strategic management ch02

© 2006 by Nelson, a division of Thomson Canada Limited. 2-1

Strategic Management and Firm Performance

Chapter Two

© 2006 by Nelson, a division of Thomson Canada Limited.


The Strategic Management

Process

Chapter 5: Bus.-Level Strategy

Chapter 6:Competitive Dynamics

Chapter 7:Corp.-Level

Strategy

Chapter 8:Acquisition & Restructuring

Chapter 9:International

Strategy

Chapter 10:Cooperative

Strategy

Strategy Formulation

Chapter 11:Corporate

Governance

Ch. 12: Org. Structure & Controls

Chapter 13:Strategic

Leadership

Chapter 14:Org. Renewal & Innovation

Strategy Implementation

StrategicActions

Ch. 1: Strat. Mgmt. & Com-petitiveness

Chapter 3:The External Environment

Chapter 4:The Internal Environment

Strategic Competitiveness

Strategic Mission & Strategic Intent

Strategic Objectives & Inputs

Chapter 1: Strategic

ManagementStrategic

Competitiveness Ch. 2: Strat. Mgmt . &

Performance

Ch. 2: Strat. Mgmt . &

Performance


Strat. Management & Firm Performance

Knowledge Objectives:1. Understand the ultimate goal of strategic mgmt. – to

impact organizational performance.2. Defining performance, particularly the differences

among above-average returns, average returns and below-average returns.

3. Discuss the different ways in which organizational performance is measured.

4. Know the strengths and weaknesses of different measures of organizational performance.

5. Define corporate social responsibility, sustainability, and the triple bottom line.


Defining Performance

An organization is an association of productive assets who have voluntarily come together to accomplish a set of goals.

The goal is to gain an economic advantage.


What Is Performance?

An important question in the study of firms.

What is performance?

• The person who runs 100 meters the fastest

• The person who jumps the highest

• The team who wins the Stanley Cup in the NHL

In athletics, it’s straightforward:

For firms, it’s when the company successfully formulates & implements a value-creating strategy.

an *


Levels of Performance

Below-normal When the actual value created is less than the value owners expectations

Normal performance Occurs when the actual value created is equal to the expected value

Above-normal When the actual value created is greater than the expected value


Defining Organizational Performance

What is received for what is given.

For customers: ‘Did I receive more than I gave?’

• If the answer is yes, value was created. • If the answer is no, value was destroyed.

?? The Concept of Value…

For shareholders: Value creation means getting more from an investment than could have been received from another investment with similar risk.


Firm Performance

• Above average returns: Returns in excess of what an investor expects to earn from other investments with similar risk.

• Average returns: Returns equal to an investor expects from other investments with similar amount of risk.

• Below average returns: Those that are less than expected given a similar level of risk.


Approaches to Firm Performance

1. Firm Survival

3. Multiple Stakeholder Approach

4. Present Value

5. Market-based Measures

6. Market Value Added / Economic Value Added

7. The Balanced Scorecard

8. Corporate social responsibility

2. Accounting Measures


Firm Survival & Firm Performance

Altman’s Z =

+ .033

+ .006

.012

+ .014

+ .100

Earnings Before Interest & TaxesTotal Assets

Market Value of Firm Equity

Book Value of Firm Debt

Total Assets

Working Capital

Retained EarningsTotal Assets

SalesTotal Assets

*



- 0 1.8 3.2 10

Altman’s Z

*

Likely to SurviveGrey Grey AreaArea

Likely to fail



+ It’s a simple and relatively obvious measure.

- It is sometimes difficult to know when a firm no longer exists.

- Death of a firm can sometimes occur over a relatively long period of time.

- It does not provide any information concerning above average returns.


Profitability Ratios 1 / 2

Accounting Measures & Firm Performance

Measures the revenue left to cover operating expenses after taking out the cost of

procurement

Gross Profit Margin

Operating Profit Margin

Net Profit Margin

(Return on Sales)

