Equity #33 - Industry and Company Analysis

Question 1

List the 3 different analaysis approaches to developing inputs to equity valuation models

Answer 1

LOS 33.a

bottom-up

top-down

hybrid

Question 2

Describe the bottom-up analysis approach to developing inputs to equity valuation models

Answer 2

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

Question 3

Describe the top-down analysis approach to developing inputs to equity valuation models

Answer 3

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%

Question 4

Describe the hybrid analysis approach to developing inputs to equity valuation models

Answer 4

LOS 33.a

Combination of bottom-up and top-down approaches

Is able to highlight inconsistencies between the two approaches.

Most common aproach used

Question 5

economies of scale (def)

Answer 5

LOS 33.c

Economies of scale are present if:

Average cost of production decreases as sales increase.

Question 6

Characteristics of companies having economies of scale

Answer 6

LOS 33.c

higher operating margins (because of lower average cost) as production volumes increase.

sales volume and margins will be positiviely correlated

Question 7

How to evaluate economies of scale

Answer 7

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

Question 8

How to calculate forecasted COGS

Answer 8

LOS 33.d

COGS is usually a variable cost, so:

COGS_forecast = (COGS_historical / revenue_historical) * revenue_{<span>forecast</span>}

or

COGS_forecast = (1 - gross_margin) * revenue_{<span>forecast</span>}

Question 9

Considerations of forecasting COGS (i.e. gross margin) more accurately

Answer 9

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.

Question 10

characteristics & considerations of forecasting SG&A

Answer 10

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

Question 11

What are the components to Financing Costs on the IS?

Answer 11

LOS 33.d

Gross Interest Expense

Interest Income

Net interest exp = gross interest exp - interest inc

Question 12

Explain the linkage of BS and IS wrt forecasting financing costs

Answer 12

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

Question 13

Calculate gross and net interest rates and yield on cash balance

Answer 13

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

Question 14

List the 3 primary tax rates used in analysis

Answer 14

LOS 33.d

statutory rate

effective tax rate

cash tax rate

Question 15

statutory tax rate (def)

Answer 15

LOS 33.d

percentage tax charged in the country where firm is domiciled

Question 16

effective tax rate (def)

Answer 16

LOS 33.d

income tax expense (IS) as a percentage of pretax income (IS):

effetive tax rate = Inc Tax Ex / EBT

Question 17

cash tax rate (def)

Answer 17

LOS 33.d

cash tax rate = cash taxes paid (IS) as a % of pretax income (IS):

cash tax rate = cash tax paid / EBT

Question 18

Account for the differences in income tax expense and cash taxes paid (aka due?)

Answer 18

LOS 33.d

Changes in deferred tax items:

Inc Tax Expense = cash tax due
+ d(deferred tax liab)
- d(deferred tax assets)

Question 19

Account for the difference in stautory and effecive tax rates

Answer 19

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.

Question 20

If a company has relatively higher earnings growth in a high-tax country, the company’s tax rate will increase or decrease?

Answer 20

LOS 33.d

increase

Question 21

IS items that flow to BS (for BS modeling purposes)

Answer 21

LOS 33.e

Retained earnings (BS) from NI (IS) - dividends declared (IS)

Working capital items (BS) related to IS items

Question 22

Forecast accounts receivable (BS)

Answer 22

LOS 33.e

projected acct receivable = DSO * Sales_forecast / 365 days,
where
DSO is days sales outstanding:

DSO = (acct receivable / sales) * 365 days

Question 23

Forecast PP&E

Answer 23

LOS 33.e

Different approaches:

1. constant proportion of sales
2. consider future depreciation and capex plans
3. 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).

Question 24

Calculate ROIC from IS and BS items

Answer 24

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”

Question 25

Describe the relationship between return on invested capital (ROIC) and competitive advantage.

Answer 25

LOS 33.e

Firms with higher ROIC relative to peers are likely exploiting some competitive advantage in the production or sales of its assets.

Question 26

Why is ROIC an effective comparison of competitive advantage for companies?

Answer 26

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.

Question 27

Companies have more pricing power when (wrt Porter’s 5 Forces):

Answer 27

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

Question 28

Ways a company may cope with inflation (deflation) wrt input costs:

Answer 28

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)

Question 29

Ways that technology advances affect demand, selling prices, costs, and margins

Answer 29

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

Question 30

What is the the “cannibalization factor”?

Answer 30

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

Question 31

What is a suitable explicit forecast horizon in analyzing a stock?

Answer 31

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.

Question 32

Analyst’s choices in developing forecasts beyond the short-term forecast horizon

Answer 32

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.

Question 33

What are the steps to developing sales-based pro forma financial statements?

Answer 33

LOS 33.m

1. Estimate revenue growth and future expected revenue.
2. Estimates COGS.
3. Estimate SG&A.
4. Estimate Financing costs
5. Estimate income tax expense and cash taxes, taking into account deferred tax items.
6. Model the BS based on items that flow from the IS and estimates for important working capital accounts.
7. Use historical depreciation and capital expenditures to estimate future capital expenditures and net PP&E for the BS.
8. Use the completed pro forma IS and BS to construct a pro forma CF statement.