DEVELOPING STRATEGIES FOR COMPETITIVE ADVANATGE Session 2 Goals, Value and Performance Session 2 Goals, Value and Performance 1

Strategy as a quest for value What is profit? The shareholder value approach The shareholder value and strategy formulation Performance appraising and diagnosis Values and Principles Corporate Social Responsibility OUTLINE 1 The Concept of Strategy

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 (= max. present value of profits over the life of the firm) For the purposes of strategy analysis we assume that the primary goal of the firm is profit maximization. Rationale: 1)Boards of directors legally obliged to pursue shareholder interest 2)To replace assets firm must earn return on capital > cost of capital (difficult when competition strong). 3)Firms that do not max. stock-market value will be acquired Hence: Strategy analysis is concerned with identifying and accessing the sources of profit available to the firm 2 Strategy as a Quest for Profit

COMPANY 2008 Rank MARKET CAP. ($BN.) NET INCOME ($BN) RETURN ON SALES (%) RETURN ON EQUITY (%) RETURN ON ASSETS (%) RETURN TO SHARE- HOLDERS (%) 1 Exxon Mobil PetroChina General Electric Gazprom China Mobile Microsoft AT&T Royal Dutch Shell Procter & Gamble Wal-Mart Stores Berkshire Hathaway Nestlè The World’s Most Valuable Companies: Performance Under Different Profitability Measures ©

Profit maximization an ambiguous goal –Total profit vs. Rate of profit –Over what time period? –What measure of profit? –Accounting profit versus economic profit (e.g. Economic Value Added: Post-tax operating profit less cost of capital Maximizing the value of the firm: Max. net present value of free cash flows: max. V =  t C t (1 + r) t Where:V market value of the firm. C t free cash flow in time t r weighted average cost of capital 4 From Profit Maximization to Value Maximization

The Value Maximizing Approach to Strategy Formulation: 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 Problems: Estimating cash flows beyond 2-3 years is difficult Value of firm depends on option value as well as DCF value Implications for strategy analysis: Some simple financial guidelines for value maximization a)On existing assets—maximize after-tax rate of return b)On new investment—seek rate of return > cost of capital Utilize qualitiative strategy analysis to evaluate future profit potential 5 Shareholder Value Maximization and Strategy Choice

ROCE Margin (Return on Sales) Asset productivity (Sales/Capital Employed) COGS/Sales Depreciation/Sales SGA expense/Sales Fixed asset turnover (Sales/PPE) Inventory Turnover (Sales/Inventories) Creditor Turnover (Sales/Receivables) Turnover of other items of working capital 8 Performing Diagnosis: Disaggregating Return on Capital Employed Performing Diagnosis: 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 competitive availability * Strategic information availability * Employee survey * Strategic competitive availability * Strategic information availability Safe and Reliable Competitive Supplier Good Neighbor On Spec On time Motivated and Prepared 10 Balanced Scorecard for Mobil North American Marketing & Refining Balanced Scorecard for Mobil North American Marketing & Refining

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; b)Have strong, consistent, ethical values. Examples: a)“Visionary” companies studied by Collins & Porras, e.g. Merck, Wal-Mart, Procter & Gamble, Disney, HP b)Boeing — Focus pre-1996: “to build great planes,” weak financial controls—yet high profitability — Focus : “creating shareholder value”—Outcome: loss of market leadership, declining profitability 11 The Paradox of Value