Chapter 2

Strategic Management and
Firm Performance
Chapter Two

© 2006 by Nelson, a division of Thomson Canada Limited. 2-1

Chapter 3
Strategic
External The Strategic .

Inputs
Environment Strat. Intent
Chapter 4 Strat. Mission
Management .

Internal
Environment
Process
Strategy Formulation Strategy Implementation
Strategic 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


Strategic Management and Firm
Performance
Knowledge 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.


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.


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.


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 NHL
For firms, it’s when the company
successfully formulates & implements a
value-creating strategy.
*
an

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


Defining Organizational Performance
The 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 getting
more from an investment than could have been
received from another investment with similar
risk.

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.


Approaches to Firm Performance
1. Firm Survival
2. Accounting Measures
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


0

Firm Survival & Firm Performance
Altman’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
*

0

Altman’s Z
Likely Grey
to fail Area Likely to Survive
-0 1.8 3.2 10

*

0


+ 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.


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 structure
perating Profit
Margin
Profits after taxes After tax profits per dollar of
Sales sales
(Return on Sales)

et Profit

Accounting Measures Profitability 0

Profit after taxes+interest Measures the return on the
eturn 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 shareholders
common equity

Accounting Measures Liquidity
& Firm Performance Ratios
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 inventory

nventory to
net working © 2006 by Nelson, a division of Thomson Canada Limited. 2-16
*

Accounting Measures Leverage

Total debt Measures use of debt to
Debt-to- Total assets finance operations
assets 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
equity ratio

Accounting Measures Leverage
Profits before interest & taxes Measures how much profits
Total interest charges can decline before firm is
unable to meet its interest
Times 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


Accounting Measures Misc. Ratios -
& Firm Performance Shareholder Returns


Annual dividends per share Measures return to common
Dividend yield Current market price per shareholders
on 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 ratios
Price/Earning
ratio
Annual dividends per share Indicates dividends paid
After-tax earnings per share out as a % of profits

Dividend
payout ratio © 2006 by Nelson, a division of Thomson Canada Limited. 2-19

Accounting Measures Miscellaneous
& Firm Performance Ratios

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

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 return
However, they
- May have a built in short‑term bias
- Are subject to manipulation by managers
- Undervalue intangible assets

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


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 returns
Net Present Value = 0 Average returns
Net Present Value > 0 Above average returns

+s
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

-s
Weaknesses
- 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)


The use of net present-value (NPV) must
be done with it’s limitations in mind.

But using Present Value
may allow for a deeper
understanding of firm
performance.


Market - Based Measures
& Firm Performance
Stock 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 rate
Risk 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

& Firm Performance
We 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]


& Firm Performance
Jensen’s Alpha is used to assess return
3
.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 unsystematic
4
risk. .

Appraisal Ratio = Risk-free rate of return for firm’s
stock* . Residual obtained when
estimating . risk free rate and
systematic risk

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.


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.

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 different
about performance than accounting measures.


Market Value Added / Economic
Value Added & Firm Performance
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
$10 billion MVA

Market Value Added / Economic Value
Added & Firm Performance

Economic 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


Market Value Added / Economic
Value Added & Firm Performance
Economic Value Added (EVA)
To create shareholder value, any or all of these
will 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.

The 2003 Stern Stewart 1000 MVA Rating


Market Value Added / Economic Value +s
+ 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.

Market Value Added / Economic Value -s
- 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.

-s
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.

An 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.


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.


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.


The Balanced Scorecard


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.

Best Corporate Citizens Rankings


Chapter 2

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Chapter 2