Equity asset valuation workbook 3rd edition

chAPter 1equIty vALuAtIOn: APPLIcAtIOns And PrOcesses LeArnIng OutcOMes After completing this chapter, you will be able to do the following: • define valuation and intrinsic value and e

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Equity ASSEt VAluAtion

Workbook

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CFA Institute is the premier association for investment professionals around the world, with over 130,000 members in 151 countries and territories Since 1963 the organization has developed and administered the renowned Chartered Financial Analyst® Program With a rich history of leading the investment profession, CFA institute has set the highest standards in ethics, education, and professional excellence within the global investment community, and is the foremost authority on investment profession conduct and practice Each book in the CFA institute investment Series is geared toward industry practitioners along with graduate-level finance students and covers the most important topics in the industry The authors of these cutting-edge books are themselves industry professionals and academics and bring their wealth

of knowledge and expertise to this series

www.AccountingPdfBooks.com

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Equity ASSEt VAluAtion

Workbook

Third Edition

Jerald E Pinto, CFA Elaine Henry, CFA Thomas r robinson, CFA John D Stowe, CFA

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Equity AssEt VAluAtion

Workbook

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PArt I

LeArnIng ObjectIves, suMMAry OvervIew,

And PrObLeMs

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chAPter 1

equIty vALuAtIOn:

APPLIcAtIOns And PrOcesses

LeArnIng OutcOMes

After completing this chapter, you will be able to do the following:

• define valuation and intrinsic value and explain sources of perceived mispricing;

• explain the going concern assumption and contrast a going concern value to a liquidation value;

• describe definitions of value and justify which definition of value is most relevant to public company valuation;

• describe applications of equity valuation;

• describe questions that should be addressed in conducting an industry and competitive analysis;

• contrast absolute and relative valuation models and describe examples of each type of model;

• describe sum-of-the-parts valuation and conglomerate discounts;

• explain broad criteria for choosing an appropriate approach for valuing a given company

suMMAry OvervIew

In this reading, we have discussed the scope of equity valuation, outlined the valuation process, introduced valuation concepts and models, discussed the analyst’s role and responsibilities in conducting valuation, and described the elements of an effective research report in which ana-lysts communicate their valuation analysis

• valuation is the estimation of an asset’s value based on variables perceived to be related to future investment returns, or based on comparisons with closely similar assets

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4 Part I: Learning Objectives, summary Overview, and Problems

• The intrinsic value of an asset is its value given a hypothetically complete understanding of the asset’s investment characteristics

• The assumption that the market price of a security can diverge from its intrinsic value—

as suggested by the rational efficient markets formulation of efficient market theory—underpins active investing

• Intrinsic value incorporates the going-concern assumption, that is, the assumption that a company will continue operating for the foreseeable future In contrast, liquidation value is the company’s value if it were dissolved and its assets sold individually

• Fair value is the price at which an asset (or liability) would change hands if neither buyer nor

sell-er wsell-ere undsell-er compulsion to buy/sell and both wsell-ere informed about matsell-erial undsell-erlying facts

• In addition to stock selection by active traders, valuation is also used for:

• inferring (extracting) market expectations;

• evaluating corporate events;

• issuing fairness opinions;

• evaluating business strategies and models; and

• appraising private businesses

• The valuation process has five steps:

1 understanding the business

2 Forecasting company performance

3 selecting the appropriate valuation model

4 converting forecasts to a valuation

5 Applying the analytical results in the form of recommendations and conclusions

• understanding the business includes evaluating industry prospects, competitive position, and corporate strategies, all of which contribute to making more accurate forecasts un-derstanding the business also involves analysis of financial reports, including evaluating the quality of a company’s earnings

• In forecasting company performance, a top-down forecasting approach moves from economic forecasts to industry forecasts and then to individual company and asset forecasts

macro-A bottom-up forecasting approach aggregates individual company forecasts to industry casts, which in turn may be aggregated to macroeconomic forecasts

fore-• selecting the appropriate valuation approach means choosing an approach that is:

• consistent with the characteristics of the company being valued;

• appropriate given the availability and quality of the data; and

• consistent with the analyst’s valuation purpose and perspective

• two broad categories of valuation models are absolute valuation models and relative tion models

valua-• Absolute valuation models specify an asset’s intrinsic value, supplying a point estimate of value that can be compared with market price Present value models of common stock (also called discounted cash flow models) are the most important type of absolute valuation model

• relative valuation models specify an asset’s value relative to the value of another asset As applied to equity valuation, relative valuation is also known as the method of compara-bles, which involves comparison of a stock’s price multiple to a benchmark price multiple The benchmark price multiple can be based on a similar stock or on the average price multiple of some group of stocks

