The business of business: Business acumen, strategy, value creation, and measuring it all: A rapid r by Corporate Research Forum

The business of business: Business acumen, strategy, value creation, and measuring it all: A rapid review!

September 2015 London Dr. Rebecca Homkes Fellow, London Business School Director, Ashridge Strategic Management Centre (ASMC)

Our Agenda: The business of business

Ø Introducing business acumen, and why it matters Ø Understanding strategy, and the strategy questions Ø Creating economic value, and how to measure it Ø Answering how are we doing, or should we do this, with a few basic financial ratios Ø Valuing a business, and a few methods Ø Recap, review, and questions 3 © Copyright 2015 Rebecca Homkes

Question and table exercise:

Exercise

Why do HR professionals need to develop business acumen skills? What are one or two key aspects of business acumen you would like to develop and apply to your role?

What business acumen is NOT!

• • • • • • • •

Technical expertise Being a visionary Common sense Knowing how you make money Hierarchical limited Operationally focused Held in one place in the organization Only process or financially based

What is business acumen? Ø Perspective: Ø Lens or framing which allows us to approach problems and situations Ø Seeing the big picture: how key pieces and drivers fit together, as well as the details that describe what is happening Ø Understanding: Ø How a company delivers shareholder value Ø How markets and macro events affect my company’s ability to drive revenue and profitability Ø What key financial metrics and ratios help explain the current situation Ø Tradeoffs inherent in strategy, making strategic decisions Ø Communication: Ø Understanding organisational and financial communications, such as financial statements Ø Ability to communicate ideas and issues effectively to others Ø Applying: Ø Using business acumen to make key decisions and take actions Ø Enhancing your own performance by better understanding organisation, industry, and macro acumen Our focus today: Strategy, execution, and value creation: Defining, measuring, understanding, and APPLYING

Our Agenda: The business of business

What is strategy?

Question and table exercise:

Exercise

Within your table groups, please discuss the following question: What is strategy? How well do you know your organisationâ&#x20AC;&#x2122;s strategy? How often is it discussed within your organisation? How often should it be?

Strategy is how an organisation creates and sustains economic value

Strategy

Customersâ&#x20AC;&#x2122; willingness to pay Cost of inputs

WHAT is strategy for execution? Rebecca’s five strategy questions

WHAT is strategy for execution? v What is the situation Diagnosis of the strategic situation: Industry; Market, our internal How will it affect us? Affect our competitors? Affect our customers? v Where will we compete (play)? Clarity on how we create value: A. Who are our ideal target customers? And who are NOT? B. What products, services, or solutions should we offer? And what should we NOT? C. How are we delivering this and reaching our customers? And how are we NOT? v How will we succeed (win)? How will we sustain our competitive advantage? How will we differentiate ourselves? What resources and capabilities do we have? Which do we need? v Whatâ&#x20AC;&#x2122;s going to stop us? What are our top, key challenges? v So, what should we do? What are our 3-5 top priorities over the next three years? Our must-win battles?

Critically, strategy also contains our aims v What is the situation Diagnosis of the strategic situation: Macro, industry, market, our internal And, What does success look like: Where do we want to be? v • •

Where will we play? What business are we in? Clarity on how we create value:* A. Who are our ideal target customers? And who are NOT? B. What products, services, or solutions should we offer? And what should we NOT? C. How are we delivering this and reaching our customers? And how are we NOT?

v How will we succeed (win)? How will we sustain our competitive advantage? How will we differentiate ourselves? What resources and capabilities do we have? Which do we need? v What’s going to stop us? What are our top, key challenges? v So, what should we do? What are our 3-5 top priorities over the next three years? Our must-win battles? To be, Who/Where/What we want to be? © Copyright 2015 Rebecca Homkes

WHAT is strategy for execution: What is the situation? Three frameworks Macro: PEST Understands the Political, Economic, Sociological, and Technological factors that may may affect the overall environment

Industry: Porterâ&#x20AC;&#x2122;s Five Forces Analyses the competitive dynamics of the industry (How attractive is this industry?) by viewing the bargaining power of suppliers, buyers, substitutes, the threat of new entrants, and existing competition Market uncertainty: Analyses the likelihood and impact of variances from current situation and Framework to understand what to do

Probability of variance from base case

adapt

mold

ignore

hedge, retain

Question and table exercise:

Exercise

Within your table groups, pick one of the four PEST factors (political, economic, sociological, technological). Discuss what the most impactful aspects are within that factor affecting your organisation today.