Ratio Calculation What the Ratio Means

Sales–Cost of goods sold Sales

Profit before interest & taxes Sales

Profits after taxes Sales

Assesses firm profitability without regard to interest charges as a result of the

capital structure

After tax profits per dollar of sales


Profitability Ratios 2 / 2

Measures the return on the total investment in the firm

Return on

Total Assets

Return on shareholders

equity

Return on common equity

Earnings per share

PAT–Preferred stock dividends Total shareholders’ equity

Return on investment common shareholders have

made in the firm

Profit after taxes+interest

Total assets

Profit after taxes (PAT) Total shareholders’ equity

Rate of return to share-holders given their

investment in the firm

Earnings available to common shareholders

PAT–Preferred stock dividends # common shares outstanding




Liquidity Ratios

Ability to cover ST debt with assets convertible to cash in the

period ST debt matures

Current ratio

Quick ratio

(Acid-Test Ratio)

Inventory to net working

capital

Current AssetsCurrent Liabilities

Ability to pay off short-term debt without relying on

inventory

Measure to which firm’s working capital is tied up

in inventory

InventoryCurrent assets-current liabilities

Current assets-InventoryCurrent liabilities



*


Leverage Ratios 1 / 2

Measures use of debt to finance operations

Debt-to-assets ratio

Debt-to-equity ratio

Long-term debt to

equity ratio

Balance between debt & equity in long-term capital

structure of firm

Total debt Total assets

Use of debt relative to shareholders’

investment in firm

Total debtTotal shareholders equity



Long-term debt Total shareholders equity


Leverage Ratios 2 / 2

Measures how much profits can decline before firm is unable to meet its interest

obligations

Times interest earned

Fixed- charge coverage

Profits before interest & taxes Total interest charges

More inclusive measure of ability of firm to handle all

of fixed-charge obligations


Profits before interest & taxes + Lease obligations

Interest charges + Lease

obligations



Misc. Ratios - Shareholder Returns

Measures return to common shareholders

Dividend yield on

common stock

Price/Earning ratio

Dividend payout ratio

Market perception of firm Faster-growing / less risky firms tend to have higher P/E ratios


Indicates dividends paid out as a % of profits

Annual dividends per share After-tax earnings per share

Current market price per share

After-tax earnings per share

Annual dividends per share Current market price per

share



Miscellaneous Ratios

Measures total cash per share available to firm

Cash Flow per Share

Break-even analysis

After-tax profits+depreciation

# of common shares outstanding

Measures the number of units that need to be sold to

begin to make a profit on that product or service


Fixed costs Contribution margin

Contribution margin = (Selling price/unit) – (variable price/unit)




+ Easily available for publicly traded firms

+ Stock exchanges stress quality accounting data . as a tool for investor decisions

+ Broad support for use as a performance measure

+ May provide insights to economic rates of return

However, they - May have a built in short‑term bias

- Are subject to manipulation by managers

- Undervalue intangible assets

$ $ $Accounting Measures are Popular in Analysis


Multiple Stakeholder Approach & Firm Performance

(The firm must maintain performance at an adequate level in order to maintain the participation of key groups affected by the firm.)

Firm

Capital Market

Stock market/Investors

Debt suppliers/Banks

Product Market

Primary Customers Suppliers

Organizational

EmployeesManagersNon-Managers

The trouble is that each group seldom has the same goals in mind


Present Value & Firm Performance

Avoid short-term bias by measuring cash flows over time.

Value all resources made available to a firm by using the discount rate concept.(Estimate net cash flows and expected discount rates for several years into the future.)

Allow assessment of firm and/or project’s performance on a forward-looking basis.

Net Present Value < 0 Below average returnsNet Present Value = 0 Average returnsNet Present Value > 0 Above average returns


+ Close link between present value

& the conceptual definition of performance

.


Strengths

+ Positive net present-value strategies

should maximize the wealth of shareholders

In doing so they will likely generate

enough cash to satisfy other stakeholders

+s


- Misjudging prediction of cash flow patterns several years into the future.


Weaknesses

- Cash flows on projects worth billions & lasting decades may be a problem.

- Hard to assess the firm’s systematic risk. - (Beta) & such risk may change over time.

But, researchers question the adequacy of the economic model on which the beta estimation is based. (Capital Asset Pricing Model: CAPM)

- s

- Measuring the discount rate is a problem.


The use of net present-value (NPV) must be done with it’s limitations in mind.


But using Present Value may allow for a deeper understanding of firm performance.