• two important aspects of converting forecasts to valuation are sensitivity analysis and ational adjustments

situ-• sensitivity analysis is an analysis to determine how changes in an assumed input would affect the outcome of an analysis

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Chapter 1 Equity Valuation: Applications and Processes 5

• situational adjustments include control premiums (premiums for a controlling interest in the company), discounts for lack of marketability (discounts reflecting the lack of a public market for the company’s shares), and illiquidity discounts (discounts reflecting the lack

of a liquid market for the company’s shares)

• Applying valuation conclusions depends on the purpose of the valuation

• In performing valuations, analysts must hold themselves accountable to both standards of competence and standards of conduct

• An effective research report:

• contains timely information;

• is written in clear, incisive language;

• is objective and well researched, with key assumptions clearly identified;

• distinguishes clearly between facts and opinions;

• contains analysis, forecasts, valuation, and a recommendation that are internally consistent;

• presents sufficient information that the reader can critique the valuation;

• states the risk factors for an investment in the company; and

• discloses any potential conflicts of interests faced by the analyst

• Analysts have an obligation to provide substantive and meaningful content cFA Institute members have an additional overriding responsibility to adhere to the cFA Institute code

of ethics and relevant specific standards of Professional conduct

3 A explain why liquidation value is generally not relevant to estimating intrinsic value for profitable companies

b explain whether making a going-concern assumption would affect the value placed

on a company’s inventory

4 explain how the procedure for using a valuation model to infer market expectations about

a company’s future growth differs from using the same model to obtain an independent estimate of value

5 example 1, based on a study of Intel corporation that used a present value model (cornell 2001), examined what future revenue growth rates were consistent with Intel’s stock price

of $61.50 just prior to its earnings announcement, and $43.31 only five days later The example states, “using a conservatively low discount rate, cornell estimated that Intel’s price before the announcement, $61.50, was consistent with a forecasted growth rate of

20 percent a year for the subsequent 10 years and then 6 percent per year thereafter.” discuss the implications of using a higher discount rate than cornell did

6 discuss how understanding a company’s business (the first step in equity valuation) might

be useful in performing a sensitivity analysis related to a valuation of the company

Practice Problems and solutions: Equity Asset Valuation, second edition, by jerald e Pinto, cFA, elaine

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7 In a research note on the ordinary shares of the Milan Fashion group (MFg) dated early july 2007 when a recent price was €7.73 and projected annual dividends were €0.05, an analyst stated a target price of €9.20 The research note did not discuss how the target price was obtained or how it should be interpreted Assume the target price represents the expected price of MFg what further specific pieces of information would you need to form an opinion on whether MFg was fairly valued, overvalued, or undervalued?

8 you are researching XMI corporation (XMI) XMI has shown steady earnings per share growth (18 percent a year during the last seven years) and trades at a very high multiple

to earnings (its P/e is currently 40 percent above the average P/e for a group of the most comparable stocks) XMI has generally grown through acquisition, by using XMI stock to purchase other companies whose stock traded at lower P/es In investigating the financial disclosures of these acquired companies and talking to industry contacts, you conclude that XMI has been forcing the companies it acquires to accelerate the payment of expenses before the acquisition deals are closed As one example, XMI asks acquired companies to immediately pay all pending accounts payable, whether or not they are due subsequent

to the acquisition, XMI reinstitutes normal expense payment patterns

A what are the effects of XMI’s pre-acquisition expensing policies?

b The statement is made that XMI’s “P/e is currently 40 percent above the average P/e for a group of the most comparable stocks.” what type of valuation model is implicit

in that statement?

The following information relates to Questions 9–16

guardian capital is a rapidly growing us investment firm The guardian capital research team is responsible for identifying undervalued and overvalued publicly traded equities that have a market capitalization greater than $500 million

due to the rapid growth of assets under management, guardian capital recently hired a new analyst, jack richardson, to support the research process At the new analyst orientation meeting, the director of research made the following statements about equity valuation at guardian:

statement 1 “Analysts at guardian capital seek to identify mispricing, relying on price

eventually converging to intrinsic value however, convergence of the market price to an analyst’s estimate of intrinsic value may not happen within the portfolio manager’s investment time horizon so, besides evi-dence of mispricing, analysts should look for the presence of a particular market or corporate event,—that is, a catalyst—that will cause the mar-ketplace to re-evaluate the subject firm’s prospects.”

statement 2 “An active investment manager attempts to capture positive alpha but

mispricing of assets is not directly observable It is therefore important that you understand the possible sources of perceived mispricing.”

statement 3 “For its distressed securities fund, guardian capital screens its investable

universe of securities for companies in financial distress.”

statement 4 “For its core equity fund, guardian capital selects financially sound

companies that are expected to generate significant positive free cash flow from core business operations within a multiyear forecast horizon.”statement 5 “guardian capital’s research process requires analysts to evaluate the rea-

sonableness of the expectations implied by the market price by comparing the market’s implied expectations to his or her own expectations.”

