Part 2 picks up from Part 1 with a discussion of Question #s 4-7. In case you missed Part 1 for a discussion of Questions 1-3 and would like to read it click here. And this is a little long but I think worth your time.
As a reminder, the Seven Nagging and Unanswered questions we are considering as examples of unanswerable questions are:
Question #1: Are Firms’ Behaviors and Actions “Determined” By Their External Environments? Determinism vs. Free Will?
Question #2: Is There A Natural Pace of Business In Those External Environments That Cannot Be Violated? Cheetah or Turtle?
Question #3: Should Firms Dominate Something or Be Diverse to Contribute to Growing the Valuation of the Firm? 500-Pound Gorilla or Hummingbird?
Question #4: Where Should A Firm’s (Within A Group of Firms) Differentiation Play Out to Contribute to Growing the Valuation of the Firm? Totally Unique and Distant From the Group or Closely Aligned With the Group?
Question #5: Can We Know the Future As Well As We Know the Present and the Past? No Field of Vision Into the Future or Long-Cast Clear Field of Vision Into the Future
Question #6: When New Unstoppable Trends Are First Observed, Does Our Firm Change First, Forcefully and All At Once or Wait and Change Piecemeal? A Charging Rhinoceros or Turtle?
Question #7: Why Is The Required Rate of Return (Weighted Average Cost of Capital) Set In Stone? First-Principle Of Capitalism or A Negotiated, Persuasive Reality Allows A Variety of Required Return Rates?
Let’s pick up with a discussion of Question #4:
Question #4: Where Should A Firm’s (Within A Group of Firms) Differentiation Play Out to Contribute to Growing the Valuation of the Firm? Totally Unique and Distant From the Group or Closely Aligned With the Group?
We may have better evidence for the answer to this question but I frequently see dissension on making this decision. We would tend to say we should be totally unique and distant from the group or perhaps even a “herd” of very similar competitors. The word “herd” comes from the book by Patrick Hoverstadt and Lucy Loh (Patterns of Strategy) I cited in Part 1 of this article and has more subtle meanings than we will discuss here in Part 2. But sometimes being closely aligned with the group or herd can benefit all.
You are probably familiar with study after study that shows that if there is a gasoline/service station on all four corners of an intersection, each one, and all of the stations, make more revenue, profit and cash flow than an intersection with only one or two gasoline/service stations. The reason is the perception that all four of the stations will be competing and prices will generally be lower. The four stations make up for it in volume and if they can manage their costs, their profits and cash flow benefit as well. Also, there is the perception of added safety at nighttime with extra lighting and activity. Each station will differ somewhat on what they stock inside their store – different quality of deli sandwiches, different kinds of tobacco, etc. This gives each store some measure of uniqueness. But they are pretty much the same in terms of their gasoline offering, how the customer pays with their credit or debit card or cash, the annoying small televisions in the gasoline islands providing advertising for anything under the sun, etc. This example can be extended to customers being more comfortable with offerings that are similar in many ways but unique in a few features. And in this example, it pays to differentiate within a known and desired set of features. That is, they stay close to the group or the herd.
In my work in 2005 with JC Penney, they discovered that they were perceived by customers to be almost exactly positioned like Kohls. Customers could not tell any difference. So, which company they chose depended on their proximity to either a Penney store or a Kohl store. The executives in the strategic planning group at JC Penney were miffed by this as they thought they were in actuality very different from Kohls and thus would be perceived that way. In this case, being different in actuality vs. perception mattered, and JC Penney moved to try to create a “differentiation” difference.
For the opposite situation, take the case of pipes used for smoking pipe tobacco. There are hundreds of manufacturers who make quality pipes at price points from $5 per pipe to over $800 per pipe. One would think that firms would try to be actually and perceptively different from each other, but the opposite is true. There are a few leaders in this industry that form a few categories of different pipe appearance and features. All of the other manufacturers try to position themselves as looking like one of these few leading categories but at lower to much lower price points.
Thus this question does not have a definitive answer yet. Where do you differentiate if that is your strategy (as opposed to being a low-cost provider like Wal-Mart) with the group/herd or distinguished from it?
Obviously a useful and correct answer for each firm is very important but to date, we do not have definitive evidence and causal relationships to help with this decision.
Question #5: Can We Know the Future As Well As We Know the Present and the Past?
