1. 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

2. 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 (= 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

3. From Profit Maximization to Value Maximization 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. The World’s Most Valuable Companies: Performance Under Different Profitability Measures The World’s Most Valuable Companies: Performance Under Different Profitability Measures COMPANYMARKET CAP. ($BN.) NET INCOME ($BN) RETURN ON SALES (%) RETURN ON EQUITY (%) RETURN ON ASSETS (%) RETURN TO SHARE- HOLDERS (%) Exxon Mobil37236.119.934.917.811.7 General Electric36316.410.722.214.7(1.5) Microsoft28112.340.330.018.8(0.9) Citigroup23924.622.021.91.54.6 BP23322.39.927.910.710.2 Bank of America21216.527.014.11.22.4 Royal Dutch Shell21125.314.726.711.611.8 Wal-Mart19711.25.521.48.1(10.3) Toyota Motor19712.110.713.04.8(22.1) Gazprom1967.328.19.87.1n.a. HSBC19015.923.016.31.0(11.8) Procter & Gamble1908.717.313.76.47.2

5. Shareholder Value Maximization and Strategy Choice 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

6. 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

7. 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

8. 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 = = = = = = Higher NPV raises option value Higher cost lowers option value Higher volatility increases option value More time allows more information to be taken into account As profit is lost to rivals, option value is lowered A higher interest rate increases option value by increasing the value of deferring investment Comments The six levers of financial and real options

9. 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 Performance Diagnosis: Disaggregating Return on Capital Employed Performance Diagnosis: Disaggregating Return on Capital Employed

10. 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

11. 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

12. 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

13. 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; 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 1997-2003 : “creating shareholder value”—Outcome: loss of market leadership, declining profitability