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Chapter 1 Equity Valuation: Applications and Processes 7

After the orientation meeting, the director of research asks richardson to evaluate three companies that are retailers of men’s clothing: diamond co., renaissance clothing, and de-luxe Men’s wear

richardson starts his analysis by evaluating the characteristics of the men’s retail clothing industry he finds few barriers to new retail entrants, high intra-industry rivalry among retailers, low product substitution costs for customers, and a large number of wholesale clothing suppliers while conducting his analysis, richardson discovers that renaissance clothing included three non-recurring items in their most recent earnings release: a positive litigation settlement,

a one-time tax credit, and the gain on the sale of a non-operating asset

to estimate each firm’s intrinsic value, richardson applies appropriate discount rates to each firm’s estimated free cash flows over a ten-year time horizon and to the estimated value of the firm at the end of the ten-year horizon

Michelle Lee, a junior technology analyst at guardian, asks the director of research for advice as to which valuation model to use for vegA, a fast growing semiconductor company that is rapidly gaining market share

The director of research states that “the valuation model selected must be consistent with the characteristics of the company being valued.”

Lee tells the director of research that vegA is not expected to be profitable for several more years According to management guidance, when the company turns profitable, it will invest in new product development; as a result, it does not expect to initiate a dividend for an extended period of time Lee also notes that she expects that certain larger competitors will become interested in acquiring vegA because of its excellent growth prospects The director

of research advises Lee to consider that in her valuation

9 based on statement 2, which of the following sources of perceived mispricing do active investment managers attempt to identify? The difference between:

A intrinsic value and market price

b estimated intrinsic value and market price

c intrinsic value and estimated intrinsic value

10 with respect to statements 3 and 4, which of the following measures of value would the distressed securities fund’s analyst consider that a core equity fund analyst might ignore?

A Fair value

b Liquidation value

c Fair market value

11 with respect to statement 4, which measure of value is most relevant for the analyst of the

fund described?

A Liquidation value

b Investment value

c going-concern value

12 According to statement 5, analysts are expected to use valuation concepts and models to:

A value private businesses

b render fairness opinions

c extract market expectations

13 based on richardson’s industry analysis, which of the following characteristics of men’s

retail clothing retailing would positively affect its profitability? That industry’s:

A entry costs

b substitution costs

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14 which of the following statements about the reported earnings of renaissance clothing

is most accurate? relative to sustainable earnings, reported earnings are likely:

16 which valuation model would the director of research most likely recommend Lee use to

estimate the value of vegA?

A Free cash flow

b dividend discount

c P/e relative valuation

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ChaPter 2

return ConCePtS

Learning outCoMeS

• distinguish among realized holding period return, expected holding period return, required return, return from convergence of price to intrinsic value, discount rate, and internal rate

• explain beta estimation for public companies, thinly traded public companies, and lic companies;

nonpub-• describe strengths and weaknesses of methods used to estimate the required return on an equity investment;

• explain international considerations in required return estimation;

• explain and calculate the weighted average cost of capital for a company;

• evaluate the appropriateness of using a particular rate of return as a discount rate, given a description of the cash flow to be discounted and other relevant facts

SuMMary overview

in this reading we introduced several important return concepts required returns are tant because they are used as discount rates in determining the present value of expected future cash flows when an investor’s intrinsic value estimate for an asset differs from its market price, the investor generally expects to earn the required return plus a return from the convergence of price to value when an asset’s intrinsic value equals price, however, the investor only expects

impor-to earn the required return

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10 Part i: Learning objectives, Summary overview, and Problems

For two important approaches to estimating a company’s required return, the CaPM and the build-up model, the analyst needs an estimate of the equity risk premium This reading examined realized equity risk premia for a group of major world equity markets and also ex-plained forward-looking estimation methods For determining the required return on equity, the analyst may choose from the CaPM and various multifactor models such as the Fama–French model and its extensions, examining regression fit statistics to assess the reliability of these methods For private companies, the analyst can adapt public equity valuation models for required return using public company comparables, or use a build-up model, which starts with the risk-free rate and the estimated equity risk premium and adds additional appropriate risk premia

when the analyst approaches the valuation of equity indirectly, by first valuing the total firm as the present value of expected future cash flows to all sources of capital, the appropriate discount rate is a weighted average cost of capital based on all sources of capital Discount rates must be on a nominal (real) basis if cash flows are on a nominal (real) basis

among the reading’s major points are the following:

