Strategy, Value and Risk: A Guide to Advanced Financial Management

By J. Rogers

Updated and revised, the third edition frames strategy as delivering firm value in both the short and long term while maintaining a sustainable competitive advantage. These issues are examined through industry evolution, the rise of the information economy, financial analysis, corporate and quantitative finance, and risk management concepts.

• Language: English
• Publisher: Palgrave Macmillan
• Release date: Apr 3, 2013
• ISBN: 9780230392687

Book preview

Strategy, Value and Risk

A Guide to Advanced

Financial Management

Jamie Rogers

Third Edition

© Jamie Rogers 2002, 2009, 2013

All rights reserved. No reproduction, copy or transmission of this publication may be made without written permission.

No portion of this publication may be reproduced, copied or transmitted save with written permission or in accordance with the provisions of the Copyright, Designs and Patents Act 1988, or under the terms of any licence permitting limited copying issued by the Copyright Licensing Agency, Saffron House, 6–10 Kirby Street, London EC1N 8TS.

Any person who does any unauthorized act in relation to this publication may be liable to criminal prosecution and civil claims for damages.

The author has asserted his right to be identified as the author of this work in accordance with the Copyright, Designs and Patents Act 1988.

First edition published 2002

Second edition published 2009

Third edition published 2013 by

PALGRAVE MACMILLAN

Palgrave Macmillan in the UK is an imprint of Macmillan Publishers Limited, registered in England, company number 785998, of Houndmills, Basingstoke, Hampshire RG21 6XS.

Palgrave Macmillan in the US is a division of St Martin’s Press LLC, 175 Fifth Avenue, New York, NY 10010.

Palgrave Macmillan is the global academic imprint of the above companies and has companies and representatives throughout the world.

Palgrave® and Macmillan® are registered trademarks in the United States, the United Kingdom, Europe and other countries.

ISBN: 978–0–230–39267–0

This book is printed on paper suitable for recycling and made from fully managed and sustained forest sources. Logging, pulping and manufacturing processes are expected to conform to the environmental regulations of the country of origin.

A catalogue record for this book is available from the British Library.

A catalog record for this book is available from the Library of Congress.

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Printed and bound in Great Britain by

CPI Antony Rowe, Chippenham and Eastbourne

Contents

List of Figures and Tables

Preface

Acknowledgments

List of Acronyms

Introduction

The external environment

Strategy, value and risk

References

Part I The Evolution of Strategy, Value and Risk

1 Strategy

1.1 Innovation and the entrepreneur

1.2 The evolution of industry sectors

1.3 From corporate planning to shareholder value

1.4 Strategy and value

Appendix – classifying industry sectors today

References

2 Value

Overview

2.1 The accounting foundations

2.2 Stocks and flows

2.3 Ratio analysis

2.4 Investments

2.5 Firm value

2.6 Optimizing the firm structure

Appendix – modularity

References

3 Risk

3.1 Investment risk

3.2 Why manage risk

3.3 Defining and measuring risk

3.4 The risk drivers

3.5 Value and risk

References

Part II The Analysis of Performance and Investments

4 The Analysis of Performance

4.1 Valuation

4.2 Residual earnings

4.3 Free cash flows

4.4 Pro forma analysis

References

5 The Analysis of Investments

Introduction

5.1 Software

5.2 Energy

5.3 The pharmaceutical industry

5.4 A growth firm

5.5 Firm abandonment

5.6 The sale of corporate real estate assets

References

Part III Quantitative Analytics and Methods

6 Data Analysis

6.1 Data and information

6.2 Time series analysis

6.3 Volatility

6.4 The lognormal distribution

6.5 Which volatility?

References

7 Derivatives

7.1 Futures, forwards and options

7.2 The replicating portfolio and risk-neutral valuation

References

8 Option Pricing Methods

8.1 A model for asset prices

8.2 The Black–Scholes formula

8.3 Numerical techniques

References

9 Implementing Derivative Models

9.1 Spot price models

9.2 Forward curve models

9.3 Alternative real options methods

9.4 Model risk

9.5 Real options portfolios and complex payoffs

Appendix – parameter estimation for the Heston stochastic volatility model

References

10 Conclusion and Practical Implications

References

Index

List of Figures and Tables

Figures

Tables

Preface

The objective of Strategy, Value and Risk is to provide a framework that integrates financial management with a firm’s external environment. This framework is examined in the context of creating value through a firm’s operating, financial and strategic decisions.

