THE IMPACT OF SALES AND INCOME GROWTH ON PROFITABILITY AND MARKET VALUE MEASURES IN ACTUAL AND SIMULATED INDUSTRIES Developments In Business Simulation & Experiential Exercises, Volume 22, 1995 56 THE IMPACT OF SALES AND INCOME GROWTH ON PROFITABILITY AND MARKET VALUE MEASURES IN ACTUAL AND SIMULATED INDUSTRIES William C. House, University of Arkansas Michael E. Benefield, University of Arkansas ABSTRACT Research and development expenditures, advertising outlays, and asset growth, as a proxy for plant and equipment expenditures, can logically be expected to influence sales and income growth in similar ways in different environments. If sales and income growth affect profitability and market value measures in simulated and actual environments, the leverage variables may have an indirect as well as a direct impact on profitability and market value. Income growth has the most significant impact on profitability and market value in the business game while asset growth is the most significant variable affecting financial performance in the executive game. Sales growth is the most significant growth variable affecting financial performance in the actual industries examined. The indirect effects vary widely from industry to industry, but research intensity appears to negatively impact sales growth in the durable products industry and has a positive impact on sales growth in the nondurable products industry. INTRODUCTION Sales and income growth can be expected to influence rate of return and market value measures in both simulated and actual industries. It is unclear if growth in one year will affect profitability and market value measures in a succeeding year in simulated and actual environments. Asset growth, which can be used as a proxy for plant and equipment expenditures, and research intensity, may also affect sales and income growth in a base year or succeeding year, indirectly affecting profitability and market value. These direct and indirect effects may be different in simulated and actual industries, but if students are to learn from simulations there should be a reasonable correspondence between variable effects in simulated environments and real world industries. Recently, value based planning and performance measurement has been receiving more attention in business literature and in actual practice, since it provides a framework for using firm value as a strategic performance measures and focuses on profitability and growth as determinants of firm value (Varaiya, Kerwin, and Weeks, 1987). Many analysts and company executives believe that shareholder value (e.g., stock appreciation + dividends) is a better measure of long term corporate performance than accounting based figures such as ROl, ROE, and EPS which are subject to variation in accounting treatments and which do not take into account the company cost of capital, including debt interest cost and equity cost. Although income measures are widely used as performance measures in simulated environments, many simulations do not provide for computation of stock prices and in those that do, market values are often not emphasized. Since return on equity has been shown to be highly correlated with market value/equity and other market value measures, it can be used as a proxy for market value indicators. INCOME MEASURES REFLECT SHORT TERM ORIENTATION Income or financial profitability measures have been frequently used as indicators of company performance in many studies of strategic evaluation. Rowe and Mason (1987) point out that the use of numerical descriptors in the form of financial ratios is very useful in showing the extent to which company revenue and profit objectives are achieved. A Conference Board Survey of financial indicators in 57 companies (Walsh, 1 987) indicated that return on assets, return on sales, and return on equity were the most important performance measures employed. These games measures were among those used by Peters and Waterman (1982) to discriminate among excellent and non-excellent companies. Krueger (1992) has emphasized the use of return on assets as an important performance measure in management analysis. Return on equity, which is equal to (profit margin) x (asset turnover) x (financial leverage), is among the most widely used income measures because it shows the return to the firm’s stockholders for an examination period. Profit margin is a useful measure of the firm’s competitive position while asset turnover is a measure of operating efficiency and capital intensity. Developments In Business Simulation & Experiential Exercises, Volume 22, 1995 57 Asset leverage is a measure of financial strategy that shows the portion of total assets financed by stockholders’ equity. Increasing financial leverage may improve the