No Field of Vision Into the Future vs. Long-Cast Clear Field of Vision Into the Future
This may seem like a ludicrous question. Of course, you might say we cannot know the future very well at all, much less as well as we know the present or the past. But an answer to what the future will look like before close rivals discern that future is one of the secular holy grails of competitive strategy.
In an article I published several months ago, I briefly chronicled my work (as part of a great team of General Motors people and us as outside resources) with the General Motors Futures Group within their strategic planning department in about 1996. They were doing 25, 50 and 75-year scenarios on the future of transportation. One of the many initiatives to come out of this effort was GM’s hydrogen car. This initiative never came to fruition, as then the cost of hybrid batteries was way too high. Thus price points to consumers would be out of bounds. But the whole exercise left us all feeling that we could sense and know the future, certainly better than when the project was started.
Scenario planning, simulation, game theory, systems dynamics, and other tools try to make sense of an uncertain future. As of this writing in November 2019 I know of no foolproof way to know the future with certainty. However I have been following developments in artificial intelligence, pattern recognition, and neural brain networks and we all could be surprised by our improvements to come to know the future…. even if only the mid-term future.
Question #6: When New Unstoppable Trends Are First Observed, Does Our Firm Change First, Forcefully and All At Once or Wait and Change Piecemeal? A Charging Rhinoceros or Turtle?
This question pertains to change management. I have seen executives wrestle with this question frequently; especially when a big change is being perceived has to be made. Notice this question is not about important change that is known has to be made. For example, say we have concluded and know that our physical products will move to become commodities. We desire to develop value-adding services that can be wrapped around the physical products. Think of CAT Scan machines that send information to a doctor across the globe immediately after scanning a patient. We know we will have to change in a big way so we can plan a big change. Or say we all know we will replace a legacy IT system next year. We also know will have to plan a comprehensive change effort, even if launched via smaller steps. Question #6 is about the perceived need to change very early due to recognizing a feint, possible unstoppable trend.
We know the current unstoppable trends we are working with and perhaps struggling to find a solution for. But the new, feint, unstoppable trends allow a huge opportunity for a firm to move first and fast and with comprehensive force. My take on research in change management and evidence from the field suggests this should be the answer to this question: that while we are at change let’s just go for it in a big way, instead of piecemealing our efforts.
However, this is easier said than done. How many times have you witnessed something like this verbal exchange: “Well we know we need to change our entire chart of accounts to map onto our newly formed business units that carve up our business in new units never before contemplated”? Note these could have been derived from recent strategic planning efforts. To go on “But we have just spent a year with a new IT system upgrade and we are exhausted. Let’s revisit this next year after we have recharged our batteries”. Common sense would suggest waiting and resting for a while. And this change is about something we know we will have to change and is difficult enough, not about a feint and possible new unstoppable trend, where on average inertia and delaying rule the day from my experience. But the allure of changing first, way ahead of rivals in the case of a possible new unstoppable trend, is palpable.
Still, no definitive answer exists for this question that I am aware of.
Question #7: Why Is The Required Rate of Return (Weighted Average Cost of Capital) Set In Stone? First-Principle Of Capitalism or A Negotiated, Persuasive Reality Allows A Variety of Required Return Rates?
Discussion of this question is a little long I realize. But it covers the heart of free-enterprise capitalism and is very important. The topic in this question is also the key part of how the price or value of stocks on equity stock markets are calculated.
Every for-profit firm has a Required Rate of Return (RRR) it can calculate. This number is identical to the firm’s Weighted Average Cost of Capital for you finance folks. This number is very important. Firms who earn more than their RRR increase their stock price if they are a publicly traded firm and increase their valuation if they are a private for-profit firm.
Here is how this works: If a firm earns just its RRR, its stock price will remain the same or its valuation will remain the same year over year. Firms who earn less than their RRR decrease their stock price or their valuation. Firms who earn more than their RRR are “wealth creators”. Thus each firm’s RRR is a benchmark for financial performance it should seek to exceed. These actual causal laws were first presented by Al Rappaport in his landmark book Creating Shareholder Value: The New Standard for Business Performance (1986, rev, 1998). In addition, Bartley Madden’s work is exemplary (see Creating Shareholder Value and the Common Good, 2005 as an example but all of his works are very good) as well in this area by presenting data that earning more than the RRR makes a firm a wealth creator. He cites the twenty-five-year run of Medtronic and others and provides vivid graphs to back up his evidence.
