Strategy and Adding Value in Finance

Strategy and adding value in finance refers to the alignment of a company’s long-term competitive goals-such as cost leadership or superior product quality-with the objective of maximizing shareholder wealth by focusing on profitable, value-enhancing projects that improve future cash flows and manage risk.

Often companies conceptualize a strategy in terms of the consumers of the company’s goods and services. For example, management may have a strategy to become the world’s leading producer of microcomputer chips by producing the best quality chip or by producing chips at the lowest cost, developing a cost (and price) advantage over its competitors. So management’s focus is on product quality and cost. Is this strategy in conflict with maximizing owners’ wealth? No.

Management must focus on the returns and risks of future cash flows to stockholders in order to add value. And management looks at a project’s profitability when making decisions regarding whether to invest in it.

A strategy of gaining a competitive or comparative advantage is consistent with maximizing shareholder wealth. This is because profitable projects arise when the company has a competitive or comparative advantage over other companies.

Suppose a new piece of equipment is expected to generate a return greater than what is expected for the project’s risk (that is, greater than its cost of capital). But how can a company create value simply by investing in a piece of equipment? How can it maintain a competitive advantage? If investing in this equipment can create value, wouldn’t the company’s competitors also want this equipment? Of course-if they could use it to create value, they would surely be interested in it.

Now suppose that the company’s competitors face no barriers to buying the equipment and exploiting its benefits. What will happen? The company and its competitors will compete for the equipment, bidding up its price. When does it all end? It ends when the difference between the present value of the inflows and the present value of the outflows for the equipment is zero.

Suppose instead that the company has a patent on the new piece of equipment and can thus keep its competitors from exploiting the equipment’s benefits. Then there would be no competition for the equipment and the company would be able to exploit it to add value.

Consider an example where trying to gain a comparative advantage went wrong. Schlitz Brewing Company attempted to reduce its costs to gain an advantage over its competitors: It reduced its labor costs and shortened the brewing cycle. Reducing costs allowed it to reduce its prices below competitor’s prices. But product quality suffered-so much that Schlitz lost market share, instead of gaining it.

Schlitz Brewing attempted to gain a comparative advantage, but was not true to a larger strategy to satisfy its customers-who apparently wanted quality beer more than they wanted cheap beer. And the loss of market share was reflected in Schlitz’s declining stock price.

Value can be created only when the company has a competitive or comparative advantage.