Chapter 2

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Chapter 2

  1. 1. Strategic Management and Firm Performance Chapter Two© 2006 by Nelson, a division of Thomson Canada Limited. 2-1
  2. 2. Chapter 3 Strategic External The Strategic . Inputs Environment Strat. Intent Chapter 4 Strat. Mission Management . Internal Environment Process Strategy Formulation Strategy ImplementationStrategic Actions Chapter 5 Chapter 6 Chapter 7 Chapter 11 Chapter 12 Bus. - Level Competitive Corp. - Level Corporate Structure Strategy Dynamics Strategy Governance & Control Chapter 8 Chapter 9 Chapter 10 Chapter 13 Chapter 14 Acquisitions & International Cooperative Strategic Entrepreneurship Restructuring Strategy Strategies Leadership & Innovation Outcomes Strategic Chapter 2 Chapter 1 Chapter 1 Feedback Above Average Strategic Strategic Returns Competitiveness Competitiveness © 2006 by Nelson, a division of Thomson Canada Limited. 2-2
  3. 3. Strategic Management and Firm PerformanceKnowledge objectives:1. Understand the ultimate goal of strategic management – to impact organizational performance.3. Defining performance, particularly the differences among above-average returns, average returns and below-average returns.4. Discuss the different ways in which organizational performance is measured. © 2006 by Nelson, a division of Thomson Canada Limited. 2-3
  4. 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. 2-4
  5. 5. Defining PerformanceAn organization is an association ofproductive assets who have voluntarily cometogether to accomplish a set of goals.The goal is to gain an economic advantage. © 2006 by Nelson, a division of Thomson Canada Limited. 2-5
  6. 6. What Is Performance?An important question in the study of firms. What is performance?In athletics, it’s straightforward:• The person who runs 100 meters the fastest• The person who jumps the highest• The team who wins the Stanley Cup in the NHLFor firms, it’s when the companysuccessfully formulates & implements avalue-creating strategy. © 2006 by Nelson, a division of Thomson Canada Limited. 2-6 * an
  7. 7. Levels of PerformanceBelow-normal When the actual value created is less than the value owners expectationsNormal performance Occurs when the actual value created is equal to the expected valueAbove-normal When the actual value created is greater than the expected value © 2006 by Nelson, a division of Thomson Canada Limited. 2-7
  8. 8. Defining Organizational PerformanceThe Concept of Value…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.For shareholders: Value creation means gettingmore from an investment than could have beenreceived from another investment with similarrisk. © 2006 by Nelson, a division of Thomson Canada Limited. 2-8
  9. 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. 2-9
  10. 10. Approaches to Firm Performance1. Firm Survival2. Accounting Measures3. Multiple Stakeholder Approach4. Present Value5. Market-based Measures6. Market Value Added / Economic Value Added7. The Balanced Scorecard8. Corporate social responsibility © 2006 by Nelson, a division of Thomson Canada Limited. 2-10
  11. 11. 0Firm Survival & Firm PerformanceAltman’s Z = Working Capital .012 Retained Assets Total Earnings + .014 Total Assets + .033 Earnings Before Interest & Taxes Total Assets Market Value of Firm Equity + .006 Book Value of Firm Debt Sales + .100 Total Assets © 2006 by Nelson, a division of Thomson Canada Limited. 2-11 *
  12. 12. 0 Firm Survival & Firm Performance Altman’s Z Likely Grey to fail Area Likely to Survive-0 1.8 3.2 10 © 2006 by Nelson, a division of Thomson Canada Limited. 2-12 *
  13. 13. 0 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. 2-13
  14. 14. Accounting Measures Profitability 0& Firm Performance Ratios 1 / 2 Ratio Calculation What the Ratio Means Measures the revenue left to Gross Profit Sales–Cost of goods sold cover operating expenses Margin Sales after taking out the cost of procurement Assesses firm profitability Profit before interest & taxes without regard to interest Sales charges as a result of the capital structureperating Profit Margin Profits after taxes After tax profits per dollar of Sales sales(Return on Sales) © 2006 by Nelson, a division of Thomson Canada Limited. 2-14 et Profit
  15. 15. Accounting Measures Profitability 0& Firm Performance Ratios 2 / 2 Ratio Calculation What the Ratio Means Profit after taxes+interest Measures the return on theeturn on Total total investment in the firm Assets Total assets Profit after taxes (PAT) Rate of return to share- Total shareholders’ holders given their eturn on investment in the firm equity shareholders Return on investment quity PAT–Preferred stock dividends common shareholders have Total shareholders’ equity made in the firm PAT–Preferred stock dividends # Earnings available to eturn on common shares outstanding common shareholderscommon equity © 2006 by Nelson, a division of Thomson Canada Limited. 2-15
