This is the second post in the fortnightly series of Strategy Dynamics Briefings. Despite a wide range of financial measures being available the interests of investors has led to the choice of one specific measure.
What is it?
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As you may know, strategy textbooks are largely devoted to commercial business situations, and as a result, the strategy concerns of public sector, voluntary, and other not-for-profit organizations are somewhat neglected. Additionally, many strategic issues in corporate situations, while they will ultimately affect financial performance, primarily concern nonfinancial issues: poor marketplace reputation, rapid loss of staff, business lost to competitors, and so on. Nevertheless, consideration of financial performance is a good starting place…
Despite a wide range of financial measures being available the interests of investors has led to the choice of one specific measure – “economic profit” – the basis for assessing performance for any particular time period. There are two elements of profit that should be distinguished. First is the “normal” profit that investors would expect to receive for the use of their capital, given the level of risk they are taking on. The second element, “economic profit”, is the surplus that remains after the costs of all inputs (including the cost of capital) have been paid out, so:
Economic profit = operating profit minus taxes minus cost of capital
An exclusive focus on current profit poses a rather obvious problem – we can nearly always boost profits now, by pushing up prices or cutting expenditure. Historical and current profits are therefore only relevant insofar as they provide important clues to what profits will likely be in the coming years. This severely limits the value of any strategy approaches or frameworks based on explanations for profitability in a single period, no matter how persuasive the statistical significance.
The money available to distribute to shareholders in future years will be the cash flow generated by the company’s operations, minus any additional capital input required to make that operating cash flow possible. So another measure that receives attention is “free cash flow.” Current period profits include an allowance for writing off the past expenditure on fixed assets, known as depreciation. This depreciation needs to be added back and replaced by the actual expenditures on fixed and working capital. This results in the following measure of a firm’s free cash flow:
Free cash flow = operating profit + depreciation – taxes – change in fixed and working capital
The value of a firm reflects the expected stream of all future free cash flows, discounted by the firm’s cost of capital to arrive at its “present value” (Figure 1.1), and the firm’s total value is the sum of all those values out into the future. So to evaluate a firm’s strategy we need a way to estimate the future trajectory of cash flows, not just a single period. Additionally, we need a way to estimate the impact on that cash flow trajectory from actions or decisions we may be considering. Such changes may be relatively minor, such as a price reduction intended to accelerate sales growth, or major, such as the acquisition of another substantial business.
In Figure 1.2, Strategy B should clearly be preferred even though it involves lower cash flows in year one. Outcome B could, for example, arise from entering a new market or launching a new product, either of which would incur short-term costs but with the prospect of enabling additional growth thereafter. Management will, of course, face the challenge of convincing investors to share their confidence in option B!
Quite simply:
Strategic management is about building and sustaining performance into the future.
This is not a novel idea in the strategy field – it goes back to work in the 1950s by Edith Penrose, who pointed out that superior profitability is neither interesting in itself, nor sustainable in any but the most exceptional circumstances. Rather, management should be concerned with growing future economic profit. I am implying here that there is a tendency for valuation to be based on near-term profits but it is not always the case that investors look only to the short term. Consider the case of Amazon.com – in the years up to 2001, the company repeatedly delivered only losses (and heavily negative cash flows). Investors nevertheless ascribed value to the firm because of the prospects that profits would arise in due course. Indeed, those early losses were often greater than investors had previously expected, yet they still valued the company positively since each new level of loss arose from additional spending to develop ever more sources of sales and future cash flows.
I referred above to the need to consider non-financial performance measures as well as financial and I will return to these in future posts. In the meantime your comments are welcome at any time.
Until next time…
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“It’s common sense – but not as we know it“.
A comment I sometimes hear when teaching strategy dynamics or on client engagements is that “It is just common sense” or “I knew that already” … but it’s rarely true!
One case concerns a strategy to drive sales growth for a popular pain-relief product in what is a pretty mature market. I can ask a class of 50 people to give the questions they would ask if invited to help solve this problem. I usually get a couple of boards full of data items that people would wish for. But never does anyone want to know ‘How many new people start using the product each month, and how many stop using it.‘ The problem simply cannot be solved without that information. [We will see why that question is so important in a later briefing].
To a large extent strategy dynamics is common sense – that’s actually key to its power because it means everyone can understand what is going on. But to quote someone famous ‘If you don’t ask the right question, you’re not likely to find the right answer.’
So now, one of the first things I do is establish what the client thinks is the answer to their challenge. When we re-visit the question at the end of the project, their views about the way forward have invariably changed a lot.
There is a case study on the Strategy Dynamics website that illustrates the process – 26 minutes – headphones or speakers required.
Read more about the book on our website