Stock Market measures

Market - Based Measures & Firm Performance

in essence:

S* - RFR* a + b ( M–RFR*) + e

% change in stock price *

–Risk free rate of

return *

=

=* For 250 trading days

Risk-free rate of return for firm’s stock +

Systematic risk in the stock market [Beta] X

% change in daily Risk free rate closing value of the - of return *

stock market index * .+

Residual obtained when estimating risk free rate and systematic risk



We can thus derive some essential formulas:

* For 250 trading days

• Sharpe’s measure is used to assess return per unit of total risk. • Sharpe’s=% change in stock price*-Risk free rate of return* Standard Deviation of % change in stock price*

• Treynor’s measure is used to assess return per unit of systematic risk• Treynor’s=% change in stock price*-Risk free rate of return* Systematic risk in the stock market [Beta]



• Jensen’s Alpha is used to assess return . relative to risk free return. • Jensen’s Alpha = Risk-free rate of return for firm’s stock*

• Appraisal Ratio is used to measure the risk free return per unit of unsystematic risk. • Appraisal Ratio = Risk-free rate of return for firm’s stock*

. Residual obtained when estimating free rate and systematic risk

* For 250 trading days



+ These measures may more accurately reflect econ. performance than accounting based measures. .

. Useful for assessing econ. value of a given strategy or . choosing between strategies that could be implemented.

Strategy researchers have increasingly relied on market-based measures of firm performance.This increased use may partially be a response to the criticisms of accounting-based measures.

+

+s

+ Market-based measures focus on the present value of future streams of income, (e.g., expected value of future cash flows) not past performance.



These measures were not originally designed for measurement of firm performance but portfolios.

-

Sharpe’s & Treynor’s measures implicitly use the risk-free rate as cost of capital & is thus a problem when assessing smaller firms.

-

Treynor Measure assumes unsystematic risk is fully diversified away. While appropriate for investment portfolios it may not be so for firms.

-

The need to use Market indexes like the TSE300 means heavily weighted firms like Nortel Networks over-influence the index.

-

- s



Although the four measures have limitations, they provide insight into the ability of a firm to achieve above-average returns, average returns or below-average returns.

!

Correlations between the accounting measures & market measures are only 0.15 to 0.30.

!

This suggests that market measures tell us something different about performance than accounting measures.


Market Value Added (MVA) is:The difference between the cash investors expect to receive given the firm’s current market value and the amount of cash that debt & equity holders have invested in the firm since inception.

$75 billion Current total market value of the firm

- $20 billion Given by firm debt holders- $15 billion Given by firm equity holders - $30 billion Retained from operations

Market Value Added / Economic Value Added & Firm Performance

$10 billion MVA


Economic Value Added (EVA) is:

An internal measure of a firm’s ability to generate MVA in the future.


The amount of operating capital at the beginning of each year times the difference between the rate of return on capital & the weighted average cost of the debt & equity capital employed.

The present value of all projected EVAs = MVA


Economic Value Added (EVA)

To create shareholder value, any or all of these will increase EVA:


1. Improve return on capital already employed. (generate more profits without employing more capital)

2. Invest more capital in strategies having a greater rate of return than the cost of the capital employed.

3. Withdraw capital from strategies/projects having a cost of capital greater than their rate of return.


The 2003 Stern Stewart 1000 MVA Rating

7.8%307.0%6 (2,174)84,379Exxon Mobil Corp108

8.7%19.1%5 3,872 103,664Merck & Co115

9.0%15.0%14 2,839 116,396 Johnson & Johnson74

8.8%13.0%17 2,935182,769Wal-Mart Stores33

8.1%14.5%1 5,946 183,386General Electric Co.22

CoC ‘02ROC ‘021997 EVA ‘02MVA ‘02Company name20012002

13.6%17.7%2 1,076219,165Microsoft Corp.11

6.9%17.5%4 2,44692,015Coca Cola Co.136

8.0%13.0%9 1,92589,722 Procter & Gamble 167

11.6%9%18 (8,032)75,175 Intl. Business Machines59

10.3%9%- 2,96468,078Citigroup610

10.4%4.8%34 (8,695)(25,862) SBC Communications72996

14.1%-12.8%487 (10,902)(36,006)JDS Uniphase Corp.999997

10.1%-22.1%30 (20,802)(37,218)Lucent Technologies1000998

9.5%-8.7%28 (28,484)(64,071)A T & T Corp.998999

9.4-8.0%99 (32,747)(83,005)A O L Time Warner Inc.9971000

© 2003 Stern Stewart



MVA is considered an estimate of the NPV of all the firm’s capital projects, both ongoing & anticipated by investors.

