Strategic Management

Competitive Advantage and Firm

Performance
Jays Kim

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 The AFI Strategy Framework

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 Chapter 5 Outline

• How do we identify the better performer as having

competitive advantage?

• How do we assess competitive advantage and firm

performance?

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 Chapter 5 Outline

Competitive Advantage and Firm Performance

– Accounting Profitability
– Shareholder Value Creation
– Economic Value Creation

*True/False?
A firm that achieves positive financial performance has
competitive advantage over other competitors in the
same industry.
False. Maybe the whole industry can have positive financial peformance.

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 Assessing Competitive Advantage

• To measure competitive advantage,

– Accurately assess firm performance
– Relative to a benchmark (industry average / other
companies in the same industry)

• When assessing firm performance, what do we have to

consider?
– Shareholder’s interest vs. Firm’s profitability
– Short-term profit vs. Long-term profit
➔ A multidimensional perspective for assessing competitive
advantage is needed
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 Accounting Profitability

• Helps assess competitive advantage:

– Hard number assessment of firm performance
– Compare firm performance to competitors / the industry
average
• Standardized accounting metrics
• A Form 10-K (e.g., "google" + "10-k“)
• Profitability ratios
– Return on invested capital (ROIC), return on equity (ROE),
return on assets (ROA), and return on revenue (ROR)

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 Accounting Profitability Ratios

Profitability Ratios Formula Characteristics

Return on Assets Firm’s efficiency in using

Net income / Total assets
(ROA) assets to generate earnings

Return on Equity Net income / Total stockholders’ Earnings to owners as

(ROE) equity measured by net assets

Return on Revenue Income earned per dollar of

Net income / Revenue
(ROR) revenue

How effectively a company

Return on Invested Net operating profit after taxes / uses the capital (owned or
Capital (ROIC) Invested Capital borrowed) invested in its
operations

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 Apple vs. Microsoft

How efficiently a company produce a good

How much of the earnings is invested in

R&D activities

How much of the earnings is invested in

sales and marketing activities

How well a company leverages its fixed

assets (e.g., property, plant, and
equipment)

How much of a firm’s capital is tied up in

its inventory

How efficiently a frim collects account

receivable: Apple is paid much faster than
Working Capital Turnover Microsoft
: how effectively capital is being used to
generate revenue
How fast a firm is paying its creditors:
* Working capital = current assets – Apples takes a bit longer to pay its
current liabilities: short-term liquidity creditors
SOURCE: Analysis of publicly available data.

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 5.1 Competitive Advantage and Firm
Performance
To measure competitive advantage, we must:
1. Assess firm performance and
2. Benchmark to the industry average / other competitors

Three performance dimensions:

• What is the firm’s accounting profitability?
• How much shareholder value does the firm create?
• How much economic value does the firm generate?

© McGraw-Hill Education. 5-9

 ROIC=Capital Efficiency
Return on Invested Capital
𝑁𝑒𝑡 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑝𝑟𝑜𝑓𝑖𝑡 𝑎𝑓𝑡𝑒𝑟 𝑇𝑎𝑥 (𝑁𝑂𝑃𝐴𝑇)
𝐼𝑛𝑣𝑒𝑠𝑡𝑒𝑑 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 (𝐼𝐶)

▪ NOPAT=the cash earnings of a company before financing costs

▪ NOPAT=EBITA (Earnings before interest, taxes, and
amortization)-Cash taxes difference? : taxes & cash taxes
▪ Invested Capital=Net working capital + Net property, plant,
and equipment + Goodwill + Other operating assets

*Net working capital=Current assets minus {Non-interest-bearing current liabilities}

**Goodwill=Assets that are not separately identifiable [Intangible asset]

© McGraw-Hill Education. 5-10

 EXERCISE #1

1) Calculate the NOPAT of 2009 and of 2011

7918-1559+1258-(-75) =7692
8993-1335-162+26=7522

**Tax shield=the reduction in income taxes that results from taking an allowable deduction
from taxable income
© McGraw-Hill Education. 5-11
 Invested Capital=Net working capital + Net property, plant, and equipment + Goodwill + Other operating assets

2) Calculate the IC of 2009 and of 2011

-3034+4043+12925+1702+5281=20917 for 2009
-2543+3916+16818+2541+6589=27321 for 2011
3) Calculate the ROIC of 2009 and of 2011
7692/20917 = 0.36 ROIC= NOPAT/ IC
7522/27321= 0.27
© McGraw-Hill Education. 5-12
 𝑁𝑂𝑃𝐴𝑇 𝑆𝐴𝐿𝐸𝑆
▪ ROIC= ∗
𝑆𝐴𝐿𝐸𝑆 𝐼𝑁𝑉𝐸𝑆𝑇𝐸𝐷 𝐶𝐴𝑃𝐼𝑇𝐴𝐿 Every dollar sales can generate how many net operating profit after tax

