Goals Values and Performance OUTLINE Strategy as a

Goals, Values and Performance OUTLINE • Strategy as a quest for value • What is profit? • The shareholder value approach • The shareholder value and strategy formulation • Mission and values

Strategy as a Quest for Profit • The stakeholder approach : The firm as a coalition of interest groups: pursuit of multiple 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 survive 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 as a measure of economic profit: – Post-tax operating profit less cost of capital

How U. S. Companies Perform Under Different Profitability Measures, 1998 Net Inc. ROS ($m) General Motors 2, 956 General Electric 6, 573 Exxon 6, 370 Philip Morris 5, 450 IBM 6, 328 Coca-Cola 3, 533 Wal-Mart 4, 430 Procter & Gamble 3, 780 Microsoft 4, 490 31. 0 Hewlett-Packard 2, 945 (%) 1. 8 9. 4 6. 3 10. 3 7. 7 18. 8 3. 2 10. 2 27. 0 6. 3 ROE (%) 19. 7 22. 2 14. 6 39. 0 32. 6 42. 0 21. 0 12. 2 3, 776 17. 4 EVA Market Return to Value Added Shareholders ($m) (%) -5, 525 -17, 943 21. 4 4, 370 285, 320 45. 3 -2, 262 114, 774 22. 4 5, 180 98, 657 64. 8 2, 541 -5, 878 77. 5 2, 194 157, 356 1. 3 1, 159, 444 107. 7 61, 661 102, 379 15. 9 328, 257 37. 5 -593 45, 464 10. 7

Value Maximization Maximizing the value of the firm: Max. net present value of max. V = t free cash flows : Ct (1 + re)t Where: V market value of the firm. Ct free cash flow in time t re+d weighted average cost of capital

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 )2 (1 + r )3 where: VH is the horizon value of the firm after 4 years

Problems of DCF Approaches to Strategy Approach • Several technical and theoretical problems (e. g. option values) • Estimating cash flows beyond 2 -3 year horizon is hazardous---especially in dynamic markets HENCE: - Some simple guidelines for maximizing shareholder value -- • On existing assets-- maximize after-tax rate of return • On new investment-- seek after-tax rate of return > cost of capital

The six levers of financial and real options Financial options OPTION VALUE Real options Comments Present value of returns to the investment The greater the NPV, the higher the option value Stock price = Exercise price = Investment cost The higher the cost, the lower the option value Uncertainty = Uncertainty Higher volatility increases option values Time to expiry Dividends = Duration of option = Time = opportunity to learn about outcomes Loss of cash flow to fully Value lost over duration of option -committed competitors lowers option value Risk-free Interest rate = Risk-free interest rate Higher interest rate increases option value by increasing value of deferring investment

Disaggregating Return on Capital Employed COGS/Sales Return on Sales Depreciation/ Sales SGA expense/ Sales ROCE Fixed Asset Turnover Sales/PPE Inventory Turnover Sales/Inventories Sales/Capital Employed Creditor Turnover Sales/Acct Turnover of other items of working capital

Linking Value Drivers to Performance Targets Sales Targets Margin Shareholder value creation Development Cost/Sales ROCE Economic Profit cogs/ sales Inventory Turnover Capital Turnover Capacity Utilization Cash Turnover CEO Corporate/Divisional Functional 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 Departments & Teams

Balanced Scorecard for Mobil N. American Marketing & Refining Strategic Objectives Financially Strong Delight the Consumer Win-Win Relationship Safe and Reliable Competitive Supplier Good Neighbor F I N A N C I A L CO UM SE TR - On Spec On time Motivated and Prepared F 1 Return on Capital Employed F 2 Cash Flow F 3 Profitability F 4 Lowest Cost F 5 Profitable Growth F 6 Manage risk * * * C 1 Continually delight the targeted consumer * Share of segment in key markets * Mystery shopper rating C 2 Improve dealer/distributor profitability * Dealer/distributor margin on gasoline * Dealer/distributor survey I 1 Marketing 1. Innovative products and services 2. Dealer/distributor quality I N T E R N A L & G R O W T H ROCE Cash Flow Net Margin Full cost per gallon delivered to customer Volume growth rate Vs. industry Risk index * Non-gasoline revenue and margin per square foot * Dealer/distributor acceptance rate of new programs * Dealer/distributor quality ratings I 2 Manufacturing 1. Lower manufacturing costs 2. Improve hardware and performance * * I 3 Supply, Trading, Logistics 1. Reducing delivered cost 2. Trading organization 3. Inventory management Delivered cost per gallon. Vs. competitors * Trading margin * Inventory level compared to plan & to output rate I 4 Improve health, safety, and environmental performance * Number of incidents * Days away from work I 5 Quality L E A R N I N G Strategic Measures ROCE on refinery Total expenses (per gallon) Vs. competition Profitability index Yield index * Quality index L 1 Organization Involvement * Employee survey L 2 Core competencies and skills * Strategic competing (? ) availability L 3 Access to strategic information * Strategic information availability

A Comprehensive Value Metrics Framework 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

Values and Mission The role of 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.