MVA - a good measure of shareholder wealth creation or destruction that also captures the ability of the firm’s senior leaders to manage the firm’s capital.

+

+ Positive EVA/MVAs suggest that firms are maximizing shareholder wealth and that these firms are efficiently allocating the resources flowing to them.

+ Changes over time should be examined closely by a firm’s stakeholders. This may be a more effective measure than absolute EVA/MVA at one point in time.

+s



EVA does not assess econ. profit (the difference in econ. value at 2 points in time) but accounting income.

-

There is a lack of consistent definitions for EVA, capital, and net operating profit after taxes.

-

EVA is too complex, requiring 160 adjustments under Generally Accepted Accounting Principles.

-

EVA is an inadequate single measure for decisions in that it only measures short-term profitability.

-

Given EVA is a short-term measure, it may be wrong to reward managers based only on EVA.

-

EVA is not appropriate for capital budgeting.-

- - ss



MVA/EVA is easy for managers to manipulate and it may create undesirable impacts:

EVA requires capitalization of R&D even if such expenditures may have no future value.

-

Managers could develop a short-term bias.-Managers could decide to spend little or no time on quality improvement.

-

EVA permits capitalization of restructuring charges & may lead to unnecessary restructuring.

-

EVA permits the holding back of expenditures as assets even if they have no future value.

-

- - ss



Less than 20 adjustments

may be needed but which

20 will vary between each

firm and be based on the

industry in which it

operates.

An educated approach to the required

160 adjustments is needed.



Assessing future direction of a firm’s EVA & knowing its value-creating / destroying capabilities allows one to derive likely scenarios for future stock prices.

EVA methodology, applied appropriately, may be very valuable in unveiling hidden investment opportunities & over-valued projects and strategies.


The Balanced Scorecard

• Brings financial measures of previous performance together with measures of the drivers of future performance.

• The Balanced Scorecard translates a business units mission into tangible objectives and measures.


The Balanced Scorecard

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What bus. processes must we excel at to satisfy shareholders & customers?

How do we appear to shareholders to succeed financially?

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What is critical to success?

How is it measured?

Performance expectation?

Key action Programs?

What is critical to ask?

© 1996 HBR Publishing


Sustainability and the Triple Bottom Line

• Sustainability:

The capability of present generations to meet

their needs without compromising the capability

of future generations to meet their needs.

• The Triple Bottom Line:

A framework for measuring and reporting firm performance against economic, environmental and social parameters.


Best Corporate Citizens Rankings’04 C o m p a n y N a m e

• Zenon Environmental Inc. • MDS Inc. • Alcan Inc.• Dofasco Inc. • Tembec Inc.• Bank of Montreal• Royal Bank of Canada• TransAlta Corporation• Great West Lifco Inc.• Suncor Energy Inc.• Enbridge Inc.• TransCanada Pipelines Ltd.

’03 C o m p a n y N a m e

1. Alcan Inc.2. Royal Bank of Canada3. Suncor Energy Inc.4. Nexen Inc.5. CIBC6. Bank of Nova Scotia 7. Domtar Inc.8. Manitoba Telecom Services9. Nova Chemicals Corp,10. BMO Financial Group11. Enbridge Inc.12. Shell Canada

© 2004 Corp. Knights


The Strategic Management

Process

Chapter 5: Bus.-Level Strategy

Chapter 6:Competitive Dynamics

Chapter 7:Corp.-Level

Strategy

Chapter 8:Acquisition & Restructuring

Chapter 9:International

Strategy

Chapter 10:Cooperative

Strategy

Strategy Formulation

Chapter 11:Corporate

Governance

Ch. 12: Org. Structure & Controls

Chapter 13:Strategic

Leadership

Chapter 14:Org. Renewal & Innovation

Strategy Implementation

StrategicActions

Chapter 3:The External Environment

Chapter 4:The Internal Environment

Strategic Competitiveness

Strategic Mission & Strategic Intent

Strategic Objectives & Inputs

Chapter 1: Strategic

ManagementStrategic

Competitiveness Ch. 2: Strat. Mgmt . &

Performance

Ch. 2: Strat. Mgmt . &

Performance

strategic management ch02

Education

firm performance chapter

firm profitability

levels of performance

actual value

economic value

firm earnings available

value creation

present value