• The return from investing in an asset over a specified time period is called the holding period

return Realized return refers to a return achieved in the past, and expected return refers to

an anticipated return over a future time period a required return is the minimum level of

expected return that an investor requires to invest in the asset over a specified time period,

given the asset’s riskiness The (market) required return, a required rate of return on an asset that is inferred using market prices or returns, is typically used as the discount rate in finding

the present values of expected future cash flows if an asset is perceived (is not perceived) as fairly priced in the marketplace, the required return should (should not) equal the investor’s

expected return when an asset is believed to be mispriced, investors should earn a return

from convergence of price to intrinsic value.

• an estimate of the equity risk premium—the incremental return that investors require for holding equities rather than a risk-free asset—is used in the CaPM and in the build-up approach to required return estimation

• approaches to equity risk premium estimation include historical, adjusted historical, and forward-looking approaches

• in historical estimation, the analyst must decide whether to use a short-term or a long-term government bond rate to represent the risk-free rate and whether to calculate a geometric or arithmetic mean for the equity risk premium estimate Forward-looking estimates include gordon growth model estimates, supply-side models, and survey estimates adjusted his-torical estimates can involve an adjustment for biases in data series and an adjustment to incorporate an independent estimate of the equity risk premium

• The CaPM is a widely used model for required return estimation that uses beta relative

to a market portfolio proxy to adjust for risk The Fama–French model (FFM) is a three factor model that incorporates the market factor, a size factor, and a value factor The Pastor-Stambaugh extension to the FFM adds a liquidity factor The bond yield plus risk premium approach finds a required return estimate as the sum of the ytM of the subject company’s debt plus a subjective risk premium (often 3 percent to 4 percent)

• when a stock is thinly traded or not publicly traded, its beta may be estimated on the basis of

a peer company’s beta The procedure involves unlevering the peer company’s beta and then re-levering it to reflect the subject company’s use of financial leverage The procedure adjusts for the effect of differences of financial leverage between the peer and subject company

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Chapter 2 Return Concepts 11

• emerging markets pose special challenges to required return estimation The country spread model estimates the equity risk premium as the equity risk premium for a developed market plus a country premium The country risk rating model approach uses risk ratings for devel-oped markets to infer risk ratings and equity risk premiums for emerging markets

• The weighted average cost of capital is used when valuing the total firm and is generally understood as the nominal after-tax weighted average cost of capital, which is used in dis-counting nominal cash flows to the firm in later readings The nominal required return on equity is used in discounting cash flows to equity

ProbLeMS

1 a Canada-based investor buys shares of toronto-Dominion bank (toronto: tD.to) for C$72.08 on 15 october 2007 with the intent of holding them for a year The dividend rate was C$2.11 per year The investor actually sells the shares on 5 november 2007 for C$69.52 The investor notes the following additional facts:

• no dividends were paid between 15 october and 5 november

• The required return on tD.to equity was 8.7 percent on an annual basis and 0.161 percent on a weekly basis

a State the lengths of the expected and actual holding-periods

b given that tD.to was fairly priced, calculate the price appreciation return (capital gains yield) anticipated by the investor given his initial expectations and initial expect-

ed holding period

C Calculate the investor’s realized return

D Calculate the realized alpha

2 The estimated betas for aoL time warner (nySe: aoL), J.P Morgan Chase & pany (nySe: JPM), and The boeing Company (nySe: ba) are 2.50, 1.50, and 0.80, respectively The risk-free rate of return is 4.35 percent, and the equity risk premium

Com-is 8.04 percent Calculate the required rates of return for these three stocks using the CaPM

3 The estimated factor sensitivities of terranova energy to Fama–French factors and the risk premia associated with those factors are given in the table below:

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5 an analyst wants to account for financial distress and market-capitalization as well as market risk in his cost of equity estimate for a particular traded company which of the

following models is most appropriate for achieving that objective?

a The capital asset pricing model (CaPM)

b The Fama–French model

C a macroeconomic factor model

6 The following facts describe Larsen & toubro Ltd’s component costs of capital and capital structure based on the information given, calculate Larsen & toubro’s waCC

an equity index is established in 2001 for a country that has relatively recently established a market economy The index vendor constructed returns for the five years prior to 2001 based

on the initial group of companies constituting the index in 2001 over 2004 to 2006, a series

of military confrontations concerning a disputed border disrupted the economy and financial markets The dispute is conclusively arbitrated at the end of 2006 in total, ten years of equity market return history is available as of the beginning of 2007 The geometric mean return relative to 10-year government bond returns over 10 years is 2 percent per year The forward dividend yield on the index is 1 percent Stock returns over 2004 to 2006 reflect the setbacks, but economists predict the country will be on a path of a 4 percent real gDP growth rate by

