1. CHAPTER 4 INDUSTRY AND COMPANY ANALYSIS Presenter’s name Presenter’s title dd Month yyyy

2. 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 2

3. 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 3 “Growth relative to GDP growth” approach “Market growth and market share” approach

4. 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 4

5. 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 5

6. 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. 6

7. EVALUATING PROFITABILITY 7

8. 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. 8 Competitive strength Threat of substitute products Intensity of rivalry Bargaining power of suppliers Bargaining power of customers Threat of new entrantsForecastedROIC

9. 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 9

10. JUDGING THE COMPETITIVE POSITION: EXAMPLES IndustryCompetitive position Fast 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 10 ? ? Please note these examples do not feature in text.

11. 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. 11

12. 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 12

13. 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 13

14. 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. 14

15. 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 15

16. 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 16

17. CONSTRUCTING THE PRO FORMA CASH FLOW STATEMENT AND BALANCE SHEET 17 Forecast capital investments and depreciation Forecast working capital accounts Build the pro forma cash flow statement Build the pro forma balance sheet

18. 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. 18

19. 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. 19

20. 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. 20