  16. 16. Accounting Measures Liquidity& Firm Performance Ratios Ratio Calculation What the Ratio Means Ability to cover ST debt with Current Assets assets convertible to cash in the Current Liabilities Current ratio period ST debt matures Ability to pay off short-term Current assets-Inventory debt without relying on uick ratio Current liabilities inventory (Acid-Test Ratio) Inventory Measure to which firm’s working capital is tied up Current assets-current liabilities in inventorynventory to net working © 2006 by Nelson, a division of Thomson Canada Limited. 2-16 *
  17. 17. Accounting Measures Leverage& Firm Performance Ratios 1 / 2 Ratio Calculation What the Ratio Means Total debt Measures use of debt to Debt-to- Total assets finance operationsassets ratio Use of debt relative to Total debt shareholders’ Total shareholders equity investment in firm Debt-to- equity ratio Long-term debt Balance between debt & equity in long-term capital Total shareholders equity structure of firm ong-term debt to © 2006 by Nelson, a division of Thomson Canada Limited. 2-17 equity ratio
  18. 18. Accounting Measures Leverage& Firm Performance Ratios 2 / 2 Ratio Calculation What the Ratio Means Profits before interest & taxes Measures how much profits Total interest charges can decline before firm is unable to meet its interestTimes interest obligations earned Profits before interest & taxes + More inclusive measure of Lease obligations ability of firm to handle all Interest charges of fixed-charge + Lease obligations Fixed- charge obligations coverage © 2006 by Nelson, a division of Thomson Canada Limited. 2-18
  19. 19. Accounting Measures Misc. Ratios -& Firm Performance Shareholder Returns Ratio Calculation What the Ratio Means Annual dividends per share Measures return to commonDividend yield Current market price per shareholderson common share stock Current market price per Market perception of firm share Faster-growing / less risky firms After-tax earnings per share tend to have higher P/E ratiosPrice/Earning ratio Annual dividends per share Indicates dividends paid After-tax earnings per share out as a % of profits Dividendpayout ratio © 2006 by Nelson, a division of Thomson Canada Limited. 2-19
  20. 20. Accounting Measures Miscellaneous& Firm Performance Ratios Ratio Calculation What the Ratio Means After-tax profits+depreciation Measures total cash per # of common shares share available to firm Cash Flow outstanding er Share Measures the number of Fixed costs units that need to be sold to Contribution margin begin to make a profit on that product or service Break-even Contribution margin = (Selling price/unit) – (variable price/unit) analysis © 2006 by Nelson, a division of Thomson Canada Limited. 2-20
  21. 21. Accounting Measures& Firm Performance $$$Accounting Measures are Popular in Analysis + 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 returnHowever, they - May have a built in short‑term bias - Are subject to manipulation by managers - Undervalue intangible assets © 2006 by Nelson, a division of Thomson Canada Limited. 2-21
  22. 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.) The trouble is that each Capital Market group seldom has the same goals in mind Firm Stock market/Investors Debt suppliers/Banks Organizational Product Market Employees Primary Customers Managers Suppliers Non-Managers © 2006 by Nelson, a division of Thomson Canada Limited. 2-22
  23. 23. Present Value & Firm PerformanceAvoid short-term bias by measuring cash flowsover time.Value all resources made available to a firm byusing the discount rate concept.(Estimate net cash flows and expected discount rates forseveral years into the future.)Allow assessment of firm and/or project’sperformance on a forward-looking basis.Net Present Value < 0 Below average returnsNet Present Value = 0 Average returnsNet Present Value > 0 Above average returns © 2006 by Nelson, a division of Thomson Canada Limited. 2-23
  24. 24. +s Present Value & Firm Performance Strengths+ Close link between present value & the conceptual definition of performance+ Positive net present-value strategies. should maximize the wealth of shareholders In doing so they will likely generate enough cash to satisfy other stakeholders © 2006 by Nelson, a division of Thomson Canada Limited. 2-24
  25. 25. -sPresent Value & Firm PerformanceWeaknesses - Misjudging prediction of cash flow patterns several years into the future. - Cash flows on projects worth billions & lasting decades may be a problem. - Measuring the discount rate is 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) © 2006 by Nelson, a division of Thomson Canada Limited. 2-25
  26. 26. Present Value & Firm PerformanceThe use of net present-value (NPV) mustbe done with it’s limitations in mind. But using Present Value may allow for a deeper understanding of firm performance. © 2006 by Nelson, a division of Thomson Canada Limited. 2-26
