In this note, we review some of the major approaches to measuring performance and relate those techniques to the concept of sustainable competitive advantage and strategic analysis.

The objective of strategy is the creation of a sustainable competitive advantage resulting in superior economic returns. In order to achieve this objective, we need some way of measuring our success relative to both our past performance as well as other competitors. In addition, we need a "yardstick" to compare the options available to the firm. But, how should we measure economic performance?

Static Measures of Economic Performance

At its most basic level, the objective of the firm is to maximize profitability. Thus, one approach to measuring performance is simply economic profit:

Profits = (Prices x Quantity Sold) - (Variable Unit Costs x Quantity Sold) - Fixed Costs

Admittedly, this definition of performance is so obvious it is almost tautological.¹ However, it is useful in that it leads to a very fundamental approach to understanding how we create competitive advantage. That is, we create competitive advantage by being able to drive a "wedge" between the revenues we generate and the costs we incur. Many managers have a tendency to think about competitive advantage in marketing terms. What's our market share? How high are our prices? However, by framing the strategic issues in this manner, these managers are only focusing on the "revenue side" of the equation, and they fail to recognize the costs they incur in attaining those marketing objectives. These managers fail to see that "MARKET SHARE IS NOT FREE!" Often a superior market position is "purchased" through the expenditure of resources on advertising, promotion, and other efforts directed at gaining market share. In addition, we have to understand the "operational" costs and capital investments necessary for executing a strategy, whether the business is in a manufacturing or service industry. Knowing how a firm's cost structure will be affected due to a change in the firm's strategy or external environment is necessary to understanding how the firm's competitive advantage will be affected as well. When formulating a strategy, we have to consider simultaneously the value we create for our customers, the revenue we receive for creating that value, as well as the costs incurred in creating that value.

As most of you are aware, there are many other static measures of performance, such as return-on-assets (ROA), return-on-equity (ROE), and gross profit margin. Formulas for calculating some of these measures appear in the table accompanying this note. Unlike measures of profitability, these measures of performance are focused on the rate of return a business delivers. Often the numerator in such formulas is just a measure for performance closely related to profitability, and the denominator measures the value of the "resources" used by the firm, i.e., the physical capital. Such measures gauge the "efficiency" with which the fixed assets of the firm are employed; this is important because given the same level of profitability we would prefer to invest in the less capital-intensive venture.

Dynamic Measures of Performance

Static measures of profitability and economic return are excellent tools for gauging how well a business is doing. However, they are problematic in that they only give a "snapshot" of a business at a particular time. Competitive advantage is not created in an instance; it evolves over time, often over long periods of time. "Sunk cost" investments we make today in physical assets, like capacity, or intangible assets, like brand image or technological knowledge, often do not "payoff" until many years in the future. As a result, static measures of performance may not give us the most accurate picture of how we are doing competitively. We need measures of performance that help us to understand how valuable our competitive advantage is "over time."

One approach to measuring the dynamics of firm performance is the Net Present Value (NPV) or Discounted Cash Flow (DCF) methods for evaluating investment opportunities. It is important that you have a basic understanding of these techniques. Basically, the NPV/DCF techniques give us a way of measuring the present value of the future cash flow streams we will receive from the investments we undertake.

Figure 1

For example, in growing a product line or a business, we will often undertake investments, in both tangible and intangible assets, that reduce cash flows in the short-run but increase them over the long run (as pictured in Figure 1). If we used static measures of performance, the attractiveness of the business would depend on what time we took "the snapshot" of the business. NPV/DCF techniques give us a way of avoiding the inaccuracies that may develop from using simple static measures of profitability. In addition, they are a useful technique for valuing and comparing potential strategies. The basic formula for calculating NPV is:

where CF_t is the net cash flow in period t and i is the discount rate. Fundamentally, what we are doing here is adding up the net cash flows from the investment discounted according to how far in the future they occur. In general, the discount rate we use in calculating NPV is the firm's cost of capital, i.e., what the firm pays to the owners of the company's stock and debt in form of returns. We can calculate the firm's weighted average cost of capital (WACC) using the following formula:

where: V_E = the market value of the firm's equity; V_D = the market value of a firm's debt; r_E = return on equity; and, r_D = the return on debt. These costs can be thought of as either the actual payments we make to shareholders and debt holders for providing the capital we use, or the opportunity costs associated with investing in the firm instead of other investment opportunities. Over the term, we will start out using static measures of performance to gauge the success of firms, but as we progress toward understanding how firms and industries change over time, we will find that NPV analysis is more useful in such situations.

