Midterm
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Chapter5.pptxChapter 5
Competitive Advantage, Firm Performance, and Business Models
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Learning Objectives
Conduct a firm profitability analysis using accounting data to assess and evaluate competitive advantage.
Apply shareholder value creation to assess and evaluate competitive advantage.
Explain economic value creation and different sources of competitive advantage.
Apply a balanced scorecard to assess and evaluate competitive advantage.
Apply a triple bottom line to assess and evaluate competitive advantage.
Use the why, what, who, and how of business models framework to put strategy into action.
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The AFI Strategy Framework
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Case Study: Microsoft vs. Apple
Both founded in the mid-1970’s, (Bill Gates/Steve Jobs)
Microsoft dominated the PC industry with Windows, the defacto OS 90% of PC’s.
Preloaded onto IBM and other PC’s, they created applications to run seamlessly for all.
Microsoft Office Suite , (Word, Excel, Outlook, PowerPoint)
Duplicated this in the corporate world using servers.
By 2000, Microsoft was most valuable company globally at $510B
Microsoft Market Cap today: $1.6T
After struggling with less than 5% of the PC market, Apple was revitalized in 2001
Introduction of the Ipod and digital portable music. Followed quickly by iTunes.
2007 introduced the smartphone, 2010 introduced the iPad
By 2012, Apple was most valuable company globally at $620B
2015: Apple Watch 2017: iPhone 10x $1000.00
Apple Market Cap today: $1.9T
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M vs. A shows that overtime, competitive advantage is transitory. It is hard to gain a competitive edge in the first place, and even harder to sustain it.
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An Overview of Frameworks Discussed
Three traditional frameworks to measure and assess firm performance:
Accounting profitability.
Shareholder value creation.
Economic value creation.
Two integrative frameworks, combining quantitative data with qualitative assessments:
Balanced scorecard.
Triple bottom line.
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Three Traditional Performance Dimensions
What is our accounting profitability?
Uses standard financial metrics.
What is our shareholder value?
Stock price
How much economic value does the firm generate?
Difference between what a buyer is willing to pay and the cost to produce.
These performance dimensions generally correlate over time:
Accounting profitability and economic value creation tend to be reflected in the firm’s stock price.
Determines the stock’s market valuation.
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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 bondholders.
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Drivers of Firm Performance
Exhibit 5.1
Source: Analysis of publicly available data.
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Apple’s ROIC is 17.3 percent, which is 8.5 percentage points higher than Microsoft’s (8.8 percent). This means that for every $1.00 invested in Apple, the company returned $1.17, while for every $1.00 invested in Microsoft, the company returned $1.09. Since Apple was almost twice as efficient as Microsoft at generating a ROIC, Apple had a clear competitive advantage over Microsoft. Although this is an important piece of information, managers need to know the underlying factors driving differences in firm profitability.
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Limitations of Accounting Data
Historical and backward-looking.
Does not consider off–balance sheet items:
For example: pension obligations, operating leases.
Focuses mainly on tangible assets:
May not be the most important.
Consider: innovation, quality, customer experience.
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This limitation of accounting data is nicely captured in the adage: Not everything that can be counted counts. Not everything that counts can be counted. Although accounting data capture some intangible assets, such as the value of intellectual property (patents, trademarks, and so on) and customer goodwill, many key intangible assets are not captured. Today, the most competitively important assets tend to be intangibles such as innovation, quality, and customer experience, which are not included in a firm’s balance sheets.
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Shareholder Value Creation: Definitions
Shareholders
Own shares of stock, are legal owners of public companies.
Risk Capital:
Money provided for an equity share.
Cannot be recovered if a firm goes bankrupt.
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 firms.
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 (in $ billion), 1990–2019
Exhibit 5.3
Source: Depiction of publicly available data
Access the text alternate for slide image.
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Microsoft was the most valuable company worldwide (in December 1999 with close to $600 billion in market cap), but its market valuation dropped in the following decade. The valuation declined because Microsoft struggled with the transition from desktop to mobile and cloud-based computing. CEO Satya Nadella, however, is moving Microsoft away from its Windows-only business model to compete more effectively in a “mobile-first, cloud-first world.” Nadella’s strategic initiative is starting to bear fruit as investors appear to be pleased with how well Microsoft is performing in future growth areas such as cloud computing. As Exhibit 5.3 shows that since Nadella took the helm at Microsoft in 2014, the company’s market cap has been increasing at a steep clip, even overtaking Apple at the end of the time period, making Microsoft again the most valuable company globally.
