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Buss498Ch5.pptxLearning Objectives
LO 5-1 Conduct a firm profitability analysis using accounting data to assess and evaluate competitive advantage.
LO 5-2 Apply shareholder value creation to assess and evaluate competitive advantage.
LO 5-3 Explain economic value creation and different sources of competitive advantage.
LO 5-4 Apply a balanced scorecard to assess and evaluate competitive advantage. (please skip this section for the exam; no slides included here either)
LO 5-5 Apply a triple bottom line to assess and evaluate competitive advantage. (please skip this section for the exam; no slides included here either)
LO 5-6 Use the why, what, who, and how of business models framework to put strategy into action.
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An Overview of Frameworks Discussed
To measure and assess firm performance:
Accounting profitability
Shareholder value creation
Economic value creation
Integrative frameworks, combining quantitative data with qualitative assessments:
The balanced scorecard
The triple bottom line
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Accounting Profitability
Accurately assesses firm performance
Compares firm performance to competitors / industry average
Available through:
Standardized accounting metrics (GAAP, FASB)
Form 10-K statements
Profitability ratios
Return on invested capital (ROIC), return on equity (ROE), return on assets (ROA), and return on revenue (ROR)
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One of the most commonly used metrics in assessing firm financial performance is return on invested capital (ROIC), where ROIC = (Net profits/Invested capital). ROIC is a popular metric because it is a good proxy for firm profitability. In particular, the ratio measures how effectively a company uses its total invested capital, which consists of two components: (1) shareholders’ equity through the selling of shares to the public, and (2) interest-bearing debt through borrowing from financial institutions and bond holders.
To explore further drivers of this difference, we break down return on revenue into three additional financial ratios:
Cost of goods sold (COGS) / Revenue.
Research & development (R&D) expense / Revenue.
Selling, general, & administrative (SG&A) expense / Revenue.
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Exhibit 5.1 Comparing Apple and Microsoft: Drivers of Firm Performance
How much of the firm’s sales is converted into profits
How effectively capital is being used to generate revenue
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Limitations of Accounting Data
Historical and backward-looking
Does not consider off–balance sheet items:
Pension obligations
Leasing obligations
Focuses mainly on tangible assets
May not be the most important
Consider: innovation, quality, customer experience
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The Declining Importance of Book Value in a Firm’s Stock Market Valuation
Exhibit 5.2
Source: Analysis and depiction of data from Compustat, 1980–2015
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In 1980, about 80 percent of a firm’s stock market valuation was based on its book value with 20 percent based on the market’s expectations concerning the firm’s future performance. This almost reversed by 2000 (at the height of the internet bubble), when firm valuations were based only 15 percent on assets captured by accounting data. The important take-away is that intangibles not captured in firms’ accounting data have become much more important to a firm’s competitive advantage. By 2015, about 75 percent of a firm’s market valuation was determined by its intangibles.
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Shareholder Value Creation - Definitions
Shareholders
Own shares of stock, are legal owners
Risk Capital
Money provided for an equity share
Total Return to Shareholders
Stock price appreciation + dividends
Market Capitalization
Dollar value of total shares outstanding
Number of outstanding shares x share price
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All public companies in the United States are required to report total return to shareholders annually in the statements they file with the Securities and Exchange Commission (SEC). In addition, companies must also provide benchmarks, usually one comparison to the industry average and another to a broader market index that is relevant for more diversified firm.
Investors also adjust their expectations over time. Since the business in the slow-growth industry surprised them by delivering higher than expected growth, they adjust their expectations upward. The next year, they expect this firm to again deliver 4 percent growth. On the other hand, if the industry average is 10 percent a year in the high-tech business, the firm that delivered 8 percent growth will again be expected to deliver at least the industry average growth rate; otherwise, its stock will be further discounted.
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Stock Market Valuations of Apple and Microsoft, 1990–2017
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Limitations of Shareholder Value Creation
Stock prices can be volatile
Difficult to assess firm performance
Macroeconomic factors affect stock prices
Economic growth or contraction
Unemployment, interest and exchange rates
Stock prices can reflect the mood of investors
Investors can be irrational
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Competitive Advantage and Economic Value Created [V-C]
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Competitive advantage can be based on: economic value creation because of superior product differentiation, or a relative cost advantage over rivals.
Value denotes the dollar amount (V) a consumer attaches to a good or service. Value captures a consumer’s willingness to pay and is determined by the perceived benefits a good or service provides to the buyer. The cost (C) to produce the good or service matters little to the consumer, but it matters a great deal to the producer (supplier) of the good or service since it has a direct bearing on the profit margin.
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Firm B’s Competitive Advantage
Same cost as firm A but firm B creates more economic value.
Firm B’s advantage is based on superior differentiation.
Exhibit 5.4
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Only Firm A and Firm B are competing in the market for laptops. Assuming that both Firm A and Firm B have the same total unit cost of producing the particular laptop models under consideration ($400) and the market at large has preferences similar to yours, then Firm B will have a competitive advantage. This is because Firm B creates more economic value than Firm A (by $200), but has the same total cost.
