Monday 13 February 2023

Fundamental principle of Business strategy

The fundamental business strategy principle simply put is: 

"If everyone can do it, it's too difficult to generate and capture value from whatever it is." or
"In a perfectly competitive market, no firm realizes economic profits". 

This means that in a competitive market, profits are competed away, the more suppliers of a good or service the cheaper that good or service becomes and suddenly every organisation providing that good or service is breaking even or just barely turning a profit. A situation such as this will generally result in one or several market organisations shifting their investments into other more profitable avenues.

To be a profitable organization, that organization needs a competitive advantage, something that will draw the market to their product or services, over their competitors. That competitive advantage could be made up of one or multiple factors, it could be as simple a superior marketing resulting in higher consumer trust, it could be quality or cost, or any other factor that makes it's product or service more appealing to the marketplace.

In economics profits are often referred to as 'rents'; the official definition is:
Economic profits (rents) are returns in excess of what an investor expects to earn from investments of similar risk (i.e. in excess of the opportunity cost of capital). The idea behind this is simple, an investor will be drawn to the opportunity which will maximize their return on investment while minimizing their risk. 

Let's say that there are two companies to invest in, both of which guarantee a return of 1 million dollars, however the first company requires an investment of 10 million where as the second requires an investment of 50 million, Obviously any investors will choose the first company. This introduces the concept of Opportunity Cost. Opportunity cost is the concept that while capital is occupied doing one thing it cannot be leveraged for something else. The investor or organisation must choose where to best deploy their assets for the greatest impact.

A common calculation used by strategy researchers to calculate the market value of an asset is to use Tobin's Q or Tobin's ration, a financial concept named after economist James Tobin. It is a measure used to evaluate the value of an asset compared to its replacement cost. Tobin's Q is calculated as the market value of an asset divided by its replacement cost.

If Tobin's Q is greater than 1, it indicates that the market value of the asset is higher than its replacement cost, which suggests that the market perceives the asset to be undervalued and that investment in the asset may yield a good return. If Tobin's Q is less than 1, it indicates that the market value of the asset is less than its replacement cost, which suggests that the market perceives the asset to be overvalued and that investment in the asset may not yield a good return. 

Tobin's Q is not a perfect measure and has limitations, but it provides a useful perspective on the relationship between the market value of an asset and its replacement cost, however it is very difficult to gain an accurate representation of an assets 'replacement value' 

Alternatively to 'Tobin's Q' strategists can leverage the Discounted Cash flow (DCF), a financial analysis technique used to evaluate the potential future cash flows of an investment, and determine its value by discounting those future cash flows to the present. The idea behind DCF is that the value of an investment today is equal to the sum of its expected future cash flows, discounted to reflect the time value of money. The discount rate used in the analysis takes into account the risk and expected return of the investment, and is generally higher for investments with higher levels of risk.

In general, DCF is a useful tool for making investment decisions, as it provides a comprehensive view of an investment's expected future cash flows and its associated risk. However, it is important to note that DCF is based on a number of assumptions, including the discount rate, expected future cash flows, and the expected holding period of the investment. As such, the results of a DCF analysis can be highly sensitive to changes in these assumptions, and care should be taken when interpreting the results.

In essence as a good or service becomes less profitable, the capital used to provide that good or service can and should be relocated to an opportunity where their is greater profitability. 

Fundamentally for an organisation to be profitable, there must exist a market inefficiency to take advantage of, otherwise the profitability will be competed out of exitance and any players in the space will operate at a break even point or with marginal profits. For an organisation to be profitable they need to have some sort of competitive advantage some sort of way to outperform their competition.

There can exist external controls to prevent this equilibrium of competition, these are in place to protect industries, for example if it was not profitable for famers to produce milk, they simply wouldn't this is why the government controls how much milk is produced, to ensure that enough supply is always available without the market crashing.

There are two schools of though when it comes to economic rents

Monopoly rents
: there is some barrier to entry that prevents competitors from entering the market, it could be cost prohibitive, or for example a particular licensing limitation, only a set number of licences to operate are given out and not all competitors can get one. The market is structured in such a way that ensures profitability.
In essence their is some barrier to competition

Ricardian rents: that certain organisations are just better at providing their product or service, they can do it cheaper, faster, at a higher quality whatever they can do they can do it better than their competition which will give them the competitive edge, earning more profits, which they can reinvest into themselves and snowball into success.
In essence their is some barrier to imitation.