return to stockholders, but also will likely increase fixed costs and volatility of earnings. MARKET VALUE-BASED MEASURES PROVIDE STRATEGIC ORIENTATION Shareholder value is created when financial benefits of strategic activities exceed the cost of such activities. Shareholder value, theoretically, is the economic value of investments discounted by an interest rate equal to the cost of capital and is often measured by increases in share prices plus dividends for an appropriate measurement period. Shareholder value has been widely used to evaluate capital investments and acquisitions, but its use in assessing strategies and operational activities is not as common. Market Value/Stockholder’s Equity (i.e., Market/Book) is a market oriented ratio that may serve as a better measure of strategic performance than return on assets or return on equity. Market value is determined by the market’s assessment of future earnings streams that company assets can generate while book value equals the amount paid for assets when acquired. Although book values can be distorted due to arbitrary allocations and inadequate adjustments for the value of the dollar, company comparisons of market ratios are often valid since all companies in an industry can be assumed to be affected in the same way. Hax and Majluf (1984) state that market/book value is the best available measure of stockholder value creation. Rappaport (1981) points out that market/book is not tied to past events but can be perceived as reflecting investor perceptions of expected returns in excess of investment. Bogue and Buffa (1984) assert that market to book values are indicators of success in improving firm value. In essence, this ratio is equal to expected future payments/past resources committed and can serve as a good proxy for the net present values of future cash flows generated by inflation and risk as seen from the investor viewpoint. KEY VARIABLES INFLUENCE MARKET VALUE If value creation is to be the focus of strategic activities, company goals and subgoals must emphasize drivers such as maximizing cash flows and increasing operating profit margins. Although increasing sales and income growth may be worthwhile objectives, such actions may not always increase shareholder value. For example, expanding operations in a given market may increase sales growth, but a key question is whether the expansion will result in a profit margin that exceeds capital cost. Rappaport (1981) says in creating shareholder value, cash flow drivers are the sales growth rate, operating profit margin, fixed working capital investment, and cost of capital. Bogue and Buffa (1984) state that there are four factors that contribute to increasing economic value: scale (size), returns in excess of cost of capital, growth inherent in selected opportunities, and duration over which growth can be maintained. Varaiya, Kerwin, and Weeks (1987), found in an analysis of 400 companies from the Standard and Poor’s 500 companies that the spread, between return on equity and cost of capital, and earnings growth were associated with higher firm value and that the spread was more important than the earnings rate. The effect of sales and asset growth on firm value has been analyzed by Fruhan (1984) and Higgins and Kerwin (1983). In a PIMS based study, major factors found to influence company stock price were profitability (return on equity), growth prospects, and risk (Branch, Gale, 1983). Investment growth and R&D intensity reflect growth expectations and ultimately market value. Companies with above average profit levels and high growth rates produced market/book ratios about three times higher than that of low profit, slow growth companies. The positive effect of sales and income growth and R&D intensity is highest when return on equity is high. An examination of stock market data for 600 companies indicated that return on equity, investment (asset) growth, R&D intensity (R&D outlays/sales revenues), and interest coverage (as evidenced by high levels of profitability) were significantly related to market value/equity (Branch and Gale, 1984). In a related study, Buzzell and Gale (1987) pointed out that research intensity coupled with high return on equity had a significant impact on stock values for companies in the PIMS database. In a study of 52 Canadian companies, researchers found that the stock market places a positive value on R&D outlays as indicators of expected profitability and growth (Johnson, Pazderka, 1993). Using 95 announcements of increased R&D outlays, researchers found that the stock market responded positively Developments In Business Simulation & Experiential Exercises, Volume 22, 1995 58 even if earnings declined (Chan, Martin, and Kensinger, 1 990). High technology firms that announced