The strategy section reviews the past to provide a foundation for how and why markets changed, how firms respond to change, and how firms can adapt to change in the future. ‘Innovation as strategy’ is a term used increasingly today across all industry sectors. A recent Wall Street Journal article noted that the term was mentioned more than 33,000 times last year in financial reports, a 64% increase over the previous five years. In this book innovation is used within the context of its influence on the evolution of industry sectors over the 19th and 20th centuries to where they are today, the shift in the economy from the dominance of industrials to information and services, and how firms used innovation to compete and adapt to change.

The value section frames a firm’s short-term and long-term objectives. In the short term the focus is on assessing current performance. A firm’s financial statements reflect its business model and where and how firm value is derived. Free cash flows are defined within the context of stocks and flows, and return on common equity (ROE) and return on invested capital (ROIC) measures are discussed. In the long term the focus is on making capital investments in assets that generate value and ensure firm continuity. Firms seek to maximize firm value by investing in assets that yield a positive net present value, with risk reflected in the appropriate discount rate.

As a substantial part of value rests on corporate decisions, it is essential to bridge strategy and value. Established valuation methods such as net present value and return on investment have limitations in capturing the value in strategic investments. These valuation approaches are applied to static scenarios while the business environment today is anything but static. Real options analysis is a valuation, project management and strategic decision paradigm that applies financial option theory to real assets. Real options provide a framework for managing and creating value, and therefore provide a linkage between strategy and value. Real options theory and its relationship to strategy, value and risk are discussed, and the concepts and methods developed as a way to respond to an increasingly dynamic business environment and address the potential limitations with the status quo. Firm value is also discussed in the context of corporate finance theory and capital structure.

The performance section covers valuation issues around intangible assets, debt and equity, and pro forma analysis of the financial statements, free cash flow and performance metrics. Investments are then evaluated in the context of strategy. Six case studies cover a corporate IT investment, a media business model migration, climate change and new energy, pharmaceutical drug research and development, a power-generating asset and commercial real estate. These case studies illustrate the established investment valuation methods such as discounted cash flow and accounting analysis, and advanced methods that include real options methods based on accounting, management science and advanced derivative techniques. Risk is extended from discount rates to advanced derivatives that include spread options, compound options and binomial trees to illustrate the advanced valuation methods. Finally a quantitative analysis and methods section discusses the techniques and issues around data analysis, derivatives, advanced valuations and risk management.

Who should read this book?

The external environment continues to present a range of issues in the aftermath of the 2008 financial crisis. While the effects of globalization and information technology continue to shape the business environment, a number of additional issues include managing exposure to value volatility, the use of leverage, access to capital markets, and defining and managing risk. In this environment managers require not only an understanding of the market, customers, investors and the industry dynamics of the firm, but also the operational drivers of success. Managers organize a firm’s resources so that there is a clear integration between a firm’s objectives and the changes occurring in markets and the external environment. Developments in concepts such as resources and capabilities, dynamic analysis and advanced financial analysis are providing frameworks to manage and cope with these changes.

The role of the CFO is undergoing a transformation, expanding from a focus on external reporting and fiduciary duties to becoming a partner with other key business partners such as operations, marketing and executive management. This requires an analysis on the business drivers of success and operational strategies that integrates finance into business and strategy. CFOs can enhance corporate value by promoting the use of a well-designed set of financial tools and guidelines to secure assets to maintain and increase value. By defining a new set of capabilities as a provider of strategic analysis and metrics, the CFO can increase the value-adding activity of the finance function.

Investment analysts and management consultants work in numerous areas that involve financial and economic concepts. These include projects of a strategic nature where valuation is essential. An analyst is required to see the larger economic setting and environment in which a firm competes, assess a firm’s industry and its position within that industry, understand which projects best serve its broad strategic goals and recognize a firm’s capabilities and options. In addition, the analyst must translate these broad insights and communicate them to management and investors.

Finally the book offers a number of potential areas that could be further explored in academic research. These include how value flows from intangible assets and their valuation, and the free cash flow relationship in regards to the optionality in real assets flowing into cash flow from operations and the timing of investment outlays.

The content covers disciplines and functions as diverse as accounting, finance, economics, econometrics, quantitative finance and management science. These subjects have their own bodies of knowledge, and there are limitations on how much of the material can be covered in one text. The content is a guide to quantifying strategy and financial management. As in other quantitative disciplines, much of the value of the analysis is in the process as opposed to just producing an end number.