Now I am familiar with and have written here of the Business Roundtable’s new statement of the purpose of the for-profit firm as of October 2019. I know other stakeholders are important, but can we deal with Question #7 by not wading into this current debate here?
So this question poses a different dilemma. It is why is the RRR a single inviolable number? Why can’t we have a range of acceptable RRR numbers for a firm to shoot for?
So let’s give a brief simple example of how this number is calculated. Hang with me here if you are not finance oriented. A firm’s RRR is really its Weighted Average Cost of Capital. It is an average of the RRR on equity investment and the cost of its debt, measured as the average of the interest rates it pays on its mid to long-term debt. Let’s break these down into the equity and debt components (again hang with me here):
RRR On Equity Investment:
RR for Equity Investment = Risk Free Rate + (Market Risk Premium X A Firm’s “Beta”)
The Risk Free Rate is the interest rate on three month Treasure Bills. The Market Risk Premium is an increase in required return (basically a fudge factor) based on participating in the more risky equity markets in general. It is the difference between the expected return on a portfolio of stocks and the Risk Free Rate. A firm’s Beta is its variability in its cash flows relative to an index of the variability of all stocks in the stock market. If a firm’s cash flows are more variable than the index, its Beta will be greater than 1. If equal to the index it will be 1 and if less variable than the market it will be less than one.
So as of November 14, 2019, the numbers are:
3 Month Treasury Bill Rate = 1.6%
Market Risk Premium = 5.4%
So say your firm’s Beta is 2. The RR for Equity for your firm would be:
1.6 + (5.4 X 2) = 12.4%
Now let’s say the average of the interest rates for your firm’s mid to long term loans is 9%.
And let’s say your capital structure has 60% Debt and 40% Equity.
Your firms overall RRR or its Weighted Average Cost of Capital would be:
(.6 X .09) + (.4 X .124) = .054 + .049 = .103 or 10.3%
The 10.3% RRR is also referred to a firm’s Hurdle Rate and again it is this number that the firm must earn more than to be a wealth creator. As an aside, the return or earnings are properly calculated as Free Cash Flow Return On Investment, not net income from the income statement.
OK now that we have the calculation out of the way, we can pose Question #7 again: Why Is this number of 10.3% in this example carved in stone? In reality, the calculation of the RRR is not so simple as this simple example suggests. There are loads of different rules of thumb used by different people, different people using slightly different input numbers (like the return on long term government bonds and not three month Treasure bills), etc.
But if this number is so important, why have only one number?
And ponder this. In two years the Risk Free Rate and/or the Market Risk Premium could change, as could the firm’s Beta. Presto we have a different RRR. So let’s say the initiatives from last year’s strategic plan were approved because they were expected to earn 12% when the RRR (or WACC) was 10.3%. This 1.7% point “positive spread” is good as it shows the approved initiative would contribute to increasing firm valuation.
But what if in two years the RRR or WACC goes to 13% due only to a change in the risk free rate and the market risk premium, two numbers that are out of the given firm’s control? All of a sudden all of those prior approved initiatives are expected to contribute to destroying that firm’s stock price or the firm’s valuation if a private for-profit firm.
Wow. Why is such an important number so subject to seeming whims? We could advocate a range of possible RRRs or WACCs as sort of a fudge factor. But this nullifies the derivation of a benchmark requirement that cannot be violated. What gives or what should give?
Conclusion
These seven questions for strategic management do not have, as of this writing in November 2019 definitive answers. Nor do many to most questions in and around strategy work. But firms must generate their answers, even tentative, to move forward. How does your firm solve these dilemmas, and others like them, considering the fact there are no definitive causal laws, guidelines, and answers? Or do you know that one or more of these questions has more definitive answers based on evidence?
This article is part of a series on what causes a firm’s value to increase.
Dr. William Bigler is the founder and CEO of Bill Bigler Associates. He is a former Associate Professor of Strategy and the former MBA Program Director at Louisiana State University at Shreveport. He was the President of the Board of the Association for Strategic Planning in 2012 and served on the Board of Advisors for Nitro Security Inc. from 2003-2005. He is the author of the 2004 book “The New Science of Strategy Execution: How Established Firms Become Fast, Sleek Wealth Creators”. He has worked in the strategy departments of PricewaterhouseCoopers, the Hay Group, Ernst & Young and the Thomas Group among several others. He can be reached at bill@billbigler.com or www.billbigler.com.
And we could use a range of RRRs around the spot number calculation I realize.