WHAT is strategy for execution: Where will we compete? Clarity on how we create economic value: A. Who are our ideal target customers? And who are NOT? • Who is our ideal customer defined in terms of what they value • Which customers will we NOT serve? B. • • • •

What product , service or solution should we offer? And what should we NOT? What job is our customers hiring us to do? How well do we do that job? What is our value proposition? From the viewpoint of our ideal customer, how is our product or service different than alternatives? How can we measure and document the value we provide to our ideal customers?

C. How are we delivering this product and service? And how are we NOT? • What is the best route to our customer? • What types of alliances or partnerships should we form?

Clear insight into how you create and sustain economic value: Example We offer trusted, convenient face-to-face financial advice based on proven, long-term investment strategies (WHAT), to conservative individual investors who delegate their financial decisions (WHO) through a national network of 10,000+ one-financial-advisor offices (HOW)

Question and table exercise:

Exercise

Our Agenda: The business of business

Why value creation matters • Ultimate goal is earning a return in excess of the opportunity cost of capital à this involves difficult trade-offs in resource allocation • Value creation, through the lens of long-term free cash flow, is an approach that helps us judge alternative strategies and subsequent performance • Value creation: – – – –

Provides a measure of success: Shows how we are doing Serves as an X-ray vision to prioritise what mattes the most Helps us make hard trade-offs Provides resources to invest in growth

Cash flow and value creation Why cash is king? – – – –

Cash is what keeps companies alive Critical measure of financial health Cannot run the business without cash Critically…..cash is the least susceptible to finance! >> can’t fudge it

*Free cash flow: What it is: Cash generated from by operating the business less the money invested to keep it running How get to: Net cash from operations less amount invested in capital equipment Why it matters:Tell us how healthy this business is; the more cash the more options (pay debt, dividends, etc.); allows managers to focus on running the business; also means will be more favorably viewed by markets © Copyright 2015 Rebecca Homkes

View of the cash flow statement: Period ending 31 Mar 2010 Net income 21,538 Operating activities, cash flows provided by or used in: Depreciation and amortization 2,790 Adjustments to net income 4,617 Decrease (increase) in accounts receivable 12,503 Increase (decrease) in liabilities (A/P, taxes 131,622 payable) Decrease (increase) in inventories -Increase (decrease) in other operating activities (173,057) Net cash flow from operating activities 13 Investing activities, cash flows provided by or used in: Capital expenditures (plant and equipment) (4,035) Investments (201,777) Other cash flows from investing activities 1,606 Net cash flows from investing activities (204,206) Financing activities, cash flows provided by or used in: Dividends paid (9,826) Sale (repurchase) of stock (5,327) Increase (decrease) in debt 101,122 Other cash flows from financing activities 120,461 Net cash flows from financing activities 206,430 Effect of exchange rate changes 645 Net increase (decrease) in cash and cash 2,882 equivalents

31 Mar 2009 24,589 2,592 621 17,236 19,822 -(33,061) 31,799 (3,724) (71,710) 17,009 (58,425) (9,188) (12,090) 26,651 27,910 33,283 (1,840)

Free cash flow (FCF): FCF: Operating cash flow minus Capital expenditures FCF: EBIT (1-tax rate) + Depreciation and amortization - Changes in net working capital (Current assets less current liabilities) - Capital expenditure

Our Agenda: The business of business

Financial measures and analysis Profitability Ratios: How are we doing? • Profit margin • Return on sales • Return on assets • Return on equity Capital budgeting decisions/ investments: Should we do this? • Pay back period • Accounting return • Discounted cash flow analysis • Net present value (NPV) • Internal rate of return (IRR) © Copyright 2015 Rebecca Homkes

