanced Scorecard for a Regional Airline Simplified Strategy Performance Targets Initiatives Map Measures Financial Market Value 25% per year Optimize routes Increase Seat Revenue 20% per year Standardize planes Profitability Plane Lease Cost 5% per year Lower Increase Cost Revenue Customer More On-time arrival First in industry Quality management Cust- rating 98% satisfaction Customer loyalty On-time omers Flights Customer ranking 5% increase in program Low Number of customers customer numbers Prices Internal On Ground Time