▪ What does the Nopat/Sales stand for? Consumer

▪ What does the Sales/Invested Capital stand for?
Production

© McGraw-Hill Education. 5-13

 ROE vs. ROA

▪ Return on equity (ROE) and return on assets (ROA)

are two of the most important measures for
evaluating how effectively a company’s
management team is managing the capital that
shareholders entrust to it.
▪ ROE helps investors gauge how their investments
are generating income, while ROA helps investors
measure how management is using its assets or
resources to generate more income.

© McGraw-Hill Education. 5-14

 Accounting Profitability

▪ Examining one of these – Return on invested capital

(ROIC), constituent parts are return on revenue and
working capital turnover.
▪ 2012 – Apple had a distinct competitive advantage
over BlackBerry because Apple’s ROIC was much
higher than BlackBerry’s.
▪ Why is the ROIC for these two companies so different?
▪ Apple vs. BlackBerry financial ratios are in Figure 5.1.

© McGraw-Hill Education. 5-15

 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒
= 𝑁𝑒𝑡 𝑀𝑎𝑟𝑔𝑖𝑛 (𝑃𝑟𝑜𝑓𝑖𝑡𝑎𝑏𝑎𝑖𝑙𝑖𝑡𝑦 %)
𝑁𝑒𝑡 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑅𝑒𝑣𝑒𝑛𝑢𝑒

𝑁𝑒𝑡 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑅𝑒𝑣𝑒𝑛𝑢𝑒

= 𝐴𝑠𝑠𝑒𝑡𝑠 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 (The efficiency of a company’s use of its asset)
𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠

𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒
= 𝑁𝑒𝑡 𝑀𝑎𝑟𝑔𝑖𝑛 𝑋 𝐴𝑠𝑠𝑒𝑡𝑠 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 = 𝑅𝑂𝐴 𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝐴𝑠𝑠𝑒𝑡𝑠
𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠

** The percentage of how profitable a company’s assets are in generating revenue.

𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠 − 𝑇𝑜𝑡𝑎𝑙 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 = 𝑆ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟𝑠 ′ 𝐸𝑞𝑢𝑖𝑡𝑦

𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠
= 𝐿𝑒𝑣𝑒𝑟𝑎𝑔𝑒 (𝑇ℎ𝑒 𝑎𝑚𝑜𝑢𝑛𝑡 𝑜𝑓 𝑑𝑒𝑏𝑡 𝑢𝑠𝑒𝑑 𝑡𝑜 𝑓𝑖𝑛𝑎𝑛𝑐𝑒 𝑎 𝑓𝑖𝑟𝑚′ 𝑠 𝑎𝑠𝑠𝑒𝑡𝑠)
𝐸𝑞𝑢𝑖𝑡𝑦

𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒
𝑅𝑂𝐴 𝑋 𝐿𝑒𝑣𝑒𝑟𝑎𝑔𝑒 = 𝐸𝑞𝑢𝑖𝑡𝑦
= ROE (Return on Equity)

© McGraw-Hill Education. 5-16

 Limitations of Accounting Data

• All accounting data are historical and thus backward-

looking.
• Accounting data do not consider off–balance sheet
items, such as:
– Leasing obligations and pension obligations
• Accounting data focus mainly on tangible assets,
which are no longer the most important.
– Innovation, reputation, culture, tacit knowledge

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 Limitations of Accounting Data

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 Limitations of Accounting Data

Profitability Ratio and Stock Price of Amazon.com

9% $800
8% $700
7%
$600
6%
5% $500

4% $400
3% $300
2%
$200
1%
0% $100
2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
-1% $0
ROA Ind. ROA Stock price
industry ROA

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 Annual revenue of Amazon Web Services from 2013 to 2020 (in million U.S. dollars)
Amazon Web Services: Annual revenue 2013-2020

50,000
45,370
45,000

40,000
Revenue in million U.S. dollars

35,026
35,000

30,000
25,655
25,000

20,000 17,459

15,000 12,219
10,000 7,880
4,644
5,000 3,108

0
2013 2014 2015 2016 2017 2018 2019 2020

Note(s): Worldwide; 2013 to 2020

Further information regarding this statistic can be found on page 8.
2 Source(s): Amazon; ID 233725