Stockholder Wealth and Capital Market Approaches to Measuring Performance

As Barney (1997) points out, firms have multiple "stakeholder" groups (customers, employees, management, the communities in which the firm is located, the government, stockholders, and bondholders), each of which have vested (and often conflicting) interests in the continued operation of the firm. While we will often consider how we can deliver superior economic returns to each of the stakeholder groups involved in the firm, we are going to consider the interests of two particular groups, i.e., the stockholders and bondholders, to dominate those of the other stakeholders in the firm.
How should we measure the returns to these two groups? One approach is to look at incremental increases in the market value of the firm. What is the market value of the firm? Basically, it is the combined market value of the total equity and debt issued by the firm. The market value of the firm is a valuable approach to measuring firm performance because the value of the securities issued by a firm should vary with expectations regarding the future performance the firm will exhibit. That is, the total market value of a firm should equal the NPV of the firm's future cash flows. The value of a firm's equity should equal the discounted value of the future cash flows of the entire firm less expected payments to the owners of debt.

Recently, a number of different measures of performance have been proposed, based upon this definition of the market value of the firm. In particular, we might consider three different measures: Market Value Added (MVA), Economic Value Added (EVA), and Tobin's q. Formulas for each of these measures appear in Table 1. Both MVA and EVA, in particular, are noteworthy because they have become extremely popular as of late (see recent issues of Fortune magazine). MVA attempts to measure the wealth created by the firm over its lifetime by taking the difference between the market value of the firm and the total capital invested. EVA takes the difference between the after-tax operating profits less this year's cost of capital (note that EVA is basically equal to economic profit). One problem with EVA is that it does not measure projected future performance of the firm, which in a sense, is what MVA accomplishes. Finally, Tobin's q, a measure often used in economic research, takes the ratio of the market value of the firm to the replacement cost of the capital invested in the firm. As one can see, Tobin's q is similar to MVA, except that it is a ratio of firm value to capital invested rather than the difference. In some ways, Tobin's q is a more appropriate measure of firm performance than MVA because it looks at the replacement costs of the capital employed (which should equal the opportunity cost of the capital) instead of the actual costs of capital. However, replacement costs are very difficult to calculate, and this probably explains why Tobin's q is not often used in managerial practice.

Relationships Between These Various Measures of Performance

At this point, we might ask the question, "How are these various measures of performance related to one another?" To an extent, we have already pointed out some similarities, but we can go further. In particular, we can look at the relationship between economic profit and NPV.

Let us consider the following example. Assume we are considering an industry where the Minimum Efficient Scale (MES) plant costs $15 Million to build and produces 100,000 units per year at a cost of $5 per unit. In addition, assume that the current market price is $25 per unit; our cost of capital is 10%; and, once built, the plant lasts forever. We can calculate the expected economic profit as follows:

Economic Profit = ($25 x 100,000) - ($5 x 100,000) - ($15 Million x 10%) = $500,000

In addition, we could undertake an NPV analysis of the project. The expected annual cash flow from the project is $25 x 100,000 - $5 x 100,000 = $2 Million. Given that the cost of capital is 10% and the initial capital outlay is $15 Million leads to the following NPV calculation:

Further,

Once again, since the NPV is greater than zero, we would undertake the investment.

Now, notice that the economic profit is simply the NPV of the project multiplied by the cost of capital, i.e., $5 Million x 10% = $500,000. This relationship will always hold as long as the expected cash flows from the project remain constant over the complete life of the project. When the cash flows are not constant, this relationship is more complicated, however, it will always be true that economic profit is positive if and only if the NPV of the project is also positive.

Using Measures of Performance as a Tool in Strategic Analysis and Decision-making

As we stated above, one of our motivations for reviewing these various measures of performance is that as managers we need tools for analyzing the various strategic options available to the firm. In most cases, what we would like to do is to build a financial model of the situation facing the firm and then use that model as means of comparing the various options available to the firm. However, we have a problem. Significant uncertainty usually surrounds most strategic decisions. Often we have only inexact estimates of what the demand for a product will be, what the costs are, or how much capital is needed. What is the point of building a complex financial model that produces numbers in which we have very little confidence? Why would we value analysis over intuition?

The value of modeling comes from the fact that it forces us to make our assumptions explicit. Thus, we can gain a clearer understanding of how the factors affecting the decision "fit" together, and how change in the assumptions affects expected outcomes. As a result, we will have a better appreciation of the risks we face.

Profits are a yearly flow arising from managerial decisions. This flow is capitalized by investors' decisions in line with their expectations about the firm's future profits. A rising profit flow makes the shares more valuable to hold as assets, because the profits will provide greater dividends or capital gains, or both, to their owners. Maximizing long-run profit is, therefore, identical to maximizing the present value (the share price) of the firm at each point.

Investors operating in financial markets are constantly reevaluating each firm's expected future profits, and their choices drive the firm's stock price up or down. The market value of the firm, then, is the going share price times the number of shares outstanding. This value reflects both (1) real factors, such as the firm's market position, capacity, product design, and management caliber, and (2) expectations about the firm's future prospects. The share price is not a perfect guide to the firm's present or future conditions; yet it is the best single approximation, based on "the market's" judgment. Therefore:

1. Managers are on a form of treadmill in order to meet the expectations of investors in the market; and

2. Excess profits are capitalized immediately as stock prices rise at the new prospect of future extra profits. The original owners will cream off the excess value of a monopoly (or innovation or bit of luck) in the form of capital gains. The firm's market value rises above the book value of actual investments made by the firm.