2009 earnings in the public corporate sector are expected to grow at a 5 percent per year real growth rate Consistent with that, the market P/e ratio is expected to grow at 1 percent per year although inflation is currently high at 6 percent per year, the long-term forecast is for an inflation rate of 4 percent per year although the yield curve has usually been upward sloping, currently the government yield curve is inverted; at the short-end, yields are 9 percent, and at 10-year maturities yields are 7 percent

7 The inclusion of index returns prior to 2001 would be expected to:

a bias the historical equity risk premium estimate upwards

b bias the historical equity risk premium estimate downwards

C have no effect on the historical equity risk premium estimate

8 The events of 2004 to 2006 would be expected to:

a bias the historical equity risk premium estimate upwards

b bias the historical equity risk premium estimate downwards

C have no effect on the historical equity risk premium estimate

9 in the current interest rate environment, using a required return estimate based on the short-term government bond rate and a historical equity risk premium defined in terms

of a short-term government bond rate would be expected to:

a bias long-term required return on equity estimates upwards

b bias long-term required return on equity estimates downwards

C have no effect on long-term required return on equity estimates

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10 a supply side estimate of the equity risk premium as presented by The ibbotson–Chen

earnings model is closest to:

a 3.2 percent

b 4.0 percent

C 4.3 percent

11 Common stock issues in the above market with average systematic risk are most likely to

have required rates of return:

a between 2 percent and 7 percent

b between 7 and 9 percent

C 9 percent or greater

12 which of the following statements is most accurate? if two equity issues have the same

market risk but the first issue has higher leverage, greater liquidity, and a higher required

return, the higher required return is most likely the result of the first issue’s:

a greater liquidity

b higher leverage

C higher leverage and greater liquidity

Questions 13 through 19 relate to Horizon Asset Management

Judy Chen is the primary portfolio manager of the global equities portfolio at horizon asset Management Lars Johansson, a recently hired equity analyst, has been assigned to Chen to assist her with the portfolio

Chen recently sold shares of novo-gemini, inc from the portfolio Chen tasks son with assessing the return performance of novo-gemini, with specific trade information provided in exhibit 1

Johans-exhibit 1 novo-gemini, inc trade Details

1 novo-gemini shares were purchased for $20.75 per share.

2 at the time of purchase, research by Chen suggested that novo-gemini shares were expected to sell for $29.00 per share at the end of a 3-year holding period.

3 at the time of purchase, the required return for novo-gemini based upon the capital asset pricing model (CaPM) was estimated to be 12.6% on an annual basis.

4 exactly 3 years after the purchase date, the shares were sold for $30.05 per share.

5 no dividends were paid by novo-gemini over the 3-year holding period.

Chen explains to Johansson that, at the time of purchase, the CaPM used to estimate a required return for novo-gemini incorporated an unadjusted historical equity risk premium estimate for the uS equity market Chen notes that the uS equities market has experienced a meaningful string of favorable inflation and productivity surprises in the past She asks Johans-son whether the historical equity risk premium should have been adjusted before estimating the required return for novo-gemini

For another perspective on the reward to bearing risk, Chen asks Johansson to calculate

a forward-looking equity risk premium for the uS equity market using data on the S&P 500 index in exhibit 2

exhibit 2 S&P 500 index Data

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Chen is now considering adding shares of bezak, inc to the portfolio Chen asks son to calculate bezak’s weighted average cost of capital using the CaPM with the information provided in exhibit 3

Johans-exhibit 3 bezak, inc.

Lastly, Chen asks Johansson to evaluate twin industries, a privately owned uS company that may initiate a public stock offering Johansson decides to adapt CaPM to estimate the required return on equity for twin industries using the MSCi / Standard & Poor’s global industry Classification Standard (giCS), Johansson identifies a publicly traded peer company with an estimated beta of 1.09 that is much larger but otherwise similar to twin industries twin industries is funded 49% by debt, while the publicly traded peer company is funded 60% by debt

13 based upon exhibit 1, the expected three-year holding period return for novo-gemini

inc at the time of purchase was closest to:

a 39.76%

b 42.76%

C 44.82%

14 based upon exhibit 1, the realized three-year holding period return for novo-gemini inc

was closest to:

17 based on exhibit 3, and assuming interest on debt is tax-deductible, the weighted average

cost of capital (waCC) for bezak, inc is closest to:

a 10.87%

b 11.36%

C 13.61%

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18 The estimate of beta for twin industries is closest to:

a does not include a size premium

b may overstate potential returns over the long term

C does not consider systematic risk arising from the economics of the industry

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• explain uses of industry analysis and the relation of industry analysis to company analysis;

