Equity #33 - Industry and Company Analysis Flashcards
List the 3 different analaysis approaches to developing inputs to equity valuation models
LOS 33.a
bottom-up
top-down
hybrid
Describe the bottom-up analysis approach to developing inputs to equity valuation models
LOS 33.a-b
Start with analysis of company or its reportable segments
Revenue projections based on:
- historical revenue growth, or
- company’s new product introductions over the forecast horizon
Describe the top-down analysis approach to developing inputs to equity valuation models
LOS 33.a-b
Start with expectations about a macroeconmic variable.
- growth relative to GDP growth:
GDP growth + x% or GDP growth * (1+x%) - market growth and market share:
estimated industry sales * mkt share%
Describe the hybrid analysis approach to developing inputs to equity valuation models
LOS 33.a
Combination of bottom-up and top-down approaches
Is able to highlight inconsistencies between the two approaches.
Most common aproach used
economies of scale (def)
LOS 33.c
Economies of scale are present if:
Average cost of production decreases as sales increase.
Characteristics of companies having economies of scale
LOS 33.c
higher operating margins (because of lower average cost) as production volumes increase.
sales volume and margins will be positiviely correlated
How to evaluate economies of scale
LOS 33.c
Larger companies in an industry have larger margins.
Use common-size income statements to economies of scale in:
- lower COGS/sales for larger companies
- lower SG&A/sales in larger companies
How to calculate forecasted COGS
LOS 33.d
COGS is usually a variable cost, so:
COGSforecast = (COGShistorical / revenuehistorical) * revenue<span>forecast</span>
or
COGSforecast = (1 - gross_margin) * revenue<span>forecast</span>
Considerations of forecasting COGS (i.e. gross margin) more accurately
LOS 33.d
Increasing or decreasing trends in gross margin should be considered to continue into the future.
Compare a company’s gross margin to its competitors as a check; seek to understand any differences.
Examine volume/price of inputs; may improve quality of forecast, especially in the short run. e.g. fuel costs, other commodity i nputs.
Forecast COGS for a firm’s various product categoires and business segments separately.
characteristics & considerations of forecasting SG&A
LOS 33.d
SG&A_OpEx - fixed cost component is greater than variable.
SG&A_R&D - mostly uncorrelated to revenues (it is set by managment)
SG&A_sell/distr costs - more directly correlated to revenues
Consider forecasting SG&A by business segment if possible to improve quality of forecasted SG&A
What are the components to Financing Costs on the IS?
LOS 33.d
Gross Interest Expense
Interest Income
Net interest exp = gross interest exp - interest inc
Explain the linkage of BS and IS wrt forecasting financing costs
LOS 33.d
Given: gross debt (BS), cash equiv (BS), ST securities (BS):
- net debt = gross debt - cash equiv & ST sec
- gross interest expense = gross debt * int rate
- net interest income = (cash equiv & ST sec)* int rate
- net int exp = gross interest expense - int inc on cash equiv & ST sec
Calculate gross and net interest rates and yield on cash balance
LOS 33.d
gross interest expense rate = gross interest expense / gross debt
net interest expense rate = net interest expense / net debt
yield on cash balance = interest income / (cash equiv + ST sec)
Note that:
numerator comes from IS; denomiator comes from BS
List the 3 primary tax rates used in analysis
LOS 33.d
statutory rate
effective tax rate
cash tax rate
statutory tax rate (def)
LOS 33.d
percentage tax charged in the country where firm is domiciled
effective tax rate (def)
LOS 33.d
income tax expense (IS) as a percentage of pretax income (IS):
effetive tax rate = Inc Tax Ex / EBT
cash tax rate (def)
LOS 33.d
cash tax rate = cash taxes paid (IS) as a % of pretax income (IS):
cash tax rate = cash tax paid / EBT
Account for the differences in income tax expense and cash taxes paid (aka due?)
LOS 33.d
Changes in deferred tax items:
Inc Tax Expense = cash tax due
+ d(deferred tax liab)
- d(deferred tax assets)
Account for the difference in stautory and effecive tax rates
LOS 33.d
Reconciliation of the two rates is contained in the footnotes to financial statements and can give details of:
- one-time events
- different tax rates in jurisdictions where company operates
Reasons for differences:
- recognized expenses that are not tax deductible (permanent difference).