Profitability Ratios: How are we doing? Gross margin: Tells us: How cost disciplined are we? How profitable are we? Insight into: How well a company controls its cost; operating efficiency Calculate: Revenue â&#x20AC;&#x201C; cost of goods sold Revenue Return on sales Tells us: How profitable are we? How operationally efficient are we? Insight into: A company's pricing strategies and how well it controls costs Calculate: Gross profit (Before profit and tax) Total sales (Total revenue) Return on assets Tells us: How profitable a company is relative to its total assets Insight into: A how efficient management is at using its assets to generate earnings Calculate: Net income Total Assets ÂŠ Copyright 2015 Rebecca Homkes

Breaking down ROE: DuPont Composition What it tells us: The efficiency of a firm at generating profits from each unit of shareholder equity (net assets or assets minus liabilities) Insight into : How well a company uses investments to generate earnings growth ROE =

Net income Total Equity

What drives differences in ROE? -Lower cost base -Greater ability to sweat assets -More efficient use of financial leverage -A combination of all of these factors?

Net income Equity

Net income Revenues

Revenues Assets

ROE

Earn profits

Sweat assets

Assets Equity Lever up

Financial measures and analysis

Capital budgeting decisions/ investments: Should we do this? • Pay back period • Accounting return • Discounted cash flow analysis – Net present value (NPV) – Internal rate of return (IRR)

Question and table exercise:

Exercise

Within your table groups, please discuss: How often do you need to prove ROI for an initiative? What works for you? Does not work for you? What do you want to understand more?

Options to compare projects and decide which ones to pursue: Should we do this? Pay back period Payback period: amount of time that it takes for a capital budgeting or other project to recover its initial cost Payback Period = Cost of Project / Annual Cash Inflows To consider • All other things being equal, the better investment is the one with the shorter payback • Helpful for cash flow analysis/ short term budgeting BUT: • Ignores any benefits that occur after the payback period and, therefore (does not measure profitability) • Ignores the time value of money • The most simple (too simple…..) Accounting return (ARR) Amount of profit, or return, that an individual can expect based on an investment made Accounting rate of return = Average profit or return/ Average capital employed To consider • The ARR is equal to or greater than the required rate of return, the project is acceptable. If it is less than the desired rate, it should be rejected • When comparing investments, the higher the ARR, the more attractive the investment BUT: • Not based on cash flows • Ignores the time value of money Discounted cash flow analysis (DCF) Projects future cash flows and discounts them (using weighted average cost of capital) to arrive at present value To consider: • If value arrived at through DCF is higher than current cost if investment, opportunity may be a good one • Takes time value of money into account BUT: • Mechanical tool, subject to errors (and manipulations) © Copyright 2015 Rebecca Homkes

Internal Rate of Return

• IRR: The internal rate of return is the rate at which an investment project promises to generate a return during its useful life. • In general, if the IRR of a new project exceeds a company’s required rate of return, that project is desirable. If IRR falls below the required rate of return, the project should be rejected. • IRR makes it easier to compare, BUT: – Only works when have a cash outflow – Does not measure the absolute size of the investment or the return

Net Present Value (NPV)

• NPV: The difference between the present value of cash inflows and the present value of cash outflows. • NPV is used in capital budgeting to analyse the profitability of an investment or project. • When calculating net present value, must consider the following: – – – – –

Incremental cash flows Sunk costs Opportunity costs Salvage value Discount rate

Applying: Why google split into Alphabet and Google

Our Agenda: The business of business

How do we assign valuations to companies? A few methods Total value, or market capitalization: • Market cap is equal to the stock price multiplied by the number of shares outstanding • Provides measure of company size, via basic determinant of asset allocation and riskreturn parameters Firm value, or Enterprise value: • Enterprise value is calculated as the market capitalization plus debt, minority interest and preferred shares, minus total cash and cash equivalents • Considered as the takeover value of the firm: If you acquired a firm, you would acquire its debt as well, but you would then own the cash! Valuation methods most used in the UK: • Adjusted net asset valuation • P/E valuation (Price/Earnings) • Discounted cash flow valuation • Cash flow multiple • EBITDA Multiple

How did we get here?????? Latest Valuation: 50 bn Total Equity Funding: 5.6 bn

Latest Valuation: 50 bn Total Equity Funding: 2.3 bn

Latest Valuation: 50 bn Total Equity Funding: 1.2 bn

Our Agenda: The business of business

Question and table exercise:

Exercise