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).