© 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.2-2 Chapter 5 Bus. - Level Strategy Chapter 6 Competitive Dynamics Chapter 7 Corp. - Level Strategy Chapter 9 International Strategy Chapter 10 Cooperative Strategies Chapter 8 Acquisitions & Restructuring Chapter 11 Corporate Governance Chapter 12 Structure & Control Chapter 13 Strategic Leadership Chapter 14 Entrepreneurship & Innovation Strategic Inputs Strategic Actions Strategic Outcomes Chapter 4 Internal Environment Chapter 3 External Environment Strat. Intent Strat. Mission The Strategic. Management. Process Strategy Formulation Strategy Implementation Strategic Competitiveness Chapter 1 Above Average Returns Chapter 2 Feedback Strategic Competitiveness Chapter 1 Above Average Returns Chapter 2

© 2006 by Nelson, a division of Thomson Canada Limited.2-3 Strategic Management and Firm Performance Knowledge objectives: 1.Understand the ultimate goal of strategic management – 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.

© 2006 by Nelson, a division of Thomson Canada Limited.2-4 Strategic Management and Firm Performance Knowledge objectives – continued… 4. Know the strengths and weaknesses of different measures of organizational performance. 5.Define corporate social responsibility, sustainability, and the triple bottom line.

© 2006 by Nelson, a division of Thomson Canada Limited.2-5 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.

© 2006 by Nelson, a division of Thomson Canada Limited.2-6 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 *

© 2006 by Nelson, a division of Thomson Canada Limited.2-7 Levels of Performance Below-normalWhen the actual value created is less than the value owners expectations Normal performanceOccurs when the actual value created is equal to the expected value Above-normalWhen the actual value created is greater than the expected value

© 2006 by Nelson, a division of Thomson Canada Limited.2-8 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.

© 2006 by Nelson, a division of Thomson Canada Limited.2-9 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.

© 2006 by Nelson, a division of Thomson Canada Limited.2-10 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

© 2006 by Nelson, a division of Thomson Canada Limited.2-11 Firm Survival & Firm Performance Altman’s Z = Earnings Before Interest & Taxes Total Assets Market Value of Firm Equity Book Value of Firm Debt Total Assets Working Capital Retained Earnings Total Assets Sales Total Assets *

© 2006 by Nelson, a division of Thomson Canada Limited.2-12 Firm Survival & Firm Performance Altman’s Z * Likely to Survive Grey Area Likely to fail

© 2006 by Nelson, a division of Thomson Canada Limited.2-13 Firm Survival & Firm Performance +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.

© 2006 by Nelson, a division of Thomson Canada Limited.2-14 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) RatioCalculation 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

© 2006 by Nelson, a division of Thomson Canada Limited.2-15 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 Accounting Measures & Firm Performance RatioCalculation What the Ratio Means

© 2006 by Nelson, a division of Thomson Canada Limited.2-16 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 Assets Current Liabilities Ability to pay off short-term debt without relying on inventory Measure to which firm’s working capital is tied up in inventory Inventory Current assets-current liabilities Current assets-Inventory Current liabilities Accounting Measures & Firm Performance RatioCalculation What the Ratio Means *

© 2006 by Nelson, a division of Thomson Canada Limited.2-17 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 debt Total shareholders equity Accounting Measures & Firm Performance RatioCalculation What the Ratio Means Long-term debt Total shareholders equity

© 2006 by Nelson, a division of Thomson Canada Limited.2-18 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 Accounting Measures & Firm Performance Profits before interest & taxes + Lease obligations Interest charges + Lease obligations RatioCalculation What the Ratio Means

© 2006 by Nelson, a division of Thomson Canada Limited.2-19 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 Accounting Measures & Firm Performance 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 RatioCalculation What the Ratio Means

© 2006 by Nelson, a division of Thomson Canada Limited.2-20 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 Accounting Measures & Firm Performance Fixed costs Contribution margin Contribution margin = (Selling price/unit) – (variable price/unit) RatioCalculation What the Ratio Means

© 2006 by Nelson, a division of Thomson Canada Limited.2-21 Accounting Measures & Firm Performance + 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 into 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

© 2006 by Nelson, a division of Thomson Canada Limited.2-22 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 Employees Managers Non-Managers The trouble is that each group seldom has the same goals in mind

© 2006 by Nelson, a division of Thomson Canada Limited.2-23 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 returns Net Present Value = 0 Average returns Net Present Value > 0 Above average returns

© 2006 by Nelson, a division of Thomson Canada Limited Close link between present value & the conceptual definition of performance. Present Value & Firm 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+s

© 2006 by Nelson, a division of Thomson Canada Limited Misjudging prediction of cash flow patterns several years into the future. Present Value & Firm Performance 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.

© 2006 by Nelson, a division of Thomson Canada Limited.2-26 The use of net present-value (NPV) must be done with it’s limitations in mind. Present Value & Firm Performance But using Present Value may allow for a deeper understanding of firm performance.

© 2006 by Nelson, a division of Thomson Canada Limited.2-27 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

© 2006 by Nelson, a division of Thomson Canada Limited.2-28 Market - Based Measures & Firm Performance We can thus derive some essential formulas: 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* 1 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] 2

© 2006 by Nelson, a division of Thomson Canada Limited.2-29 Market - Based Measures & Firm Performance 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* 3 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. risk free rate and systematic risk 4

© 2006 by Nelson, a division of Thomson Canada Limited.2-30 Market - Based Measures & Firm Performance + 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+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.

© 2006 by Nelson, a division of Thomson Canada Limited.2-31 Market - Based Measures & Firm 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

© 2006 by Nelson, a division of Thomson Canada Limited.2-32 Market - Based Measures & Firm Performance 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 ! This suggests that market measures tell us something different about performance than accounting measures.

© 2006 by Nelson, a division of Thomson Canada Limited.2-33 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

© 2006 by Nelson, a division of Thomson Canada Limited.2-34 Economic Value Added (EVA) is: An internal measure of a firm’s ability to generate MVA in the future. Market Value Added / Economic Value Added & Firm Performance 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

© 2006 by Nelson, a division of Thomson Canada Limited.2-35 Economic Value Added (EVA) To create shareholder value, any or all of these will increase EVA: Market Value Added / Economic Value Added & Firm Performance 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.

© 2006 by Nelson, a division of Thomson Canada Limited.2-36 The 2003 Stern Stewart 1000 MVA Rating

© 2006 by Nelson, a division of Thomson Canada Limited.2-37 Market Value Added / Economic Value Added & Firm Performance 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+s

© 2006 by Nelson, a division of Thomson Canada Limited.2-38 Market Value Added / Economic Value Added & Firm Performance 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. - - s

© 2006 by Nelson, a division of Thomson Canada Limited.2-39 Market Value Added / Economic Value Added & Firm Performance 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. - - s

© 2006 by Nelson, a division of Thomson Canada Limited.2-40 Market Value Added / Economic Value Added & Firm Performance 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.

© 2006 by Nelson, a division of Thomson Canada Limited.2-41 Market Value Added / Economic Value Added & Firm Performance 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.

© 2006 by Nelson, a division of Thomson Canada Limited.2-42 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.

© 2006 by Nelson, a division of Thomson Canada Limited.2-43 The Balanced Scorecard

© 2006 by Nelson, a division of Thomson Canada Limited.2-44 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.

© 2006 by Nelson, a division of Thomson Canada Limited.2-45 Best Corporate Citizens Rankings