  27. 27. Market - Based Measures& Firm PerformanceStock Market measures in essence: Risk-free rate of return for firm’s stock + % change in Systematic risk in the stock market [Beta] stock price * X – = % change in daily Risk free rateRisk free rate of closing value of the - of return * return * stock market index * . + Residual obtained when estimating risk free rate and systematic risk S* - RFR* = a + b ( M–RFR*) + e * For 250 trading days © 2006 by Nelson, a division of Thomson Canada Limited. 2-27
  28. 28. Market - Based Measures& Firm PerformanceWe can thus derive some essential formulas: Sharpe’s Measure is used to assess return . per unit of total risk.1 Sharpe’s = % change in stock price*- Risk free rate of return* . Standard Deviation of % change in stock price* Treynor’s Measure is used to assess return . per unit of systematic risk.2 Treynor’s = % change in stock price*- Risk free rate of return* . Systematic risk in the stock market [Beta] © 2006 by Nelson, a division of Thomson Canada Limited. 2-28
  29. 29. Market - Based Measures& Firm Performance Jensen’s Alpha is used to assess return3 .relative to risk free return. Jensen’s Alpha = Risk-free rate of return for firm’s stock* Appraisal Ratio is used to measure the risk . free return per unit of unsystematic4 risk. . Appraisal Ratio = Risk-free rate of return for firm’s stock* . Residual obtained when estimating . risk free rate and systematic risk © 2006 by Nelson, a division of Thomson Canada Limited. 2-29
  30. 30. Market - Based Measures 0 +s& Firm Performance+ 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.+ 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.+ 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. 2-30
  31. 31. Market - Based Measures 0 -s& 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. © 2006 by Nelson, a division of Thomson Canada Limited. 2-31
  32. 32. Market - Based Measures 0& 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 0.30.This suggests that market measures tell us something differentabout performance than accounting measures. © 2006 by Nelson, a division of Thomson Canada Limited. 2-32
  33. 33. Market Value Added / EconomicValue Added & Firm PerformanceMarket 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 $10 billion MVA © 2006 by Nelson, a division of Thomson Canada Limited. 2-33
  34. 34. Market Value Added / Economic ValueAdded & Firm PerformanceEconomic Value Added (EVA) is: An internal measure of a firm’s ability to generate MVA in the future. 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. 2-34
  35. 35. Market Value Added / EconomicValue Added & Firm PerformanceEconomic Value Added (EVA)To create shareholder value, any or all of thesewill increase EVA: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. 2-35
  36. 36. The 2003 Stern Stewart 1000 MVA Rating © 2006 by Nelson, a division of Thomson Canada Limited. 2-36
  37. 37. Market Value Added / Economic Value +sAdded & Firm Performance+ 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. MVA is considered an estimate of the NPV of all the firm’s capital projects, both ongoing & anticipated by investors.+ 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. © 2006 by Nelson, a division of Thomson Canada Limited. 2-37
  38. 38. Market Value Added / Economic Value -sAdded & 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. © 2006 by Nelson, a division of Thomson Canada Limited. 2-38
  39. 39. Market Value Added / Economic Value -sAdded & Firm PerformanceMVA/EVA is easy for managers to manipulateand 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. © 2006 by Nelson, a division of Thomson Canada Limited. 2-39
  40. 40. Market Value Added / Economic Value Added & Firm PerformanceAn educated approach to the required 160 adjustments is needed. 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. © 2006 by Nelson, a division of Thomson Canada Limited. 2-40
  41. 41. Market Value Added / Economic ValueAdded & Firm PerformanceAssessing future direction of a firm’s EVA & knowing itsvalue-creating / destroying capabilities allows one to derivelikely scenarios for future stock prices.EVA methodology, applied appropriately, may be veryvaluable in unveiling hidden investment opportunities &over-valued projects and strategies. © 2006 by Nelson, a division of Thomson Canada Limited. 2-41
  42. 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. 2-42
  43. 43. The Balanced Scorecard © 2006 by Nelson, a division of Thomson Canada Limited. 2-43
  44. 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. 2-44
  45. 45. Best Corporate Citizens Rankings © 2006 by Nelson, a division of Thomson Canada Limited. 2-45

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