• compare methods by which companies can be grouped, current industry classification tems, and classify a company, given a description of its activities and the classification system;

sys-• explain the factors that affect the sensitivity of a company to the business cycle and the uses and limitations of industry and company descriptors such as “growth,” “defensive,” and

“cyclical”;

• explain how a company’s industry classification can be used to identify a potential “peer group” for equity valuation;

• describe the elements that need to be covered in a thorough industry analysis;

• describe the principles of strategic analysis of an industry;

• explain the effects of barriers to entry, industry concentration, industry capacity, and market share stability on pricing power and price competition;

• describe industry life cycle models, classify an industry as to life cycle stage, and describe limitations of the life-cycle concept in forecasting industry performance;

• compare characteristics of representative industries from the various economic sectors;

• describe macroeconomic, technological, demographic, governmental, and social influences

on industry growth, profitability, and risk;

• describe the elements that should be covered in a thorough company analysis

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18 Part I: learning objectives, summary overview, and Problems

anal-• Industry analysis is useful for:

• understanding a company’s business and business environment;

• identifying active equity investment opportunities;

• formulating an industry or sector rotation strategy; and

• portfolio performance attribution

• The three main approaches to classifying companies are:

• products and/or services supplied;

• business-cycle sensitivities; and

• statistical similarities

• Commercial industry classification systems include:

• global Industry Classification standard;

• russell global sectors; and

• Industry Classification Benchmark

• governmental industry classification systems include:

• International standard Industrial Classification of All economic Activities;

• statistical Classification of economic Activities in the european Community;

• Australian and new Zealand standard Industrial Classification; and

• north American Industry Classification system

• A limitation of current classification systems is that the narrowest classification unit assigned

to a company generally cannot be assumed to constitute its peer group for the purposes of detailed fundamental comparisons or valuation

• A peer group is a group of companies engaged in similar business activities whose economics and valuation are influenced by closely related factors

• steps in constructing a preliminary list of peer companies:

• examine commercial classification systems if available These systems often provide a ful starting point for identifying companies operating in the same industry

use-• review the subject company’s annual report for a discussion of the competitive ment Companies frequently cite specific competitors

environ-• review competitors’ annual reports to identify other potential comparables

• review industry trade publications to identify additional peer companies

• Confirm that each comparable or peer company derives a significant portion of its nue and operating profit from a similar business activity as the subject company

reve-• not all industries are created equal some are highly competitive, with many companies struggling to earn returns in excess of their cost of capital, and other industries have attractive characteristics that enable a majority of industry participants to generate healthy profits

• differing competitive environments are determined by the structural attributes of the try For this important reason, industry analysis is a vital complement to company analysis The analyst needs to understand the context in which a company operates to fully under-stand the opportunities and threats that a company faces

indus-www.AccountingPdfBooks.com

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Chapter 3 Introduction to Industry and Company Analysis 19

• The framework for strategic analysis known as “Porter’s five forces” can provide a useful ing point Porter maintains that the profitability of companies in an industry is determined

start-by five forces: 1) The threat of new entrants, which in turn is determined start-by economies of scale, brand loyalty, absolute cost advantages, customer switching costs, and government regulation; 2) the bargaining power of suppliers, which is a function of the feasibility of product substitution, the concentration of the buyer and supplier groups, and switching costs and entry costs in each case; 3) the bargaining power of buyers, which is a function of switching costs among customers and the ability of customers to produce their own product; 4)the threat of substitutes; and 5) the intensity of rivalry among existing competitors, which

in turn is a function of industry competitive structure, demand conditions, cost conditions, and the height of exit barriers

• The concept of barriers to entry refers to the ease with which new competitors can challenge incumbents and can be an important factor in determining the competitive environment

of an industry If new competitors can easily enter the industry, the industry is likely to be highly competitive because incumbents that attempt to raise prices will be undercut by newcomers As a result, industries with low barriers to entry tend to have low pricing power Conversely, if incumbents are protected by barriers to entry, they may enjoy a more benign competitive environment that gives them greater pricing power over their customers because they do not have to worry about being undercut by upstarts

• Industry concentration is often, although not always, a sign that an industry may have pricing power and rational competition Industry fragmentation is a much stronger signal, however, that the industry is competitive and pricing power is limited

• The effect of industry capacity on pricing is clear: tight capacity gives participants more pricing power because demand for products or services exceeds supply; overcapacity leads

to price cutting and a highly competitive environment as excess supply chases demand The analyst should think about not only current capacity conditions but also future changes in capacity levels—how long it takes for supply and demand to come into balance and what effect that process has on industry pricing power and returns