increases in R&D had positive abnormal shareholder returns, while low technology firms had negative returns. The relationship of firm R&D intensity to industry average R&D intensity was more important than the size of the increase, industry concentration, or firm’s dominance in its industry. As Chauvin and Hirschey (1993) point out, size advantages appear to make advertising and R&D more profitable for large firms, and such firms seem to make greater gains in market value but it is rare to find firms that have both substantial R&D and advertising programs. It seems likely that advertising and R&D are seen as alternative forms of product differentiation in real world industries, although this perception is not common in simulated environments. R&D activities not only create entry barriers but also permit introduction of new product lines, providing indications of expected growth prospects and improved cash flows (Jose, Nichols, and Stevens, 1986). Advertising and promotion expenditures make product differentiation possible, allow economies of scale in production as promotion expenditures increase sales, and cause firms to gravitate to similar intensity levels, thereby reducing industry profit. Firm promotional and R&D intensity levels, which were significantly above or below industry benchmark figures, reduced firm stock values based on a study of 155 firms covering the period 1963 to 1977. METHODOLOGY To examine the effects of growth and R&D variables on profitability and market value, data was collected for two years for 29 companies playing the executive game and 28 companies playing a modified version of the Edge, Keys, and Remus business game. The Edge, Keys, and Remus game is a moderately complex game involving two products which allows students to make decisions involving advertising and research and development levels, pricing, number of salespersons, sales commission rates, production quantities and plant expansion. The Executive Game is a one-product game in which sales and income results are affected by the marketing/price/R&D mix as well as by maintenance, production levels, raw materials purchases and plant expansion decision. In order to compare the game outcomes with real-world industries, data was collected for years 1 992 and 1 993 on growth, R&D, income, and market value variables for 48 durable products companies (i.e., computer/electronics companies) and 48 nondurable products companies (i.e., drugs/chemical companies). Sales, income, and asset growth for years one and two, R&D/sales revenues, and return on sales were correlated with return on equity and with market value of equity (in industries where available) for years one and two using a SAS program to provide industry comparisons. RESULTS Table One gives correlations for variables in the Business Game and Table Two gives correlations for variables in the Executive games. As Table One shows, in the Business Game environment, sales growth has the strongest effect on return on equity of any of the growth measures in years one and two. Asset growth and R&D/sales revenue had a strong positive impact on sales growth while advertising/sales has a negative impact on sales growth in years one and two. Sales growth is related to income growth in both years but income growth is related to return on equity only in year one. In Table Two for the Executive Game companies, sales growth is positively correlated with income growth only in year one and with asset growth only in year two. Asset growth is related to income growth only in year one. Both sales and asset growth are positively related to return on equity in years one and two, with sales growth having the strongest impact in year one and asset growth having the most significant impact on return on equity in year two. R&D/Sales revenues are positively related to sales and income growth as well as asset growth in years one and two for the Business Game companies. In the Executive Game, R&D/sale’s revenue is negatively correlated with sales growth in year one. In the Business Game environment, advertising/sales revenue is negatively correlated with sales and income growth as well as with asset growth in year one. It is also negatively correlated with sales growth in year two. For the Executive Game companies, advertising/sales revenue is not related to any growth measure in years one or two. Increasing R&D/sales revenue, generally has a positive impact on the growth variables in the Business Game while increasing advertising/sales has a negative impact. In the Executive Game, increasing advertising levels does not significantly affect sales or asset growth in either year. Developments In Business Simulation & Experiential Exercises, Volume 22, 1995 59 In the Business Game, sales and income