Chapter 2 Flashcards
basics and formulas
Profit
Revenue - Cost
Producer surplus
Profit - “rents” to input provider
Customer surplus
the willingness to pay, or the total value the customer gets from the product/service, not the price it cost.
Value creation
consumer surplus + producer surplus
Or
total customer value - Real cost of production
Market capitalization
the value of a company that is traded on the stock market, calculated by multiplying the total number of shares by the present share price.
ROS= return on sales
operating profit as a percentage of sales revenue.
Return on capital employed (ROCE)
Earnings before interest and tax (EBIT) / (Total assets - current liabilities)
ROCE is also known as return on invested capital (ROIC). The denominator can also be measured as shareholders’ equity plus long-term debt.
Return on equity (ROE)
Net income / Shareholders’ equity
ROE measures a firm’s ability to use equity capital to generate profits that can be returned to share- holders. Net income may be adjusted to exclude discontinued operations and special items.
Return on assets (ROA)
Operating profit (orEBITorEBITDA) / Total assets
The numerator should correspond to the return on all the firm’s assets.
Gross margin
Operating margin
Net margin
Sale—Cost of bought-in goods and services / Sales
Operating profit / Sales
Net income / Sales
There are three types of profit, what do they mean?
Gross profit
Operating profit
Net profit
sales revenue less (minus) material cost
gross profit less operating expences, before tax/interest
profit after deducting all expenses
Economic Profit
Economic profit is pure profit, combining the normal return to capital and the surplus available after all inputs (including capital) have been paid for.
Operating Profit — (WACC x Capital Employed)
WACC = weighted average cost of capital
EVA
Economic value added
What is Cash flow?
There are two types of cash flow:
Operating Cash Flow: The cash generated by the firm’s operations.
Free Cash Flow: Operating cash flow less capital investment.
What is the strategic goal of a business?
The strategic aim of a business is to earn a return on capital. However, there is a debate over the appropriate goals for business enterprises. Some argue that the primary goal is to maximize shareholder value, while others believe that the firm should operate in the interests of all its stakeholders.
How does companies create value for their customers?
The purpose of business is to create value for customers. Value can be created in two ways:
Production: physically transforming products that are less valuable into products that are more valuable.
Commerce: repositioning products in space and time to increase their value.
Value for Whom?
The value created by a firm is distributed among different parties:
Customers: receive consumer surplus
Owners: receive profits
Employees and input owners: receive rents (excess earnings)
What are two approaches to value creation?
Stakeholder value maximization: the firm should operate in the interests of all its stakeholders, maximizing total value creation.
Shareholder value maximization: the firm should operate in the interests of its owners, maximizing profits.
What are the problems with Pursuing stakeholder interests?
(maximizing total value creation and ensuring its equitable distribution among stakeholders)
Measuring performance: estimating the components of value creation is near impossible.
Balancing stakeholder interests: prioritizing the interests of different stakeholders can be challenging.
What is The Primary Goal of Strategy?
To provide simplicity and clarity to our analysis of firm strategy, we assume that the primary goal of strategy is to maximize the value of the enterprise through seeking to maximize profits over the long term.
What are the Justifications for Focusing on Profit Maximization?
Competition: Competition erodes profitability. To survive, a firm must earn a rate of profit that covers its cost of capital over the long term.
Threat of Acquisition: Management teams that fail to maximize profits tend to be replaced by teams that do. Companies that underperform financially suffer a depressed share price, attracting acquirers.
Convergence of Stakeholder Interests: There is likely to be more community of interests than conflict of interests among different stakeholders. Profitability over the long term requires loyalty from employees, trusting relationships with suppliers and customers, and support from governments and communities.
Enterprise Value
Enterprise value is equal to the market capitalization of equity plus the market value of debt.
Market Capitalization of Equity + Market Value of Debt
Maximizing the value of the firm (enterprise value) is equivalent to maximizing the present value of the firm’s profits over its lifetime
Appraising Current and Past Performance
Appraising current and past performance is the first task of any strategy formulation exercise. This involves identifying the current strategy of the firm and assessing how well that strategy is doing in terms of the performance of the firm.