- taxable income in several countries having different tax rates.
If a company has relatively higher earnings growth in a high-tax country, the company’s tax rate will increase or decrease?
LOS 33.d
increase
IS items that flow to BS (for BS modeling purposes)
LOS 33.e
Retained earnings (BS) from NI (IS) - dividends declared (IS)
Working capital items (BS) related to IS items
Forecast accounts receivable (BS)
LOS 33.e
projected acct receivable = DSO * Salesforecast / 365 days,
where
DSO is days sales outstanding:
DSO = (acct receivable / sales) * 365 days
Forecast PP&E
LOS 33.e
Different approaches:
- constant proportion of sales
- consider future depreciation and capex plans
- break out capex for maintenance and capex for growth.
For capex for maintenance, historical depreciation should be increased by the inflation rate (because replacement cost can be expected to increase with inflation).
Calculate ROIC from IS and BS items
LOS 33.f
ROIC = NOPLAT / net op assets
, where
NOPLAT = OpInc * (1 - effective tax rate), and
net operating assets = operating assets - operating liabilities
companies with higher ROIC are exploiting some competitive advantage
NOPLAT stands for “Net Operating Profit Less Adjusted Taxes”
Net operating assets is also called “invested capital”
Describe the relationship between return on invested capital (ROIC) and competitive advantage.
LOS 33.e
Firms with higher ROIC relative to peers are likely exploiting some competitive advantage in the production or sales of its assets.
Why is ROIC an effective comparison of competitive advantage for companies?
LOS 33.e
ROIC is a return of both equity and debt, so firms with differing capital structures can be compared.
NOTE: Return on Capital Employed (net operating profit / invested capital) may be used to compare companies with different tax rates.
Companies have more pricing power when (wrt Porter’s 5 Forces):
LOS 33.g-h
threat of substitute products is low
- switching costs are high
intensity of industry rivalry is low
- few revials (i.e. concentrated industry)
- fixed costs are low
- exit barriers are low
- industry growth is high
- products are highly differentiated
supplier power is low
- many supplier options
- companies can extract more value from the chain
buyer power is low
- many small customers (no big customers)
- buyer switching costs are high
threat of new entrants is low
- high barriers to entry
Ways a company may cope with inflation (deflation) wrt input costs:
LOS 33.i
hedge their input cost exposure
- reduces short-term effects
- gives more time to pass on increase costs (price increase)
become vertically integrated
- they become their own supplier
rapidly pass on cost to customer (price increase)
Ways that technology advances affect demand, selling prices, costs, and margins
LOS 33.j
decreases cost of production, which increases margins (for early adopters)
over time, increases industry supply and unit sales
may result in improved substitutes or wholly new products
What is the the “cannibalization factor”?
LOS 33.j
One way an aanalyst can model the introduction of new substitutes for a company’s products–a percentage of new product sales that will replace existing product sales
What is a suitable explicit forecast horizon in analyzing a stock?
LOS 33.k
- for buy-side analyst - the expected holding period of a stock in the portfolio (considers the investment strategy)
- for highly cyclical companies - should include the middle of a cycle so that the analyst can forecast normalized earnings (i.e. expect mid-cycle earnings)
- case of recent impactful events - consider them temporary; forecast horizon should be long enough to that perceived effects of events can be realized.
Analyst’s choices in developing forecasts beyond the short-term forecast horizon
LOS 33.l
continued revenue growth trend beyond the forecast horizon
terminal value at the end of the horizon; estimated using relative value (price multiple) or DCF approach:
P/E approach - final forecasted earnings are multiplied by company’s historical P/E
DCF approach - present value of a perpetuity, therefore small changes in growth rate can have large effect on terminal value and thus stock valuation.
What are the steps to developing sales-based pro forma financial statements?
LOS 33.m
- Estimate revenue growth and future expected revenue.
- Estimates COGS.
- Estimate SG&A.
- Estimate Financing costs
- Estimate income tax expense and cash taxes, taking into account deferred tax items.
- Model the BS based on items that flow from the IS and estimates for important working capital accounts.
- Use historical depreciation and capital expenditures to estimate future capital expenditures and net PP&E for the BS.
- Use the completed pro forma IS and BS to construct a pro forma CF statement.