Organization of the book

The book is divided into three parts:

• Part I looks at innovation and the entrepreneur, and their influence on the evolution of industry sectors over the 20th century to where they are today. Corporate strategy, how it adapted to the external environment, and strategy and value are also discussed. The value section covers the financial statements, their analysis, and firm investment methods. Finally there is a discussion on risk.

• Part II covers the analytical methods for performance and investments. The performance section addresses valuation issues, financial statement analysis and metrics and their pro forma forecasts. The investment concepts are illustrated in six case studies, an IT investment, an energy power generating asset, pharmaceutical research and development, firm growth, firm abandonment and the sale of real estate assets.

• Part III covers the quantitative methods and applications that are relevant to corporate valuation and risk analysis.

• Finally the conclusions and practical applications are discussed.

Acknowledgments

The third edition of this book represents an accumulation of experience and feedback on the first and second editions from friends, colleagues, practitioners and academics.

I would like to thank Charles Alsdorf, Richard Baskin, Ian Clark, Satyajit Das, David Garrard, David Kellogg, Elayne Ko, Richard LeBuhn, Chris Loyd, Michael Nesbitt, Stephen Penman, Lloyd Spencer, Michael Stutchbury, Michael Thomas, Larry Vielhaber and Geoff Warren. I also wish to acknowledge Maria Barbera, Bill Birkett and Roger Flather Snr who are no longer with us.

I thank Les Clewlow and Chris Strickland for their contribution and commitment to the quantitative sections of the book, David Friedman and Stephen L’Heureux for the Corporate Real Estate article, and Elroy Dimson, Paul Marsh, and Mike Staunton for granting permission for the reproduction of the data in Tables 1.1 and 1.2. I also thank Peter Baker and Aimee Dibbens at Palgrave Macmillan for their commitment to the third edition, and Vidhya Jayaprakash and her team in production.

I dedicate this book to my mum and the memory of my dad and grandmother. I would also like to thank my wife Meg for her continued patience, guidance, and support.

Every effort has been made to trace all the copyright holders but if any have been inadvertently overlooked, the publishers will be pleased to make the necessary arrangements at the first opportunity.

List of Acronyms

Introduction

The external environment

Technology is defined as the processes by which an organization transforms labor, capital materials and information into products and services of greater value. All firms have technologies. Innovation refers to a change in one of these technologies. So spectacular was the wave of innovation in the late 19th century that the Commissioner of the United States Office of Patents recommended in 1899 that the office be abolished with the words ‘Everything that can be invented has been invented.’ History is littered with such predictions about technology, and with companies that failed to stay on top of their industries when confronted with changes in markets and technologies.

The economist Joseph Schumpeter recognized and analyzed the dynamic interaction between competition and industry structures. Schumpeter focused on innovation as the central component of competition and the driving force behind industry evolution. A normal healthy economy was described by Schumpeter as one not in equilibrium as in classical economics, but one that is constantly being disrupted by innovations in technology. The entrepreneur’s or innovator’s role is to act as a catalyst in the process of creative destruction, allowing the economy to renew itself.

In Schumpeter’s view each long wave of economic activity is unique, driven by entirely different clusters of industry. Each upswing stimulates investment and an expansion of the economy, resulting in a boom. Each long boom eventually peters out as the technologies mature and investors’ returns decline. After a period of slower expansion comes the inevitable decline, only to be followed by a new wave of innovations that destroy the old methods and create the conditions for a new upswing.

In Table 0.1, the third cycle of Schumpeter’s ‘successive industrial revolutions’ had already run its course by 1950. The fourth cycle, driven by oil, electronics, aviation and mass production, is now rapidly winding down, if not already gone. The evidence suggests that a fifth industrial revolution, based on semiconductors, fiber optics, genetics and software, is not only well under way but even approaching maturity. Another issue illustrated by Table 0.1 is the increasing speed of industrial structural change, with the economic waves shortening from 50 to 60 years to around 30 to 40 years. During the third wave in the early part of the 20th century governments, firms and entrepreneurs began to search systematically for new technologies capable of creating whole new markets and the next wave.

Table 0.1  The industrial waves and accelerating cycles

In the last quarter of the 20th century a number of fundamental changes emerged in the global economy. The burst of innovation in information technology reduced the cost of communications, which in turn facilitated the globalization of production and capital markets. This laid to the groundwork for the use of innovative new business models. A new knowledge economy also emerged, driving the transformation from an industrial to a post-industrial economy centered around intangible assets and services. This led to the growing significance of intellectual assets relative to physical assets. Finally there was a shift from closed to open innovation systems. As a result of these factors stock market indexes are now dominated by service industries such as information