growth are positively related to market value/equity in years one and two. Asset growth is not related to market value, R&D intensity has a positive relationship to sales growth in both years, and this appears to exert an indirect influence on market value/equity. The Executive Game does not have a stock price, but the strong influence of asset growth on return on equity suggests it could significantly influence market value. Tables Three and Four give correlations for variables from actual companies. As Tables Three and Four indicate, in both the nondurable and durable products industries, asset growth is positively related to sales growth in years one and two. However, sales growth is not related to income growth in years one or two for the nondurable products group and only to income growth in year two for the durable products group. Sales, income, and asset growth are positively related to return on equity in year one for the nondurable products group but asset growth is more strongly related to sales growth in year one than year two. The growth variables are not related to return on equity in year one in the case of the durable products group. In year two, sales and asset growth are positively related to return on equity only in the durable products industry. R&D/sales revenue is positively related to sales growth in year one for the nondurable products industry and in negatively related to sales growth in year two for the durable products industries. However, research intensity is not related to income growth in either year for either industry. Percentage increase in R&D is positively related to sales and asset growth in years one and two for the nondurable products group. For the durable products companies, the percentage increase in R&D is positively related to sales and asset growth in year one and sales growth in year two. In the nondurable products industries, sales growth has the most significant impact on return on equity and this impact seems to be reinforced with the positive impact of research intensity and asset growth on sales growth. In the durable products industries, asset growth has a positive impact on sales growth in both years with the effect most pronounced in year two. However, the effect of asset growth on sales growth is partially offset by the negative impact of R&D outlays. This can be explained in part by company efforts to maintain existing levels of R&D activity during periods of reduced profitability. In the nondurable industries, sales and asset growth in year one and asset growth in year two are positively related to market value/equity. R&D/sales revenue has a positive influence on sales growth, and percentage increase in R&D has a strong impact on asset growth in year two, suggesting an indirect impact on market value. None of the growth measures are related to return on equity or market value/equity in the durable products industry for year one, although income growth has the strongest relationship with these performance measures. In year two, sales growth is positively related to market value/equity and the strong correlation of asset growth with sales growth implies an indirect effect on market value/equity. CONCLUSIONS Sales and income growth in the Business Game appear to have a significant impact on market value with plant and equipment expansion (i.e., asset growth) and research intensity exerting a positive indirect effect. Sales and asset growth in the Executive Game, along with income growth in year one, would seem to be driving forces in efforts to increase market value. Advertising intensity, with a positive effect on income growth in year one, appears to have more impact on return on equity as a proxy for market value than does research intensity. In the nondurable products industry, sales and asset growth positively affect market value in year one with asset growth more significant in year two. R&D/sales have an indirect impact on market value in year one due to its relationship with sales growth. Percentage increase in R&D is also indirectly related to market value, since it is highly correlated with sales and asset growth in years one and two. In the nondurable products industry, none of the growth measures are related to either return on equity or market value/equity in year one. However, sales growth is positively related to market value/equity in year two and asset growth is indirectly related to market value due to its strong relationship with sales growth. Research intensity has a negative impact on sales growth, which could offset to some extent the impact of asset growth. In the Business Game environments examined, income growth is more highly correlated with market value than the other growth measures while asset growth has the most significant