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The Declining Importance of Book Value in a Firm’s Stock Market Valuation, 1980–2015
Exhibit 5.2
Source: Analysis and depiction of data from Compustat, 1980–2015
Access the text alternative for slide image.
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For the firms in the S&P 500 (the 500 largest publicly traded companies by market capitalization in the U.S. stock market, as determined by Standard & Poor’s, a rating agency), the importance of a firm’s book value has declined dramatically over time. This decline mirrors a commensurate increase in the importance of intangibles that contribute to growth potential and yet are not captured in a firm’s accounting data.
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Limitations of Shareholder Value Creation
Stock prices can be volatile.
Difficult to assess short-term firm performance.
This is due to market volatility, external factors and investor sentiment.
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.
What do you feel stock prices really say about the economy?
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Economic Value Creation
The difference between:
A buyer’s willingness to pay for a product / service and the firm’s total cost to produce it.
The difference between value (V) and cost (C).
What is another word for the result of this equation?
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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.
What is the difference between a Macy’s brand polo shirt and Ralph Lauren
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Economic Value Creation
From an economic context, strategy is about:
Creating economic value and
Capturing as much of it as possible
A large difference between V and C gives the firm two distinct pricing options:
1. Charge higher prices to reflect the higher product value and increase profitability
OR
2. Charge the same price as rivals and gain market share
The strategic objective is to maximize (V – C), which is the economic value created.
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$1M menu http://www.king5.com/video/news/local/seattle/this-seattle-cocktail-menu-includes-a-200-martini/281-8095610
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Economic Value Creation
Apple watch at entry level when introduced retailed for $349.
Material and Labor is approximately $84
Apple’s profit for each watch sold is estimated to be $265 with a profit margin of 315%.
Apple creates economic value and captures as much of it as possible.
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Baah, sheep.
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Economic Value Creation
Creates large value for customers and 3rd party sellers, but captures very little.
Retail drives little or no profit
AWS is said to be a profit engine, but margins are -1%
Whole Foods? Grocery store margins are thin
Amazon can create negative margins and still their stockholders applaud.
Bezos is focused on long-term performance vs. short term. Investors approve as Market Cap is $906B
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Amazon prime membership
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Competitive Advantage and Economic Value Created: The Role of Value, Cost, and Price
Exhibit 5.7
Source: Adapted from N. Siggelkow (2002), “Evolution toward fit,” Administrative Science Quarterly 47: 146.
Access the text alternate of slide image.
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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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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 consumer’s income, preferences, time, etc.
To measure firm-level competitive advantage, we must estimate economic value created for all products and services offered by the firm.
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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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The Two Integrative Frameworks
The Balanced Scorecard
The Triple Bottom Line
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The Balanced Scorecard
Managers tool which harnesses multiple internal and external performance metrics in order to balance financial and strategic goals
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Just as airplane pilots rely on a number of instruments to provide constant information about key variables—such as altitude, airspeed, fuel, position of other aircraft in the vicinity, and destination—to ensure a safe flight, so should managers rely on multiple yardsticks to more accurately assess company performance in an integrative way.
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Balanced-Scorecard Approach to Creating and Sustaining Competitive Advantage
Exhibit 5.8
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This image depicts the balanced-scorecard framework. Strategic leaders using the balanced scorecard develop appropriate metrics to assess strategic objectives by answering four key questions. Brainstorming answers to these questions ideally results In measures that give managers a quick but also comprehensive view of the firm’s current state. The four key questions are:
How do customers view us?
How do we create value?
What core competencies do we need?
How do shareholders view us?
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Examples of Metrics for the Balanced Scorecard
Customers:
Revenue, profit, customer satisfaction.
Value Creation, (Learning):
Competitiveness, innovation, organizational learning.
Core Competencies, (Internal):
Key business processes.
Shareholders, (Financial):
Cash flow, operating income, ROIC, ROE, total returns to shareholders.
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Customer view: In the air-express industry, for example, managers learned from their customers that many don’t really need next-day delivery for most of their documents and packages; rather what they really cared about was the ability to track the shipments. This discovery led to the development of steeply discounted second-day delivery by UPS and FedEx, combined with sophisticated real-time tracking tools online.
Value Creation: For example, 3M requires that 30 percent of revenues must come from products introduced within the past four years.
