CHAPTER 4INDUSTRY AND COMPANY ANALYSISPresenter’s namePresenter’s titledd Month yyyy

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APPROACHES TO MODELING REVENUE

Top-Down Approach

• Start with the economy

• Look at successively more narrowly defined levels

Bottom-Up Approach

• Begin with individual product lines, locations, or business segments

• Aggregate projections over products or segments to reach the company level

• Aggregate company revenues to reach the industry level

Hybrid Approach

• Combine top-down and bottom-up approaches

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TOP-DOWN APPROACHES TO FORECASTING REVENUE

Forecast the growth rate of nominal gross

domestic product (GDP)

Relate the company’s

growth rate to the growth of nominal GDP

Forecast real GDP and inflation

Forecast company’s revenues

Forecast growth in a particular market

Evaluate the company’s current and anticipated

market share

Apply the expected

market share to the

forecast

Forecast company’s revenues

“Growth relative to GDP growth” approach

“Market growth and market share” approach

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INCOME STATEMENT MODELING: OPERATING COSTS

• Analyst can take a top-down, bottom-up, or hybrid approach to analyzing and forecasting costs.- Consider fixed and variable cost components of operating costs

• Economies of scale is present if the average cost per unit falls as revenues increase.- Indicative of economics of scale: operating margins positively correlated with

revenues.• Costs are challenging to estimate based on reported accounts

- For example, companies reserve against losses based on estimates, but the actual losses may differ from the estimates

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FORECASTING COSTS

• Generally forecasted as a percentage of sales and can be broken down by product line or segment

• Consider a company’s hedging activity that may affect costs of raw materials• Compare with competitors’ gross margins.

•Cost of goods sold: focus on gross margins

• Some SG&A expenses vary with cost of goods sold, whereas other SG&A expenses are relatively fixed (e.g., overhead)

• Benchmarking against competitors may be useful

Selling, general, and administrative (SG&A) expenses: focus on type of expense

• Interest income varies with cash and investments, whereas interest expense varies with debt

• Taxes are affected by the jurisdiction and the type of business

Nonoperating costs: depends on the type of cost

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BALANCE SHEET MODELING• Balance sheet modeling is the process of forecasting a company’s balance

sheet based on the following:- Items that flow from the income statement (e.g., retained earnings) - Items that vary with revenues (e.g., accounts receivable) - Items that are the result of investment or financing decisions (e.g., gross

plant, property, and equipment)• Items affected by the level of revenues can often be forecasted by using

historical or projected efficiency (e.g., turnover) ratios.• Forecasts of long-term assets are a function of forecasted capital expenditures

and depreciation. Capital expenditures include- maintenance capital expenditures, needed to sustain the business, and- growth capital expenditures, needed to expand the business.

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EVALUATING PROFITABILITY• Using forecasted income statement and balance sheet accounts, an analyst

can evaluate the company’s forecasted profitability.• Useful measures of profitability include:

- Return on invested capital (ROIC)

- Return on capital employed (ROCE)

• Because of the uncertainty associated with forecasting, analysts can use sensitivity analysis or scenario analysis to evaluate the forecasted profitability.

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ROIC AND COMPETITIVE ADVANTAGE• Understanding the competitive strength of the industry in which a company

operates helps an analyst forecast profitability and, hence, ROIC.• Tools to assess the competitive structure of an industry include Porter’s five

forces.

Competitive strength

Threat of substitute products

Intensity of rivalry

Bargaining power of suppliers

Bargaining power of customers

Threat of new entrants

Forecasted ROIC

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COMPETITIVE PRESSURES AFFECTING PRICES AND COSTS

• Ability to control costs affects a company’s ROIC- A company that has weak bargaining power with suppliers has less ability to

control costs• Ability to control prices affects a company’s ROIC

- A company that has weak bargaining power with customers is less able to control prices

- If there are lower barriers to entry for an industry, companies in the industry are not be able to control prices

- If there is a strong threat of substitutes, a company has less ability to control prices

- A company in an industry with intense rivalry will not be able to control prices

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JUDGING THE COMPETITIVE POSITION: EXAMPLES

Industry Competitive positionFast food industry• Many convenient locations• Low start-up costs• Alternatives available

Mobile phone industry• Capital requirements for manufacturing • Patents for hardware and software• Innovation-driven market• Many substitutes• Ties to service providers

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Please note these examples do not feature in text.