effect on the return on equity used as a market value proxy in the Executive Game Developments In Business Simulation & Experiential Exercises, Volume 22, 1995 60 environment. In the actual durable and nondurable industry environments, sales growth seems to be the growth variable exerting the most influence on market value, enhanced by the indirect effect of asset growth. Research intensity has a positive effect on growth in year one for the nondurable products companies and a negative effect on growth in year two for the durable products companies. Future research will be needed to clarify certain unexplained aspects of the study. Examination of the variable relationships over a three to five year period would shed ‘light on lead-lag effects. Incorporating cost of capital into market value calculations would make these measures more pertinent. The effects of company size and deviations from industry averages for research and advertising intensity upon profitability and market value should also be considered. An examination of the impact of the size and timing of plant and equipment expenditures on market values in actual and simulated environments should also prove interesting. Developments In Business Simulation & Experiential Exercises, Volume 22, 1995 61 Developments In Business Simulation & Experiential Exercises, Volume 22, 1995 62 REFERENCES Branch, Ben and Bradley Gale, Linking Corporate Stock Price Performance to Strategy Formulation, Journal of Business Strategy, Summer 1983, pp. 40-50. Branch, Ben and Bradley Gale, Allocating Capital More Effectively, Sloan Management Review, Fall 1 987, pp. 21-31. Bogue, Marcus C. Ill and Elwood S. Buffa, Corporate Strategic Analysis, New York, The Free Press, 1984. Chan, Su Han, John Martin, and John W. Kensinger, Corporate Research and Development Expenditures and Share Value, Journal of Financial Economics, 1990 (26), pp. 255-276 Chauvin, Keith W. and Mark Hirschey, Advertising, R&D Expenditure, and the Market Value of the Firm, Financial Management, Winter 1993, pp. 128-140. Day, George S. and Liam Fahay, Putting Strategy Into Shareholder Value Analysis, Harvard Business Review, March-April 1990, pp. 156-162. Day, George S. and Liam Fahay, Valuing Market Strategies, Journal of Marketing, July 1 988, pp. 45-57. Hax, Arnold C. and Nicolas S. Majluf, Strategic Management: An Integrative Perspective, Englewood Cliffs, N.J., Prentice Hall, 1984. Johnson, W. Bruce and Bohumir Pzaderka, Firm Value and Investment in R&D, Managerial and Decision Economics, Vol. 14 (1993), pp. 15-24. Jose, Manuel L., Len M. Nichols, and Jerry Stevens, Contributions of Diversification, Promotion, and R&D to the Value of Multiproduct Firms: A Tobin’s Q Approach, Financial Management, Winter 1 986, pp. 33-42. Krueger, C. A., Spotting Profits and Problems with ROA, Business, January-March 1989 Rappaport, Alfred, CFO’s and Strategists: Forging a Common Framework, Harvard Business Review, May- June 1992, pp. 84-91. Rappaport, Alfred, Have We Been Measuring Success with the Wrong Ruler? Wall Street Journal, June 25, 1984. Rappaport, Alfred, Selecting Strategies that Create Stockholder Value, Harvard Business Review, May-June 1981 Rowe, A. J. and R. 0 Mason, Strategic Management: A Methodological Approach, Reading, Mass., Addison- Wesley, 1 987. Walsh, F. J., Measuring Business Unit Performance, National Industrial Conference Board Research Bulletin No. 206, New York, 1 987. Wenner, David L. and Richard W. Leber, Managing for Shareholder Value--From Top to Bottom, Harvard Business Review, November-December 1 989, pp. 52-66. Varaiya, Nikhil, Roger A. Kerwin, and David Weeks, The Relationship Between Growth, Profitability, and Firm Value, Strategic Management Journal, Vol. 8, 1987, pp. 487-497. Table of Contents Volume 22, 1995 Simulation Performance, Learning and Struggle Are Good Simulation Performers Consistently Good? Cognitive and Behavioral Consistency in a Computer-Based Marketing-Simulation-Game Environment: An Empirical Investigation of the Decision-Making Process Chalk & Cheese: Executive Short-Course vs. Academic Simulations Revisiting Personality Bias in Total Enterprise Simulations Are Good Strategies Consistently Good? Investigating the Use of a Computer Simulation as an Effective Pedagogical Tool for the Application of a Strategic Model The Problem of determining an Individualized Simulation's Validity as an Assessment Tool A Simulation Based Analysis of the Value of Information in the Hrebiniak Joyce Typology of Adaptation Relative to Porter's Generic Strategies The Impact of Sales and Income Growth on Profitability and Market Measures in Actual and Simulated Industries A Comparison of a Stand Alone Version of a Simulation with the Traditional Competitive Version Computer-Assisted