chapter 2 hitt pp slides
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strategic managementTRANSCRIPT
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Strategic Management and Firm Performance
Chapter Two
2-2
Chapter 5Bus. - Level
Strategy
Chapter 6Competitive
Dynamics
Chapter 7Corp. - Level
Strategy
Chapter 9International
Strategy
Chapter 10CooperativeStrategies
Chapter 8Acquisitions &Restructuring
Chapter 11
CorporateGovernance
Chapter 12Structure& Control
Chapter 13Strategic
Leadership
Chapter 14Entrepreneurship & Innovation
Str
ateg
icIn
pu
ts
Str
ateg
icA
ctio
ns
Str
ateg
ic O
utc
om
esChapter 4Internal
Environment
Chapter 3External
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
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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.
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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.
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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.
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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 *
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Levels of Performance
Below-normal When the actual value created is less than the value owners expectations
Normal performance Occurs when the actual value created is equal to the expected value
Above-normal When the actual value created is greater than the expected value
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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.
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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.
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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
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Firm Survival & Firm Performance
Altman’s Z =
+ .033
+ .006
.012
+ .014
+ .100
Earnings Before Interest & TaxesTotal Assets
Market Value of Firm Equity
Book Value of Firm Debt
Total Assets
Working Capital
Retained EarningsTotal Assets
SalesTotal Assets
*
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Firm Survival & Firm Performance
- 0 1.8 3.2 10
Altman’s Z
*
Likely to SurviveGrey Grey AreaArea
Likely to fail
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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.
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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)
Ratio Calculation 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
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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
Ratio Calculation What the Ratio Means
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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 AssetsCurrent Liabilities
Ability to pay off short-term debt without relying on
inventory
Measure to which firm’s working capital is tied up
in inventory
InventoryCurrent assets-current liabilities
Current assets-InventoryCurrent liabilities
Accounting Measures & Firm Performance
Ratio Calculation What the Ratio Means
*
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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 debtTotal shareholders equity
Accounting Measures & Firm Performance
Ratio Calculation What the Ratio Means
Long-term debt Total shareholders equity
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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
Ratio Calculation What the Ratio Means
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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
Ratio Calculation What the Ratio Means
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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)
Ratio Calculation What the Ratio Means
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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
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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
EmployeesManagersNon-Managers
The trouble is that each group seldom has the same goals in mind
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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 returnsNet Present Value = 0 Average returnsNet Present Value > 0 Above average returns
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+ 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
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- 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.
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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.
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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
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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*
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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]
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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*
33
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
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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
+ Market-based measures focus on the present value of future streams of income, (e.g., expected value of future cash flows) not past performance.
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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
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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 0.30.
!
This suggests that market measures tell us something different about performance than accounting measures.
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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
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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
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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.
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The 2003 Stern Stewart 1000 MVA Rating
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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
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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.-
- - ss
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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.
-
- - ss
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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.
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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.
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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.
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The Balanced Scorecard
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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.
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Best Corporate Citizens Rankings