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INFLATION AND DEFLATION• Inflation is the overall increase in the prices of goods and services, and

deflation is the overall decrease in the prices of goods and services.• Inflation and deflation affect companies differently and can affect revenues and

expenses within a company differently.• Industry structure can affect prices

- In a concentrated market, companies can exert pressure on suppliers against price increases for goods and services because of inflation, whereas companies in a more fragmented market cannot exert such pressure.

- A company’s ability to pass on increased prices to customers depends on the bargaining power of customers and the degree of rivalry among competitors.

- In a highly competitive industry, pricing is influenced by input prices.

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TECHNOLOGICAL DEVELOPMENTS• Technological developments can affect the demand for a product, the quantity

of a product, or both.- Technology can reduce the cost of manufacturing- Technology can create substitutes

FY2011 FY2012E FY2013E FY2014E100,000

120,000

140,000

160,000

180,000

200,000

Pre- and Post-Cannibalization of PC Unit SalesConsumer PC shipments (pre-cannabilzation) Consumer PC shipments (post-cannabilzation)

Non-consumer PC shipments (pre-cannabilization) Non-consumer PC shipments (post-cannabilization)

Fiscal Year

Unit Projections(thousands)

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FORECASTING CONSIDERING TECHNOLOGICAL DEVELOPMENTS

Begin with base year

Use alternative scenarios to forecast revenues, including possible cannibalization

Analyze the cost structure (i.e., fixed versus variable)

Project costs and expenses

Forecast net income and earnings per share (EPS) based on forecasts of revenues and expenses

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FORECAST HORIZON• Factors affecting forecast horizon include the following:

- Investment strategy for which the stock is being considered- Cyclicality of the industry- Company-specific factors- Analyst’s employer preferences

• Longer-term projections may give a better picture of the normalized earnings of a company.- Normalized earnings are the expected level of sales mid-cycle, but without

unusual or temporary factors.

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PROJECTIONS BEYOND THE SHORT-TERM HORIZON

• Beyond the short-term horizon, an analyst estimates a terminal value.• Methods of estimating a terminal value include

- multiples (historical or adjusted historical) and- discounted cash flow (DCF)

• Considerations- When will the future look different than the past—that is, where is the

inflection point?- Economic disruptions- Regulation- Technology- Sustainable long-term growth

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CONSTRUCTING THE PRO FORMA INCOME STATEMENT

Forecast revenues

Forecast cost of goods sold

and SG&A expenses

Forecast nonoperating

expenses and taxes

Build the pro forma income

statement

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CONSTRUCTING THE PRO FORMA CASH FLOW STATEMENT AND BALANCE SHEET

Forecast capital

investments and

depreciation

Forecast working capital

accounts

Build the pro forma cash flow statement

Build thepro forma

balance sheet

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USING THE PRO FORMA FINANCIALS• Once pro forma income, cash flow, and balance sheet statements are

constructed, an analyst can use this information in valuation metrics, such as free cash flow, EPS, EBITDA, or EBIT.

• Company-specific information would be required to build a discounted cash flow (DCF) model using these metrics, but these statements and the information used to construct these statements contribute significantly to the basic data needed for a DCF valuation.

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SUMMARY• Analysts can use a top-down, bottom-up, or a hybrid approach to forecasting

income and expenses.• In a “growth relative to GDP” approach, an analyst forecasts the growth rate of

nominal GDP as well as industry and company revenue growth relative to GDP growth.

• In a “market growth and market share” approach, an analyst forecasts revenue growth of markets and the company’s share in these markets.

• Operating margins correlated with sales is evidence of economies of scale.• Some balance sheet items are related to revenues, whereas others flow from

the income statement.• Efficiency ratios are commonly used to model working capital accounts.

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SUMMARY• Return on invested capital (ROIC) is an after-tax measure of profitability. A

related measure is the return on capital employed (ROCE).• Porter’s five forces can be used to identify competitive factors that may affect

the price of goods and services the company needs and the price of goods and services the company provides.

• The effect of inflation on pricing depends on the industry’s structure, competitive forces, and the nature of consumer demand.

• The possibility of product cannibalization as new products are introduced requires forecasting the effect of such cannibalization.

• Forecast horizons are affected by the projected holding period, the investor’s average portfolio turnover, cyclicality of an industry, company specific factors, and employer preferences.

• The process of developing pro forma income, cash flow, and balance sheet statements provides an analyst with information that can be used in the valuation of a company.