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

Strategy as a Quest for Profit The stakeholder approach : The firm is a coalition of interest groups—it seeks to balance their different 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 avoid 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 (EVA) as a measure of economic profit: — Post-tax operating profit less cost of capital From profit maximization to value maximization —Net present value of firm = Discounted future profits over the life of the firm

Net Inc.ROSROEEVA Market Return to Value Added Shareholders ($m) (%) (%)($m) ($m) (%) General Motors2, , , General Electric6, , , Exxon6, , , Philip Morris 5, ,180 98, IBM6, ,541 -5, Coca-Cola3, ,194157, Wal-Mart4, , , Procter & Gamble3, ,661102, Microsoft4, ,776328, Hewlett-Packard2, , How U.S. Companies Perform Under Different Profitability Measures, 1998

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

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

Problems of DCF Approaches to Strategy Approach Net Present Value of the Firm depends on option values as well as discounted cash flow expectations Estimating cash flows beyond 2-3 year horizon is hazardous---especially in dynamic markets HENCE: Some simple guidelines for maximizing the value of the firm— On existing assets-- maximize after-tax rate of return On new investment-- seek after-tax rate of return > cost of capital

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

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

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

FINANCIALFINANCIAL F1 Return on Capital Employed F2 Cash Flow F3 Profitability F4 Lowest Cost F5 Profitable Growth F6 Manage risk F1 Return on Capital Employed F2 Cash Flow F3 Profitability F4 Lowest Cost F5 Profitable Growth F6 Manage risk Strategic Objectives Financially Strong * ROCE * Cash Flow * Net Margin * Full cost per gallon delivered to customer * Volume growth rate Vs. industry * Risk index * ROCE * Cash Flow * Net Margin * Full cost per gallon delivered to customer * Volume growth rate Vs. industry * Risk index Strategic Measures C O U M S E T R - C1 Continually delight the targeted consumer C2 Improve dealer/distributor profitability C1 Continually delight the targeted consumer C2 Improve dealer/distributor profitability * Share of segment in key markets * Mystery shopper rating * Dealer/distributor margin on gasoline * Dealer/distributor survey * Share of segment in key markets * Mystery shopper rating * Dealer/distributor margin on gasoline * Dealer/distributor survey Delight the Consumer Win-Win Relationship I1 Marketing 1. Innovative products and services 2. Dealer/distributor quality I2 Manufacturing 1. Lower manufacturing costs 2. Improve hardware and performance I3 Supply, Trading, Logistics 1. Reducing delivered cost 2. Trading organization 3. Inventory management I4 Improve health, safety, and environmental performance I5 Quality I1 Marketing 1. Innovative products and services 2. Dealer/distributor quality I2 Manufacturing 1. Lower manufacturing costs 2. Improve hardware and performance I3 Supply, Trading, Logistics 1. Reducing delivered cost 2. Trading organization 3. Inventory management I4 Improve health, safety, and environmental performance I5 Quality INTERNALINTERNAL * Non-gasoline revenue and margin per square foot * Dealer/distributor acceptance rate of new programs * Dealer/distributor quality ratings * ROCE on refinery * Total expenses (per gallon) Vs. competition * Profitability index * Yield index Delivered cost per gallon.Vs. competitors * Trading margin * Inventory level compared to plan & to output rate * Number of incidents * Days away from work * Quality index * Non-gasoline revenue and margin per square foot * Dealer/distributor acceptance rate of new programs * Dealer/distributor quality ratings * ROCE on refinery * Total expenses (per gallon) Vs. competition * Profitability index * Yield index Delivered cost per gallon.Vs. competitors * Trading margin * Inventory level compared to plan & to output rate * Number of incidents * Days away from work * Quality index L E & A G R N O I W N T G H L1 Organization Involvement L2 Core competencies and skills L3 Access to strategic information L1 Organization Involvement L2 Core competencies and skills L3 Access to strategic information * Employee survey * Strategic competing (?) availability * Strategic information availability * Employee survey * Strategic competing (?) availability * Strategic information availability Safe and Reliable Competitive Supplier Good Neighbor On Spec On time Motivated and Prepared Balanced Scorecard for Mobil N. American Marketing & Refining

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 A Comprehensive Value Metrics Framework

The Paradox of Value The companies that are most successful in creating long term shareholder value are typically those that: a)Have a mission—They give precedence to goals other than profitability and shareholder return; a)Have strong, consistent, ethical values. Examples: a)“Visionary” companies studied by Collins & Porras, e.g. Merck, Wal-Mart, Procter & Gamble, Disney, HP b)Boeing — Boeing’s focus pre-1996: “to build great planes” with weak financial controls — post-1996 focus: creating shareholder value — after 2000, rapid decline in Boeing profitability

Values and Mission The role of (ethical) 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.