GOALS, VALUES & PERFORMANCE MGMT 460 Business Planning CHAPTER 2 GOALS, VALUES & PERFORMANCE Alex Zabolotnov 1

The Concept of Strategy -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 Value Business is about creating value! Value is the monetary worth of a product or asset. The purpose of business is; First: to create value for customers Second: to extract some of that customer value in the form of profit, thereby creating value for the firm… Value can be created in two ways: by production and by commerce

PRODUCTION vs COMMERCE Production creates value by physically transforming products that are less valued by consumers into products that are more valued by consumers Turning clay into coffee mugs Turning wheat into bread

PRODUCTION vs COMMERCE Commerce creates value not by physically transforming products but by repositioning them in space and time. Trade involves transferring products from individuals and places where they are less valued to individuals and locations where they are more valued. China vs US

Value Added The difference between the value of a firm’s output and the cost of its material inputs is its value added… The value added created by firms is distributed among different parties: employees (wages and salaries), lenders (interest), landlords (rent), government (taxes) and owners (profit).

What is Profit? Profit is the surplus of revenues over costs available for distribution to the owners of the firm. But, if profit maximization is to be a realistic goal, the firm must know what profit is and how to measure it…

From Accounting Profit to Economic Profit Accounting profit is using book values, does not consider financial value of the company. Economic Profit, which is the pure surplus available after all inputs (including capital) have been paid for. Economic profit represents a purer and more reliable measure of profit that is a better measure of performance.

From Accounting Profit to Economic Profit

Economic Profit Economic profit has two main advantages over accounting profit as a performance measure. It sets a more demanding performance discipline for managers. At many capital intensive companies seemingly healthy profits disappear once cost of capital is taken into account. Using economic profit improves the allocation of capital between the different businesses of the firm by taking account of the real costs of more capital intensive businesses.

Linking Profit to Enterprise Value There is also the problem of time. Once we consider multiple periods of time, then profit maximization means maximizing the net present value of profits over the lifetime of the firm. Profit maximization translates into maximizing the value of the firm.

Enterprise Value Thus, the value of an enterprise (V) is the sum of its free cash flows (C) in each year t, discounted at the enterprise’s cost of capital (r).8 The relevant cost of capital is the weighted average cost of capital (re+d) that averages the cost of equity (re) and the cost of debt (rd) where free cash flow (C) is measured as: net operating profit + depreciation—taxes—investment in fixed and working capital

Putting Performance Analysis into Practice Challenges: How can we best appraise overall firm (or business unit) performance? How can we diagnose the sources of poor performance? How can we select strategies on the basis of their profit prospects? How do we set performance targets?

Appraising Current and Past Performance Forward-Looking Performance Measures- Stock Market Value: for public companies we do have a good indicator: stock market valuation, which represents the best available estimate of expected cash flows into the future. Thus, to evaluate the effectiveness of a firm’s CEO, we can look at the change in the market value of the firm relative to that of competitors over the CEO’s period of tenure.

Appraising Current and Past Performance Backward-Looking Performance Measures - Accounting Ratios: Given the volatility of performance measures based on stock market values, evaluation of firm performance for the purposes of assessing the current strategy or evaluating management effectiveness tends to concentrate on accounting-based performance. All of these are using historical data.

Performance Diagnosis If profit performance is unsatisfactory, we need to identify the sources of poor performance so that management can take corrective action. Diagnosis primarily involves disaggregation of return on capital in order to identify the fundamental “value drivers.” This analysis allows us to identify the sources of poor performance in terms of specific activities.

Can Past Performance Guide Strategies for the Future? The worse a company’s performance, the more likely it is that management will concentrate on the short term. For companies facing bankruptcy, such as General Motors and American Airlines long-term strategy takes a back seat; survival is the dominant concern. The role of strategy is to allow the firm to adapt to change. The challenge is to look into the future and identify factors that threaten performance or create new opportunities for profit.

Setting Performance Targets An important role for strategic planning systems is to drive corporate performance through setting performance goals then monitoring results against targets. To be effective, performance targets need to be consistent with long-term goals, linked to strategy, and relevant to the tasks and responsibilities of individual organizational members

Beyond Profit: Values and Social Responsibility In Chapter 1 we introduced the simplifying assumption that the primary goal of the firm is long-run profitability. But in reality firms are motivated by goals other than maximizing profit. “to build a motor car for the great multitude that everyone will be able to afford” (Ford) “build great planes” (Boeing)

Beyond Profit: Values and Social Responsibility Profits are to business as breathing is to life. Breathing is essential to life, but is not the purpose for living. Similarly, profits are essential for the existence of the corporation, but they are not the reason for its existence Dennis Bakke, founder of the international power company AES,

Beyond Profit: Values and Social Responsibility Google’s mission is: “. . . to organize the world’s information and make it universally accessible and useful.” “The IKEA vision is to create a better everyday life for the many people