• examining the market share stability of an industry over time is similar to thinking about barriers to entry and the frequency with which new players enter an industry stable market shares typically indicate less competitive industries, whereas unstable market shares often indicate highly competitive industries with limited pricing power

• An industry’s position in its life cycle often has a large impact on its competitive dynamics,

so it is important to keep this positioning in mind when performing strategic analysis of an industry Industries, like individual companies, tend to evolve over time and usually experi-ence significant changes in the rate of growth and levels of profitability along the way Just

as an investment in an individual company requires careful monitoring, industry analysis

is a continuous process that must be repeated over time to identify changes that may be occurring

• A useful framework for analyzing the evolution of an industry is an industry life-cycle model, which identifies the sequential stages that an industry typically goes through The five stages

of an industry life cycle according to the hill and Jones model are:

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over-20 Part I: learning objectives, summary overview, and Problems

decisions are also likely to be the focus of competitive rivalry in the industry Broadly, dustries for which price is a large factor in customer purchase decisions tend to be more competitive than industries in which customers value other attributes more highly

in-• external influences on industry growth, profitability, and risk include:

compa-• Porter identifies two chief competitive strategies:

• A cost strategy (cost leadership) is one in which companies strive to become the cost producers and to gain market share by offering their products and services at lower prices than their competition, while still making a profit margin sufficient to generate a superior rate of return based on the higher revenues achieved

low-• A product/service differentiation strategy is one in which companies attempt to establish themselves as the suppliers or producers of products and services that are unique either in quality, type, or means of distribution to be successful, the companies’ price premiums must be above their costs of differentiation, and the differentiation must be appealing to customers and sustainable over time

• A checklist for company analysis includes a thorough investigation of:

ProBleMs

1 which of the following is least likely to involve industry analysis?

A sector rotation strategy

B top-down fundamental investing

C tactical asset allocation strategy

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2 A sector rotation strategy involves investing in a sector by:

A making regular investments in it

B investing in a pre-selected group of sectors on a rotating basis

C timing investment to take advantage of business-cycle conditions

3 which of the following information about a company would most likely depend on an

industry analysis? The company’s:

A dividend policy

B competitive environment

C trends in corporate expenses

4 which industry classification system uses a three-tier classification system?

A russell global sectors

B Industry Classification Benchmark

C global Industry Classification standard

5 In which sector would a manufacturer of personal care products be classified?

A health care

B Consumer staples

C Consumer discretionary

6 which of the following statements about commercial and government industry

classifica-tion systems is most accurate?

A Many commercial classification systems include private for-profit companies

B Both commercial and government classification systems exclude not-for-profit companies

C Commercial classification systems are generally updated more frequently than ment classification systems

7 which of the following is not a limitation of the cyclical/non-cyclical descriptive approach

to classifying companies?

A A cyclical company may have a growth component in it

B Business-cycle sensitivity is a discrete phenomenon rather than a continuous spectrum

C A global company can experience economic expansion in one part of the world while experiencing recession in another part

8 A company that is sensitive to the business cycle would most likely:

A not have growth opportunities

B experience below-average fluctuation in demand

C sell products that the customer can purchase at a later date if necessary

9 which of the following factors would most likely be a limitation of applying business-cycle

analysis to global industry analysis?

A some industries are relatively insensitive to the business cycle

B Correlations of security returns between different world markets are relatively low

C one region or country of the world may experience recession while another region experiences expansion

10 which of the following statements about peer groups is most accurate?

A Constructing a peer group for a company follows a standardized process

B Commercial industry classification systems often provide a starting point for structing a peer group

con-C A peer group is generally composed of all the companies in the most narrowly defined category used by the commercial industry classification system

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11 with regard to forming a company’s peer group, which of the following statements is not

de-C Comparing the company’s performance measures with those for a potential group company is of limited value when the companies are exposed to different stages

peer-of the business cycle

12 when selecting companies for inclusion in a peer group, a company operating in three different business segments would:

A be in only one peer group

B possibly be in more than one peer group

C not be included in any peer group

13 An industry that most likely has both high barriers to entry and high barriers to exit

is the:

A restaurant industry

B advertising industry

C automobile industry

14 which factor is most likely associated with stable market share?

A low switching costs

B low barriers to entry

C slow pace of product innovation

15 which of the following companies most likely has the greatest ability to quickly increase

its capacity?

