Economic Foundations of Strategy
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Transcript of Economic Foundations of Strategy
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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.
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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