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Reading Assignment: HBR: (Day and Fayhee) "Putting Strategy into Shareholder Value" (Read prior to class) Case Discussion: Apple Inc. in 2010
Financial Analysis Lecture Notes
Financial Analysis.ppt EVA (Economic Value Added) is a measure of a company's net operating profits after taxes and after deducting the cost of capital. Cost of capitol is the minimum rate of return demanded by lenders and shareholders and varies with the riskiness of the company. Capital is all the money tied up in things such as heavy equipment, real estate, computers, working capital, cash, inventories, accounts receivable. When you make more money than your cost of capital you create wealth for shareholders. Shareholders typically demand 6% more on stocks than government bonds. If long-term treasury rates are at 7.5% then shareholder cost of equity is 13.5% on average.
"Putting Strategy into Shareholder Value" Day and Fahey, (HBR March/April 1993)
Shareholder value analysis is a technique or set of techniques for analyzing the financial consequences of strategies. However, it has its detractors. Operating managers often feel victimized by the complexities and restrictive assumptions SVA uses. or because it can be manipulated or because managers seldom agree on issues that influence results (e.g., discount rates, planning period, projected cash flows or because excessive number crunching suppresses strategic thinking. Day and Fahey suggest these criticisms reflect problems in application not the technique itself. To be successful, the numbers generated in SVA must be linked to the company's best strategic thinking. Managers must understand the relationship between competitive advantage, value creation, and business strategy. * Competitive Advantage: Outperforming competitors in terms of cost, technology, service, raw materials acquisition (Sustainable). * Value Creation:Shareholder value is increased when the company earns more than its cost of capital. * Sound Strategy: - Creates Both!!!!
Two Separate But Complimentary Concepts
1.Strategy Analysis is to establish superior value in the eyes of the customer or achieve the lowest delivered cost. (Focus on customers and competitors) 2.SVA seeks to maximize returns to shareholders (Focus on shareholders) 3.(See Exhibit p. 158)
For SVA to be successful and meaningful it should consider a strategy's potential to produce superior value and maximize returns to shareholders!
Reasons Why SVA is Sometimes an Untrustworthy Measure of a Strategy's Potential in the Marketplace. 1. Undervaluing a Strategy Two types of investment strategies that are often undervalued: (1) investing in future options, (2) investing to hold customers. Investing in future options allows a firm:
WAYS TO SUCCESSFULLY LINK SVA TO STRATEGY ANALYSIS 1. product mix. (Reason: No projected cash flows) However. and failing to consider all options. y because business as usual promises to deliver acceptable performance. Overlooking Strategies A third problem with SVA is when managers fail to put forward all of the best strategy alternatives. of color TVs. Before committing any numbers to paper or spreadsheet ask penetrating questions about the requirements for success. 2.The option of making future investments if the technology takes off The ability to learn (Failure to invest may preclude the company from entering that market) This ties in with the core competencies article: US mfg. the market recognizes the value of future growth options (Growth stocks sell with high price/earnings multiples.(Straw-man arguments created to maintain the status-quo. o Market growth improved o Gross Margins improved o Working Capital cut (Results: Fantasy that is adopted as true or probable. tend to become accepted as gospel. overvaluing strategies. 35%) SVA also falls short in measuring the value of keeping customers.P.) 2. Find solid evidence that a strategy will outperform the competition. it must be tightly linked to Strategy Analysis and that Strategy Analysis must be rigorous enough to prevent problems with undervaluing strategies.) Unnecessarily high risk hurdles exacerbates the problem of undervaluation (H. fits their assumptions. Human Problems With SVA Projections of cash in-flows rest on forecasts of sales volume. But prices can vary widely if: y Excess capacity floods the market with products. 3.) y Sometimes alternative strategies become implausible due to game playing in spread-sheets. Overvaluing A Strategy y Good forecasting is very important and very difficult. or New technologies reduces competitor's costs. Include more options in your strategy analysis process "What would you achieve if you had twice the funding you want?" (A signal that incremental change won't satisfy the boss. y Numbers whether good or bad. and unit prices. or y b/c they don't want to push themselves.) For SVA to work. o Where is the opportunity? o How is success defined? . y Some managers have already committed to a strategy because it suits their needs. Options are intangible assets that can account for a large portion of a company's assets. It is harder to document the damage to competitive advantage from not investing than the savings from making an investment. out-flows depend on forecasts of each cost element and of working capital and required investments. y Forecasts are often overly optimistic. People are also inclined to withhold information to protect their own interests. o Managers Can't Imagine: o Competitors Making Countermoves (Cash inflows too high!) o Customers Resisting New Offerings o Delays in Production (Cash outflows too low!) o Extra Costs y Past trends tend to dominate over future assessments. Discounted cash flow procedures don't recognize that value and underestimate the attractiveness of new growth areas. The competitive context of cash flows must be considered and directly tied to competitive analysis projections.
technology. Section 5 recomendations .) 3. Assumptions about: Competitors.What customer-based advantages can the company developed? How can it sustain these advantages? (Helps keep managers from overlooking weaknesses. SVA is much more like an examination of the strategic fundamentals than a numbercrunching exercise. Specific related questions: Could R&D deliver the product with specific features within given cost guidelines? How quickly could the product move from R&D to marketplace? Can it provide sufficient after-sales service to clearly distinguish the product from competitor's offerings? Will customers see added value and be willing to pay extra for it? Management should then assess the vulnerability of each strategy Q: What will happen to key results if: important assertions are wrong? critical tasks not accomplished? or programs schedules slip badly? how likely are these events to happen? Of course a strategy is not valuable unless it is well implemented? Does the organization have the necessary skills and resources to implement the alternative strategy successfully? If not. Scrutinize the validity of underlying assumptions. suppliers. SVA should be the last step in a rigorous evaluation of how strategic alternatives are likely to fare in the marketplace. industry. is there enough time and money to develop them? Used correctly. SVA is much more like an examination of the strategic fundamentals than a numbercrunching exercise. Used correctly. economic conditions Candor is essential!! To get it managers must insist on evidence to support claims. SVA should be the last step in a rigorous evaluation of how strategic alternatives are likely to fare in the marketplace. customers. governments.
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