Forward-Looking Performance Measures: Stock Market Value:
What is Stock Market Value?
Stock Market Value: The best available estimate of the Net Present Value (NPV) of future cash flows (net of interest payments).
To evaluate the performance of a firm in creating value, we can compare the change in the market value of the firm relative to that of competitors over a period (preferably several years).
Backward-Looking Performance Measures: Accounting Ratios
What is Accounting Ratios?
Accounting Ratios: Historical measures of performance that use financial reports to assess a firm’s effectiveness in generating profits from its assets.
Disaggregating Return on Assets:
Breaking down return on assets into its component parts to identify the sources of poor performance.
Components to look at during a performance diagnosis.
Sales Margin: Measures the extent to which a firm adds value to the goods and services it buys in.
Asset Turnover: Measures a firm’s ability to extract profit from its sales.
Fixed Asset Turnover: Measures a firm’s ability to extract profit from its fixed assets.
Inventory Turnover: Measures a firm’s ability to extract profit from its inventories.
Creditor Turnover: Measures a firm’s ability to extract profit from its creditors.
Performance targets are measurable goals to reach that align with the companys’ strategy. What are the three main approaches to setting performance targets?
Financial Disaggregation: Breaking down financial goals into smaller, more manageable targets.
Benchmarking: Comparing a firm’s performance to that of its competitors or industry averages.
Balanced Scorecard: Using a combination of financial and non-financial measures to evaluate a firm’s performance.
What is Performance Management?
Performance management is a systematic process of setting goals, measuring performance, and providing feedback to employees. The goal of performance management is to align individual performance with organizational goals and objectives.
What is a Balanced Scorecard?
A balanced scorecard is a strategic management tool that helps organizations achieve their goals by measuring performance from four different perspectives:
Financial Perspective: How do we look to shareholders?
Measures: cash flow, sales growth, return on equity
Customer Perspective: How do customers see us?
Measures: new products, on-time delivery, defect and failure levels
Internal Business Perspective: What must we excel at?
Measures: productivity, employee skills, cycle time, yield rates, quality and cost measures
Innovation and Learning Perspective: Can we continue to improve and develop?
Measures: new product development cycle times, technological leadership, rates of improvement
Strategic profit drivers are the key factors that drive profit in an organization. By focusing on these drivers, organizations can create value for shareholders and other stakeholders.
What are some strategic profit drivers?
Obliquity
Obliquity is the idea of pursuing goals indirectly. Instead of focusing on profit directly, organizations should focus on the strategic factors that drive profit.
Corporate Social Responsibility
Corporate social responsibility refers to the idea that businesses have a responsibility to society beyond just making a profit.
Values and Principles
Values and principles are the guiding principles that shape an organization’s culture and behavior.
what is the 7S framework?
Strategy: The organization’s overall plan and direction
Structure: The organization’s design and architecture
Systems: The organization’s processes and technology
Skills: The organization’s human resources and capabilities
Style: The organization’s culture and leadership style
Staff: The organization’s employees and human resources
Shared Values: The organization’s core values and principles
What is Corporate Social Responsibility (CSR)?
CSR refers to a company’s efforts to improve social, environmental, and economic impacts.
Firm as Property View: The primary responsibility of a business is to operate in the interests of shareholders.
Firm as Social Entity View: A company has a broader responsibility to its stakeholders, including employees, customers, and the environment.
What is the Definition of Real Options?
“A real option is the right, but not the obligation, to undertake a particular business initiative or investment.”
what are the Types of Real Options?
Growth Options: The option to expand or replicate a business if it is successful.
Abandonment Options: The option to abandon a project if it is not successful.
How does companies Create Real Options?
Firms can create real options by:
Making small initial investments in a number of future business opportunities.
Designing projects and plants that permit adaptation to different circumstances.
Introducing decision points at multiple stages, where the main options are to delay, modify, scale up, or abandon the project.
Real Options in Strategy Formulation
Real options can be used to:
Enhance the creation of both social and shareholder value.
Create enterprise value not only by generating profit but also by creating real options.
Inform strategy formulation by providing a framework for evaluating investment opportunities.
