Strategic Value Creation and Performance Analysis

Posted on Feb 2, 2025 in International Business Economics

The Tools of Strategy Analysis

Strategy as a Quest for Value

Doing business is about creating value for customers and deriving profit for the organization from that value. Value creation happens through:

  1. Production: This involves transforming products that customers value less into products they value more. The transformation could be physical, such as assembling raw materials into a finished product.
  2. Commerce: This doesn’t change the product physically but changes its position in space (trade) and time (speculation) to enhance its value.

Costs of Differentiation

Differentiation involves various direct and indirect costs, impacting the ability to exploit economies of scale or learning economies. New manufacturing technologies and the internet have redefined traditional trade-offs between efficiency and variety, allowing differentiation to be postponed to later stages of the value chain.

Value Chain in Differentiation Analysis

Effective differentiation matches the firm’s ability to supply uniqueness with the attributes customers value most. This involves:

  1. Constructing a Value Chain: Develop value chains for both the firm and the customer, considering firms further downstream.
  2. Identifying Drivers of Uniqueness: Analyze each activity in the value chain for differentiation potential.
  3. Selecting Promising Differentiation Variables: Focus on the most important drivers of uniqueness for the differentiation strategy.
  4. Linking Value Chains: Create linkages between the firm’s activities and customer cost reduction and differentiation to measure potential profitability.

Value Added

Value added can be defined as: Value Added = Sales Revenue from Output – Cost of Material Inputs.

This value added is distributed as: Value Added = Wages/Salaries + Rent + Interest + Royalties/License Fees + Taxes + Dividends + Retained Profit.

Shareholders versus Stakeholders

  • Stakeholder Approach: Firms operate to create value for multiple parties, including customers, employees, society, and the environment, not just shareholders. The aim is to create consumer surplus where the customer’s satisfaction exceeds the price paid.
  • Shareholder Capitalism: The firm’s main duty is to generate profit for its owners. This approach emphasizes profit maximization as a key to success, though it is not the sole motivation for businesses.

What is Profit?

Profit represents the surplus of revenues over costs and is available for distribution to the firm’s owners. Profit can be measured in different ways:

  1. Accounting Profit: Combines normal returns to capital (rewarding investors) and economic profit.
  2. Economic Profit (Economic Rent): Pure surplus available after all inputs are paid for. It’s a better performance measure because it sets higher performance standards for managers and improves capital allocation within the firm.

A common measure of economic profit is Economic Value Added (EVA): EVA = Net Operating Profit After Tax – (Capital Employed x WACC).

Linking Profit to Enterprise Value

Profit maximization involves maximizing the net present value (NPV) of profits over the firm’s lifetime. The firm’s value is calculated as: V=ΣT (Ct/(1+re+d)t) where:

  • Ct: Net operating profit + Depreciation – Taxes – Investment in fixed and working capital.
  • re: Cost of equity.
  • re+d: Average cost of capital.
  • rd: Cost of debt.

This approach, known as the discounted cash flow (DCF) method, values the firm by forecasting and discounting future cash flows.

Enterprise Value and Shareholder Value

The value of a firm’s assets equals the value of claims against those assets. For public companies, the DCF value corresponds to the market value of the firm’s securities. Shareholder Value = DCF Value of Firm – Debt.

Applying DCF Analysis

The DCF method is used to value companies, business units, and strategies, especially under uncertain future cash flows: V=(C0/(re+d – g)t) where C0 is the current year’s cash flow growing at a constant rate g.

Valuing Strategies

To value strategies using DCF:

  1. Identify strategy alternatives.
  2. Estimate the cash flow for each strategy.
  3. Estimate the cost of capital implications for each strategy.
  4. Select the strategy with the highest NPV.

Strategy and Real Options

Real option analysis, a recent development in financial theory, applies to strategy analysis. It allows a project to be divided into phases, with decisions at each phase based on prevailing circumstances and new information. Types of real options include:

  1. Growth Options: Initial small investments in future opportunities without commitment.
  2. Flexibility Options: Projects/plants that allow adaptation to different circumstances.

Putting Performance Analysis into Practice

Appraising Current and Past Performance

Analyze current strategy and financial performance, identify sources of unsatisfactory performance.

Forward-Looking Performance Measures

Estimate future cash flows despite uncertainty, using stock market valuation for public companies.

Backward-Looking Performance Measures

Use accounting ratios (ROIC, ROCE, ROA, ROE) to assess past performance, considering both longitudinal (over time) and inter-firm (against competitors) comparisons.

Performance Diagnosis

Identify performance issues by disaggregating return on capital using the DuPont formula, which breaks down ROIC into sales margin and capital productivity. This helps pinpoint specific problem areas and identify corrective measures.

Can Past Performance Guide Future Strategies?

Analyzing past performance is useful for future strategies. Poor performance prompts short-term operational corrections, while successful companies focus on sustaining success factors. Financial analysis helps understand determinants of success and inform future strategies.

Setting Performance Targets

Effective performance targets should align with long-term goals, be linked to strategy, and relevant to individual responsibilities. They should be appropriate for different organizational levels and functions.

Balanced Scorecards

This method integrates financial and strategic goals, balancing short-term financial targets with long-term objectives. It considers four perspectives:

  1. Financial.
  2. Customer.
  3. Internal Business.
  4. Innovation and Learning.

Beyond Profit: Value and Social Responsibility

Businesses pursue goals beyond profit maximization. Companies motivated by broader purposes often achieve greater profitability and shareholder value. Sustaining a sense of purpose involves clear mission statements, values, and principles guiding decisions and actions.

Corporate Social Responsibility (CSR)

The debate over CSR involves the firm’s obligations to society. Two conceptions exist:

  1. Property Conception: The firm is a set of assets owned by stockholders.
  2. Social Entity Conception: The firm is a community supported by its relationships with the economic, political, social, and natural environment.