The amount of total perceived consumer benefits equals the maximum willingness to pay, or the reservation price. This amount is then split into economic value creation and the firm’s total unit cost. Firm A and Firm B have identical total unit cost, $400 per laptop. However, Firm B’s laptop (e.g., Apple’s MacBook Pro) is perceived to provide more utility than Firm A’s laptop (e.g., Dell’s generic laptop), which implies that Firm B creates more economic value ($1,200 – $400 = $800) than Firm A ($1,000 – $400 = $600). Taken together, Firm B has a competitive advantage over Firm A because Firm B creates more economic value. This is because Firm B’s offering has greater total perceived consumer benefits than Firm A’s, while the firms have the same total cost. In short, Firm B’s advantage is based on superior differentiation leading to higher perceived value. Further, the competitive advantage can be quantified: It is $200 (or, $1,200 – $1,000) per laptop sold for Firm B over Firm A.
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Firm C’s Competitive Advantage
Exhibit 5.5
Same total perceived consumer benefits as firm D, but firm C creates more economic value.
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In this image, two different laptop makers each offer a model that has the same perceived consumer benefits ($1,200). Firm C, however, creates greater economic value ($900, or $1,200 – $300) than that of Firm D ($600, or $1,200 – $600). This is because Firm C’s total unit cost ($300) is lower than Firm D’s ($600). Firm C has a relative cost advantage over Firm D, while both products provide identical total perceived consumer benefits ($1,200). In this example, Firm C could be Lenovo with lower cost structure than Firm D, which could be HP, but both firms offer the same value. As this image shows, Firm C has a competitive advantage over Firm D because it has lower costs. Firm C’s competitive advantage over Firm D is in the amount of $300 for each laptop sold. Here, the source of the competitive advantage is a relative cost advantage over its rival.
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Opportunity Costs and Limitations of Economic Value Creation
Opportunity costs
The value of the best forgone alternative
Limitations of Economic Value Creation
Valuing a consumer good isn’t easy
The value of a good changes in the eyes of consumers
Income, preferences, time, etc.
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Example of Opportunity Costs of an Entrepreneur: (1) forgone wages if employed elsewhere; (2) the cost of capital invested in the business vs. the stock market vs. U.S. Treasury bonds.
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Why, What, Who, and How of Business Models Exhibit 5.10
Details a firm’s competitive tactics and initiatives
Explains how the firm:
Intends to make money
Conducts its business
With buyers, suppliers, and partners
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How companies do business can sometimes be as important, if not more so, to gaining and sustaining competitive advantage as what they do. Indeed, a slight majority (54 percent) of senior executives responded to a recent survey stating that they consider business model innovation to be more important than process or product innovation.
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Popular Business Models
Razor-razorblade: pay for replacements
Subscription: pay for access
Pay as you go: pay for what you consume
Freemium: pay for extra features / add-ons
Wholesale: products sold at a discount
Agency: products sold on commission
Bundling: more than one product sold at a discount
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Razor-razorblade: was invented by Gillette, which gave away its razors and sold the replacement cartridges for relatively high prices. The razor–razor-blade model is found in many business applications today. For example, HP charges little for its laser printers but imposes high prices for its replacement toner cartridges.
Subscription: Microsoft uses a subscription-based model for its new Office 365 suite of application software. Other industries that use this model presently are cable television, cellular service providers, satellite radio, internet service providers, and health clubs. Netflix also uses a subscription model.
Pay as you go: most widely used by utilities providing power and water and cell phone service plans, but it is gaining momentum in other areas such as rental cars and cloud computing such Microsoft’s Azure.
Freemium: examples include Spirit Airlines (in the United States), Ryanair (in Europe), or AirAsia, which provide minimal flight services but allow customers to pay for additional services and upgrades à la carte, often at a premium.
Wholesale: book publishers sell books to retailers at a fixed price (usually 50 percent below the recommended retail price). Retailers, however, were free to set their own price on any book and profit from the difference between their selling price and the cost to buy the book from the publisher (or wholesaler).
Agency: long used in the entertainment industry, where agents place artists or artistic properties and then take their commission. More recently we see this approach at work in a number of online sales venues, as in Apple’s pricing of book products or its app sales.
Bundling: In the Microsoft Office Suite, a user might value Word more than Excel and vice versa. Instead of selling both products for $120 each, Microsoft bundles them in a suite and sells them combined at a discount, say $150.
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Dynamic Nature of Business Models
Business Models:
Can be combined
Can evolve
Can be disrupted
Businesses must respond to disruption & adapt
Legal conflicts can arise
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Examples:
Business models can be combined: AT&T uses both razor-razorblade & subscription models
Business models can evolve: Freemium is an evolution of razor-razorblade
Business models can be disrupted: Amazon disrupted wholesale models of publishers
Businesses must respond to disruption & adapt: Many book publishers worked with Apple on an agency approach, in which the publishers would set the price for Apple and receive 70 percent of the revenue, while Apple received 30 percent. Publishers inked their deals with Apple, but how could they get Amazon to play ball? For leverage, publishers withheld new releases from Amazon. This forced Amazon to raise prices on newly released e-books in line with the agency model to around $14.95
Legal conflicts can arise: In 2012 the Department of Justice determined that Apple and major publishers had conspired to raise prices of e-books. A year later, Apple was found guilty of colluding with several major book publishers to fix prices on e-books and had to change its agency model.
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