Strategy and Value Creation in Finance

Strategy and value creation together refer to the deliberate planning and execution of actions that guide an organization toward achieving long-term goals while enhancing stakeholder value through growth, efficiency, and sustainable success.

The company’s chief financial officer is in a good position to link the corporate strategy with value creation. Most surveys indicate that CFOs feel that their focus is shifting from historical assessment of performance to forward-looking tasks such as the development of strategy and decision making.

For example, a March 2006 report prepared by CFO Research Services in collaboration with Deloitte Consulting found that CFOs not only participate in the development of a company’s strategy, but in many cases the CFO is also charged with executing the strategy and measuring the company’s progress toward the strategic goals.

Sources of Value Creation

A company’s strategy is a path to create value. But value cannot be created out of thin air. Value creation-that is, generating economic profit-requires identifying comparative and competitive advantages, and developing a strategy that exploits these advantages.

One way to look at these advantages is to use the framework introduced by Michael Porter.

Porter’s Five Forces relate to the company’s or industry’s ability to generate economic profits. Briefly:

• The bargaining power of suppliers relates to the power of the providers of inputs-both goods and services.
• The bargaining power of buyers relates to the power of those who buy the company’s goods and services.
• The threat of new entrants is related to barriers to entry into the industry.
• The threat of substitutes relates to alternative goods and services the company’s customers may buy.
• The competitive rivalry among existing members of the industry is affected by the number and relative size of the companies in the industry, the strategies of the companies, the differentiation among products, and the growth of the sales in the industry.

Porter’s Five Forces do not provide a magic formula for determining whether a company can create value. Rather, the purpose of the five forces is to provide a framework for thinking about the powers and threats that affect an industry’s-and company’s-ability to generate economic profits.

Porter’s forces are, basically, an elaboration of the theories of economics that tell us how a company creates economic profit. Though Porter’s forces may seem over simplistic in a dynamic economy, they provide a starting point for analysis of a company’s ability to add value.

Porter argues that an individual company may create a competitive advantage through relative cost, differentiation, and relative prices. Management, in evaluating a company’s current and future performance, can use these forces and strategies to identify the company’s sources of economic profit.

Management should never ignore the basic economics that lie behind value creation. If a company has a unique advantage, this can lead to value creation. If the advantage is one that can be replicated easily by others, this advantage-and hence any value creation related to it-may erode quickly.

The herding behavior of companies, seeking to mimic the strategies of the better-performing companies, may result in the erosion of value from that strategy. This herding behavior therefore requires that strategic planning be dynamic and that feedback from performance evaluation is important in this planning process. Therefore, strategic planning should be a continual process that requires setting strategic objectives, developing the strategy, periodically measuring progress toward those goals, and then reevaluating the strategic objectives and strategy.