273: M3 - Understanding Industry and the Firm (Equity Valuation)

Question 1

What is the movement of an index influenced by?

Answer 1

The movement of the index is determined by the movement of the shares prices of the underlying companies within it

Question 2

In-depth understanding of the business steps

Answer 2

To understand the business, one needs to understand the Industry.
To understand the Industry, one needs to have an understanding as to how the industry is impacted by the underlying forecasted economic conditions

Question 3

Strategic analysis

Answer 3

The process of understanding the firm. The process allows the analyst to probe the economics of a firm at the qualitative level to ensure the analysis is grounded in reality. Overall, the analyst is seeking to understand what drives risks, profitability and the competitive advantage of the firm.

Question 4

What do analysts commonly use to organize their analysis?

Answer 4

To organize their analysis, analysts often undertake what is referred to as the Top Down Approach.

Global economy –> Domestic Economy –> Industry –> Company

Question 5

Macro-environment analysis steps

Answer 5

The first step in macro-environment analysis is identifying the jurisdiction of operations of the firm, this means all countries and regions where:
1) it sells its products or provides services,
2) where its products are produced,
3) where raw materials are procured and
4) through which its products are shipped.

Question 6

PESTEL Analysis

Answer 6

Political (rules, regulations, and actions)
Economic (how dependent is the company on global conditions)
Social (include shifts in demographics and associated consumer behaviour)
Technological (innovations in technology that may impact the firm)
Environmental (environmental impacts of the firm, and social system impacts)
Legal (ties to politics as laws are passed by politicians)

Question 7

GDP

Answer 7

Gross domestic product (GDP) - measures the market value of goods and services produced by an economy

GDP is a good predictor or future labour costs in a country where production occurs and global GDP is an indicator or future raw material costs. Common leading indicators of real GDP growth include unemployment insurance claims, consumer spending (especially on discretionary items), consumer confidence, business orders business productivity and housing and construction activity.

Question 8

Interest Rates

Answer 8

It is important to consider interest rates due to the impact on both the company and the potential consumer of its products. Interest rates impact a company’s cost of capital and its ability to finance growth opportunities. Rates also impact consumer behavior. Historically, lower rates have led to greater consumer borrowing and an increase in consumer spending.

Question 9

What happens to the company once interest rates rises

Answer 9

As interest rates rise, the company experiences higher borrowing costs on variable rate debt which increases expenses. Higher interest rates impact the consumer in the same way, decreasing discretionary spending. The end result is higher expenses and lower revenue.

Question 10

Inflation

Answer 10

Inflation can either be beneficial or detrimental to a company’s business. A company that has the ability to raise prices in line with inflation will be the beneficiary of increased revenue. However, if a company has its input costs increase at a higher rate than its revenue, it will be worse off. Inflation also impacts the consumer, if the price of goods increases at a rate greater than wage increases the consumer effectively has less disposable income.

Question 11

Foreign Exchange Rates

Answer 11

Foreign exchange rate movements can work in favour or against a company depending on the location of the firms production and the location of its sales. Exchange rates also effect consumers by impacting prices for imported goods potentially, increasing or decreasing discretionary spending.

A strengthening CAD is nice for Canadians who what to travel abroad but it is very problematic for exporters in Canada who sell to the US as the price of exported goods have essentially increase from the perspective of the US customer.

Question 12

Industry Analysis 3 Primary Objectives

Answer 12

Industry analysis has three primary objectives:

1. To understand the sensitivity of the industry to key macro-environment factors.
2. To understand the state of the industry, how it operates, supply and demand trends and the key performance metrics for evaluating those operations.
3. To understand the competitive structure of the industry.

Question 13

Industry Lifecycle Stages

Answer 13

1. Start-up
2. Growth
3. Shakeout
4. Maturity
5. Decline

Question 14

Start-up phase

Answer 14

In the startup phase there is limited availability of the product as one or two companies are just starting to launch the product or service. In the startup phase, competition is almost non-existent and profitability is low as there are few economies of scale.

Question 15

Growth Phase

Answer 15

As an industry enters the growth phase, profitability starts to rise as consumer awareness and demand increase. Product costs decrease as economies are realized and competitors enter the industry resulting in low levels of rivalry.

Question 16

Shakeout

Answer 16

As the industry enters the shakeout stage rivalry has reached the point where we start to see consolidation and some companies fail as the more differentiated or lower cost producers draw more customers and realized greater economies of scale and consumer recognition. In this stage rivalry is typically high and revenue, cash flows and profits start to decline.

Question 17

Maturity

Answer 17

This phase is followed eventually by maturity where the majority of the companies in the industry are well established and the industry reaches full consumer penetration. This phase is the most stable, with consistent sales, revenue and profitability between established industry participants.

Question 18

Decline

Answer 18

The final stage is decline where consumer demand wains as an alternative product captures consumer interest. Companies at this stage are faced with low revenue and high losses and are forced to reinvent themselves or perish.

Question 19

Porter’s Five Forces

Answer 19

1. Rivalry among existing competitors
2. Threat of substitute products
3. Bargaining power of suppliers
4. Threats of new entrants
5. Bargaining power of buyers

Question 20

Rivalry among existing firms

Answer 20

Rivalry among existing firms refers to the level of competition within an industry. In a very competitive industry profit margins will be compressed and therefore scale becomes very important. Companies will attempt to differentiate product offerings and will often market service levels as a value proposition.

Question 21

Threat of New Entrants

Answer 21

What is the likelihood of additional companies entering an industry? More companies competing for the same customers will ultimately reduce profitability. Typical barriers to entry would include factors such as, regulations, capital requirements, etc.

Question 22

Threat of substitute products

Answer 22

The profitability of an industry is impacted by the ability of a potential buyer to switch to a competitor’s product.

Question 23

Bargaining power of suppliers

Answer 23

A supplier, that has few competitors, of inputs to an industry will have substantial bargaining power. One can think of the drug industry as an example where a supplier would have high bargaining power. There are often few alternatives and a supplier is protected from competition by patents for a period of time. A supplier that is supplying a commodity product, such as copper, has no bargaining power.

Question 24

Bargaining power of buyers

Answer 24

Any industry where a potential buyer has the ability to negotiate price is likely an industry where a buyer has substantial power and ultimately limits the profitability of that industry. An individual purchasing a new vehicle potentially has a fair amount of buying power as long as they are not limiting their purchase to a specific vehicle. If they are not satisfied with a negotiated price they have the ability to take their business to another dealer.

Question 25

Key firm competitiveness analysis

Answer 25

1. Know the firms’ products
2. Know the industry competition
3. Know the technology
4. Know the management
5. Know the firms’ products (A thorough understanding of the company’s products is fundamental. One would want to determine the source of demand, the elasticity of that demand, the availability of substitute products, and the protection (patents) for its products.)
6. Know the industry competition (Having completed an industry analysis, the task it is important to integrate the subject business into that analysis. We are particularly interested in the geographic regions the company operates within to aid in the forecasting process)
7. Know the technology (Technology is playing an ever-increasing role in all businesses. An analyst will want to determine the impact of technology on all facets of a business. These would include the production process, the marketing and distribution process, etc.)
8. Know the management (Corporate governance including a greater focus on management has recently become a bigger issue with the rise of ESG investing. It is a difficult task for an outside analyst to critically evaluate a management team. However, critical points, such as, compensation plans, management experience and corporate governance can be investigated.)

Question 26

SWOT Analysis

Answer 26

S - strengths
W - weaknesses
O - opportunity
T - threats