Core Competencies: Honda’s core competency is to design and manufacture small but powerful and highly reliable engines. Its business model is to find places to put its engines. Beginning with motorcycles in 1948, Honda nurtured this core competency over many decades and is leveraging it to reach stretch goals in the design, development, and manufacture of small airplanes.
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Example: SWA
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Advantages of the Balanced Scorecard
Links strategic vision to responsible parties.
Translates vision into measurable goals.
Designs and plans business processes.
Implements feedback and organizational learning.
Alerts to needed strategic goal adaptation.
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Implementing a balanced scorecard allowed FMC’s managers to align their different perspectives to create a more focused corporation overall. General managers now review progress along the chosen metrics every month, and corporate executives do so on a quarterly basis. Implementing a balanced-scorecard approach is not a onetime effort. It requires continuous tracking of metrics and updating of strategic objectives, if needed. It is a continuous process, feeding performance back into the strategy process to assess its effectiveness.
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Disadvantages of the Balanced Scorecard
Focused on implementation, not formulation
How to get back on track if deviations occur?
Lacks guidance:
Which metrics to use?
How to address setbacks?
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Implementing a balanced scorecard allowed FMC’s managers to align their different perspectives to create a more focused corporation overall. General managers now review progress along the chosen metrics every month, and corporate executives do so on a quarterly basis. Implementing a balanced-scorecard approach is not a onetime effort. It requires continuous tracking of metrics and updating of strategic objectives, if needed. It is a continuous process, feeding performance back into the strategy process to assess its effectiveness.
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The Triple Bottom Line
Focus: economic, social and ecological performance.
Three dimensions:
Profits: Economic Dimension.
People: Social Dimension.
Planet: Ecological Dimension.
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Rather than emphasizing sustaining a competitive advantage over time, sustainable strategy means a strategy that can be pursued over time without detrimental effects on people or the planet. Using renewable energy sources such as wind or solar power, for example, is sustainable over time. It can also be good for profits, or, simply put, “green is green,” as Jeffrey Immelt was fond of saying while CEO at GE. GE’s renewable energy business brought in more than $9 billion in revenues in 2016 (up from $3 billion in 2006). Immelt retired in 2017.
Instructors:
The digital companion to this book McGraw-Hill Connect has a video case exercise from a mining industry executive on this section of the textbook. It builds student confidence on the triple bottom line.
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Stakeholder perspective
Economic, social and ecological dimensions make up the triple bottom line.
Noneconomic factors can have a significant impact on a firm’s financial performance, as well as its reputation and goodwill.
Extended producer responsibility – In anticipation of government regulation – proactively addressing social or ecological issues
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Corporate Social Responsibility
Historically, economic performance has been the focus of firm performance.
More recently, society and investors require companies to also address social and ecological concerns.
Millennials (1980-1995) and Gen Z expect firms to be socially responsible and have a strong interest in working for companies that match their values.
Research studies – CSR and firm performance relationship:
Some find CSR improves financial performance.
Others conclude superior financial performance makes CSR possible.
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What Is a Business Model?
A plan that details the firm’s competitive tactics and initiatives.
A business model explains how the firm intends to make money AND how the firm conducts its business with buyers, suppliers, and partners.
Business model innovation may be more important in achieving superior performance than product or process innovation.
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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. This is because product and process innovation is often more costly, is higher risk, and takes longer to come up with in the first place and to then implement. Moreover, business model innovation is often an area that is overlooked in a firm’s quest for competitive advantage, and thus much value can be unlocked by focusing on business model innovation.
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The Why, What, Who, and How of Business Models Framework
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Popular Business Models
Razor-razorblades: 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: Invented by Gillette, which gave away its razors and sold the replacement cartridges for relatively hi prices. HP charges little for its laser printers but imposes hi prices for its replacement toner cartridges.
Subscription: MS uses subscription-based model for its new Office 365 suite of application software. Other industries that use this model presently are cable television, cellular providers, satellite radio, internet service providers, and health clubs. Netflix.
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/artistic properties and then take a 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…Carriers started with Rzr/Rzr blade and combined with Subscription.
Can evolve….Freemium is an evolution of Rzr/Rzr blade.
Can be disrupted…Amazon disrupted wholesale model of publishers.
Businesses must respond to disruption and 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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Pizza Wars
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What is the overall Business Model for these players?
https://www.fastcompany.com/video/how-andpizza-is-reinventing-your-traditional-pizza-parlor/4oR7kfMf
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No reproduction or further distribution permitted without the prior written consent of McGraw Hill.
Because learning changes everything.®
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