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 Limitations of Accounting Data

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 Real Example
• https://www.sec.gov/ix?doc=/Archives/edgar/data/1318605/
000156459020004475/tsla-10k_20191231.htm

• Tesla, INC
• 10-K (annual financial statement)
• 8-K (quarterly financial statement)

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 Tesla 10-K

• Automotive
• Services
• Energy generation and storage

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© McGraw-Hill Education.
 • Earning per share is one of the most important variables for
determining a company’s share prices. A high EPS indicates
that the company is more profitable and has more profits to
distribute to shareholders.
• P/E Ratio = the price-to-earnings ratio indicates the dollar
amount an investor can expect to invest in a company in
order to receive one dollar of that company’s earnings.
P/E=20. (willing to pay $20 for $1 of current earnings).
what kind of earnings? earning per share or revenues

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© McGraw-Hill Education.
 Shareholder Value Creation

• Shareholders
– Own one or more shares of stock in a company
– The legal owners of public companies

• Risk Capital
– Money provided for an equity share in a company
– Cannot be recovered if the firm goes bankrupt

• Total Return to Shareholders

– Stock price appreciation plus dividends
增值
？– From the perspective of shareholders, the measure of competitive

advantage is the return on their risk capital

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 Shareholder Value Creation

• What makes stock price change?

– Effective strategies can increase firm’s profitability and thus
stock price
– Discrepancy between the firm’s rate of growth and investor’s
差异
expectations
• Firm’s realized rate of growth > Investor’s expectations:
➔ Increase in stock price
• Firm’s realized rate of growth < Investor’s expectations:
➔ Decrease in stock price
– Investors adjust their expectations over time.

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 Shareholder Value Creation

• Market Capitalization
– External and forward-looking performance measure
– Efficient-market hypothesis: all available information
about a firm’s past, current state, and expected future
performance is reflected in the market price of the firm’s
stock
– Dollar value of total shares outstanding
– Number of outstanding shares x share price
e.g.) 50 million shares outstanding traded at $200 in the
market: 50million*200 = $10 billion

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 Limitations of Shareholder Value Creation

• Stock prices can be highly volatile.unstable

– Makes it 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.
– Can be irrational

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 Limitations of Shareholder Value Creation

• Geopolitical risk and stock price volatility

2016.9.9 5th 2017.8.9 Trump’s 2017.9.3 6th

North Korea “fire and fury” North Korea
nuclear test statement nuclear test

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 10억

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$400
$500
$600
$700
$800

$100
$200
$300

$0
19900331
19901231
19910930
19920630
19930331
19931231
19940930
19950630
19960331
19961231
19970930
19980630
19990331
19991231

Apple
20000930
20010630
20020331
20021231
20030930
20040630
20050331
20051231

Microsoft
20060930
20070630
20080331
20081231
20090930
Market Capitalization: Apple vs. Microsoft

20100630
20110331
20111231
Shareholder Value Creation

20120930
20130630
20140331
20141231
20150930
20160630
 Exhibit 5.4 Apple’s Market Cap
(December 2011- April 2013)

Market Capitalization
=Number of outstanding shares
X Share price

© McGraw-Hill Education. 5-33

 Economic Value Creation

• A firm has a competitive advantage when it creates more

economic value than rivals
• Economic value created is the difference between a buyer’s
maximum willingness to pay (WTP) for a product/service
(Total perceived consumer benefits) and the firm’s total cost
to produce it: V-C, where (V)=value and (C)= cost
• Competitive advantage can be based on:
– Superior product differentiation
– A relative cost advantage over rivals

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 Economic Value Creation

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 Economic Value Creation and Competitive Advantage

• Two laptops with different willingness to pay (WTP)

$1000 $1200

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 Economic Value Creation and Competitive Advantage

Firm B’s advantage is based on superior differentiation leading to higher

perceived value

➔ Same cost as Firm A but Firm B creates more economic value

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 Economic Value Creation and Competitive Advantage

• Two laptops with same willingness to pay (WTP)

$1200 $1200

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 Economic Value Creation and Competitive Advantage

Firm C has a competitive advantage over Firm D because it has lower

costs.

➔ Same total perceived consumer benefits as Firm D, but Firm C creates

more economic value

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 What Makes the Apple Watch Tick

Let’s assume that 1) consumer’s

maximum willingness to pay is $500
and 2) marginal cost is equal to the
estimated cost.