A restaurant

B steel producer

C legal services provider

16 A population that is rapidly aging would most likely cause the growth rate of the industry

producing eye glasses and contact lenses to:

A decrease

B increase

C not change

17 If over a long period of time a country’s average level of educational accomplishment

in-creases, this development would most likely lead to the country’s amount of income spent

on consumer discretionary goods to:

C removal of features that differentiate the product or service provided

19 which of the following life-cycle phases is typically characterized by high prices?

A Mature

B growth

C embryonic

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20 In which of the following life-cycle phases are price wars most likely to be absent?

A Mature

B decline

C growth

21 when graphically depicting the life-cycle model for an industry as a curve, the variables

on the axes are:

A price and time

B demand and time

C demand and stage of the life cycle

22 which of the following is most likely a characteristic of a concentrated industry?

A Infrequent, tacit coordination

B difficulty in monitoring other industry members

C Industry members attempting to avoid competition on price

23 which of the following industry characteristics is generally least likely to produce high

returns on capital?

A high barriers to entry

B high degree of concentration

C short lead time to build new plants

24 An industry with high barriers to entry and weak pricing power most likely has:

A high barriers to exit

B stable market shares

C significant numbers of issued patents

25 economic value is created for an industry’s shareholders when the industry earns a return:

A below the cost of capital

B equal to the cost of capital

C above the cost of capital

26 which of the following industries is most likely to be characterized as concentrated with

strong pricing power?

A Asset management

B Alcoholic beverages

C household and personal products

27 which of the following industries is most likely to be considered to have the lowest barriers

to entry?

A oil services

B Confections and candy

C Branded pharmaceuticals

28 with respect to competitive strategy, a company with a successful cost leadership strategy

is most likely characterized by:

A a low cost of capital

B reduced market share

C the ability to offer products at higher prices than competitors

29 when conducting a company analysis, the analysis of demand for a company’s product is

least likely to consider the:

A company’s cost structure

B motivations of the customer base

C product’s differentiating characteristics

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30 which of the following statements about company analysis is most accurate?

A The complexity of spreadsheet modeling ensures precise forecasts of financial statements

B The interpretation of financial ratios should focus on comparing the company’s results over time but not with competitors

C The corporate profile would include a description of the company’s business, ment activities, governance, and strengths and weaknesses

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chAPter 4

Industry And coMPAny AnAlysIs

leArnIng outcoMes

• compare top-down, bottom-up, and hybrid approaches for developing inputs to equity valuation models;

• compare “growth relative to gdP growth” and “market growth and market share” approaches

• describe approaches to balance sheet modeling;

• describe the relationship between return on invested capital and competitive advantage;

• explain how competitive factors affect prices and costs;

• judge the competitive position of a company based on a Porter’s five forces analysis;

• explain how to forecast industry and company sales and costs when they are subject to price inflation or deflation;

• evaluate the effects of technological developments on demand, selling prices, costs, and margins;

• explain considerations in the choice of an explicit forecast horizon;

• explain an analyst’s choices in developing projections beyond the short-term forecast horizon;

• demonstrate the development of a sales-based pro forma company model

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• In a “growth relative to gdP growth” approach to forecasting revenue, the analyst forecasts the growth rate of nominal gross domestic product and industry and company growth rel-ative to gdP growth.

• In a “market growth and market share” approach to forecasting revenue, the analyst bines forecasts of growth in particular markets with forecasts of a company’s market share in the individual markets

com-• operating margins that are positively correlated with sales provide evidence of economies

of scale in an industry

• some balance sheet line items, such as retained earnings, flow directly from the income statement, whereas accounts receivable, accounts payable, and inventory are very closely linked to income statement projections

• A common way to model working capital accounts is to use efficiency ratios

• return on invested capital (roIc), defined as net operating profit less adjusted taxes

divid-ed by the difference between operating assets and operating liabilities, is an after-tax measure

of the profitability of investing in a company high and persistent levels of roIc are often associated with having a competitive advantage

• competitive factors affect a company’s ability to negotiate lower input prices with suppliers and to raise prices for products and services Porter’s five forces framework can be used as a basis for identifying such factors

• Inflation (deflation) affects pricing strategy depending on industry structure, competitive forces, and the nature of consumer demand

• when a technological development results in a new product that threatens to cannibalize mand for an existing product, a unit forecast for the new product combined with an expect-

de-ed cannibalization factor can be usde-ed to estimate the impact on future demand for the existing product

• Factors influencing the choice of the explicit forecast horizon include the projected holding period, an investor’s average portfolio turnover, cyclicality of an industry, company specific factors, and employer preferences

ProBleMs

Angela green, an investment manager at horizon Investments, intends to hire a new ment analyst After conducting initial interviews, green has narrowed the pool to three can-didates she plans to conduct second interviews to further assess the candidates’ knowledge of industry and company analysis

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