Gaming of International Business Analyzing Simulations with Computer-Based Programs and Applying the Experience to a Real-World Business A Preliminary Investigation of the Use of a Bankruptcy Indicator in a Simulation Environment Graduates' Views on the Use of Computer Simulation Games Versus Cases as Pedagogical Tools An Analytical Advertising Model Approach to the Determination of Market Demand Dealing with the Complexity Paradox in Business Simulation Games A Prototyping Approach for Incorporating Large Data Bases into Media Planning Simulations: An Example Using Magazine Media Through the Looking Glass, Inc: Superior-Subordinate Personality Type and the Leniency effect Evaluating the Effectiveness of Role Playing Simulation and Other Methods in Teaching Managerial Skills Student and Teacher Perceptions of a Management Simulation Course Performance Evaluation: The Effect on the Propensity to Create Budgetary Slack Management Team Formation for Large Scale Simulations Comparative Static Analysis with the Complete PPA Package: A Strategic Market Planning Tool Consistency in Intent: Learning Objectives at the 1994 Intercollegiate Business Policy Competition A New Twist on an Old Game: The Business Strategy Game: A Global Industry Simulation 3ed Evaluation of Performance in Management Simulation: A Management Coefficients Model Building SimuWorlds: Strategic Management Games of the Future Bulls and Bears: A Stock Market Simulation A Systems Thinking Paradigm and Think Computer Simulation Model of Broadcast and Cable Television Industry Competition Jacket Factory The Sales Management Simulation The Marketing Management Simulation A Demonstration of Promodel Demonstrating A New, Cross-Functional Business Simulation: Vision+ A Cost Chain For The Business Strategy Game Simulation Special Session On Experiential Teaching Compensation Dilemmas: An Exercise In Ethical Decision-Making Organizational Storytelling: Telling Tales In The Business Classroom Evaluating Experiential Training: Case Study And Recommendations The Internship Portfolio: An Innovative Tool For Experiential Learning, Critical Thinking, And Communication An Ethnographic Analysis Of The Pedagogical Impact Of Cooperative Communicating Consumer Behavior: A Long-Term Integrated Exercise Using Personal Consumption Journals And Consumer Analysis Papers An Experiential Paradigm For Teaching Business Problem Solving Developing Leadership Skills The Spss® Student Assistant: The Integration of A Statistical Analysis Program Into A Marketing Research Textbook Negotiating With Your Students Using TQM Principles To Transform Accounting Systems Into An Experiential Exercise Enhancing The Effectiveness Of Outdoor-Based Experiential Training Using Virtual Reality Concepts Case Writing In A Developing Country: An Indonesian Example Experiential Learning Using Focus Groups How Real Should Experiential Pedagogy Be? A Viewpoint From Our Students Reengineering The Internship: A New Approach To Experiential Learning Utilizing The Cosmopolitan/Local And Marginal Man Constructs To Measure Students' Propensity For Creativity Developing Experiential Processes For Teaching Quantitative Techniques For Business Team Learning Roles: A Cooperative Learning Technique Creating the Ultimate Small Business Student Experience: Melding Score/Ace with SBI The Development of Trust in Work Teams: The Impact of Touch Some Outcomes of Experiential Learning: How the Cultural Dynamics of Different Countries are reflected in Workplace Norms & Values Incorporation of Job Analysis Results in Various Forms of Selection Interviews Chudesno, Inc.: An Evaluation of an Experiential Training and Development Simulation An Exercise for Exploring the Relationship between Jungian Psychological Types and Organizational Dynamics Partnership: A Radical Approach to Experiential Learning Partnership: A Nice Idea, But How Do I Get Started? Recognizing Discrimination at Work Using Critical Incident Skills Questions to Help Students Become More Successful at Job Interviewing The Video Project Introduction to Psychological Type Theory Come On Down Understanding Facilitation for Development and Continuous Learning: A Micro-Workshop Leadership and Empowerment: An Experiential Exercise in Decision Making Experiential Exercises and Pedagogy Track Workshop: Selecting a Manager for Maquiladora, Inc. Experiential Training In Multi-Cultural Corporate Settings The Role of Facilitation as an Aid to Complete Learning An Experiential Exercise to Illustrate Difference in Information Processing Behaviors and Styles How to Deliver Accessible Survey Results Age Diversity in the Workplace- Family Feud Style Nafta Standoff: A Cross-Cultural negotiating Role-Play Three Strikes and You're Out!: A Downsizing Experiential Exercise