• Calculate economic value created

by Apple.
349-83.7=
⽣產者剩餘指賣者得到的量減去其最低所能接受的量。
• Calculate producer surplus and
consumer
=
surplus.
consumer surplus producer surplus：349-83.9=
500-349
• Given that Samsung’s Galaxy Gear
makes economic value of $150 with
the estimated cost same as the
Apple watch, assess Apple’s
competitive advantage
samsung: cost 83.7.
economic value 150 WTP
SOURCE: Wall Street Journal 83.7+150=233.7 Com A:
500-233.7=266.3

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 Producer & Consumer Surplus

• Producer surplus (also called profit)

– The difference between the price charged (P) and the cost
to produce (C)
• Consumer surplus
– The difference between what you would have been willing
to pay (V) and what you paid (P)
• Both parties capture some of the value created

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 Economic Value Creation

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 Economic Value Creation and Competitive Advantage

The role of consumer surplus and producer surplus

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 Opportunity Costs

• Fixed and variable costs are not the only costs

• The loss of potential gain from forgone alternatives
when one alternative is chosen
• Example: 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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 Opportunity Costs: Exercise

• You have two options for your career path after graduation: 1)
being an entrepreneur or 2) being an employee.
✓ You need to invest $750,000 to open your own business.
✓ You can make an accounting profit of $70,000 (total revenue –
expense) if you choose option 1.
✓ Your salary is $60,000 if you choose option 2.
✓ If you choose option 2, you can buy U.S. Treasury bills with a 2percent
return instead of investing $750,000 in your business.
Considering all these factors, which option do you prefer and why?
What if you value the independence as an entrepreneur more than
5,000?

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 Limitations of Economic Value Creation

• Determining value for consumers is not simple.

• The value of a good in the eyes of consumers
changes.
– Based on income, preferences, time, and other factors
• To measure firm-level competitive advantage, we
must estimate the economic value created for all
products and services offered by the firm.

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 The Balanced Scorecard Approach

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 The Balanced Scorecard Approach

• How do customers view us?

– Revenue, profit, customer satisfaction
• How do we create value?
– Competitiveness, innovation, organizational learning
• What core competencies do we need?
– Core competencies, supporting business processes
• How do shareholders view us?
– Cash flow, operating income, ROIC, ROE, total returns to
shareholders

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 Chapter 5 Summary

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 Key Takeaway 1

•To measure competitive advantage, we must be able to (1) accurately assess

firm performance, and (2) compare and benchmark the focal firm’s
performance to other competitors in the same industry or the industry
average.
•To measure accounting profitability, we use standard metrics derived from
publicly available accounting data.
•Commonly used profitability metrics in strategic management are return on
assets (ROA), return on equity (ROE), return on invested capital (ROIC), and
return on revenue (ROR).
•All accounting data are historical and thus backward-looking. They focus
mainly on tangible assets and do not consider intangibles that are hard or
impossible to measure and quantify, such as an innovation competency.

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 Key Takeaway 2

•Investors are primarily interested in total return to shareholders, which

includes stock price appreciation plus dividends received over a specific
period.
•Total return to shareholders is an external performance metric; it indicates
how the market views all publicly available information about a firm’s past,
current state, and expected future performance.
•Applying a shareholders’ perspective, key metrics to measure and assess
competitive advantage are the return on (risk) capital and market
capitalization.
•Stock prices can be highly volatile, which makes it difficult to assess firm
performance. Overall macroeconomic factors have a direct bearing on stock
prices. Also, stock prices frequently reflect the psychological mood of the
investors, which can at times be irrational.

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 Key Takeaway 3

•The relationship between economic value creation and competitive

advantage is fundamental in strategic management. It provides the
foundation upon which to formulate a firm’s competitive strategy of cost
leadership or differentiation.
•Three components are critical to evaluating any good or service: value (V),
price (P), and cost (C). In this perspective, cost includes opportunity costs.
•Economic value created is the difference between a buyer’s willingness to
pay for a good or service and the firm’s cost to produce it (V – C).
•A firm has a competitive advantage when it is able to create more economic
value than its rivals. The source of competitive advantage can stem from
higher perceived value creation (assuming equal cost) or lower cost
(assuming equal value creation).

© McGraw-Hill Education.
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 Exercise Answer
NOPAT=6800-1250+825=6375
IC=(-2500)+4000+5000+1700+10000=18200
ROIC=6375/18200=0.3503

Decompose the CA
(6375/36200) X (36200/18200)=0.1761 X 1.989=0.3503
Consumer advantage (0.1761) X Production advantage
(1.989)

*There were only two groups that had right answer for
ROIC question.
**There were only one group that had right answers for
every question. (Trevor and Inchul; good job)
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