The Valuation Process

There are five steps involved in the valuation process:

1. Understanding the business.
2. Forecasting company performance.
3. Selecting the appropriate valuation model.
4. Using forecasts in a valuation.
5. Applying the valuation conclusions.

1. Understanding the Business

To forecast a company’s financial performance, an analyst needs to fully understand the industry that the company operates in, its strategy, and its previous financial performance.

Industry and Competitive Analysis

Complete industry analysis enables an analyst to develop appropriate scenarios that can be used in the valuation process. Sensitivity analysis is used to determine how change on one input affects the output of the analysis.

The following questions are relevant in understanding a business and its industry.

How Attractive is the Industry that the Company Operates In?

Michael Porter’s five forces are widely used in understanding the industry structure. These are:

1. The intensity of industry rivalry: Low intensity of industry rivalry—especially with few industry participants in a growing industry—enhances industry profitability.
2. New entrants: High barriers of entry to the industry result in few industry participants and less competition enhancing industry profitability.
3. Substitutes: When there are few substitutes or the cost of switching to the substitutes, companies in the industry are capable of passing on increases in costs to the consumers, therefore enhancing industry profitability.
4. Supplier power: An industry with many suppliers reduces the suppliers’ power to increase the prices of their products because industry participants can easily switch suppliers. This enhances industry profitability.
5. Buyer power: When there are many consumers in an industry, the consumers lack the power to negotiate lower prices. This will enhance industry profitability.

What is the Company’s Competitive Position and Strategy in the Industry?

A company that can create and sustain an advantage relative to its competition will have a higher value. According to Porter, there are three strategies to achieving an above-average performance:

1. Cost leadership: This is where a company has the lowest production costs while maintaining comparable products with competitors allow companies to price their products at or near the industry average.
2. Offering unique products: A company using this strategy is expected to have higher selling expenses but also higher gross margins relative to a company using a cost leadership strategy. This is because it can charge a premium relative to others in the market.
3. Focus: This involves pursuing a competitive advantage within a segment or segments in an industry based on cost leadership or differentiation. 

How Well does the Company Execute its Strategy?

Analyzing a company’s past financial reports gives an insight into how it has performed relative to its objectives and provides a basis for developing a company’s future performance. By analyzing a few years’ worth of past annual reports, an analyst can see how management has predicted and adapted to challenges.

When analyzing a company’s strategic execution, an analyst should:

• Consider non-numeric factors like ownership structure, intangible assets, potential legal disputes, and other contingent liabilities.
• Avoid extrapolating past performance when forecasting performance. This is because companies that are doing well will attract competitors and reduce profitability while poorly performing companies will be restructured. As a result, past performance may not provide a reliable indication of future results since the long-term growth forecast is estimated to converge towards the growth rate of the economy.

Quality of Financial Statement Information

Industry and company information can be derived from mandated disclosures, regulatory filings, press releases, investor relations materials, contacts with other analysts, industry organizations, market intelligence providers.

Two crucial things to consider when using accounting information are:

• Quality of earnings: Which involves examining all financial statements to evaluate the proportion of income attributable to the core operating activities of a business.
• Sustainability: Which involves analyzing aspects of the performance that are likely to recur in the future. Earnings with significant components of nonrecurring events are of lower quality and less sustainable.

An analyst should also identify reported decisions that result in earnings that are unlikely to continue. For example, breaking down net income into an accrual and cash component. A company with a high proportion of accruals indicates that most of its sales are sold on credit. The cash component is more persistent than the accruals and companies with high accruals will have a relatively lower return on assets (ROA) in the future. Net income with a high proportion of accruals is considered to be of lower quality.

Example: Quality of Earnings

$$\small{\begin{array}{l|l} \textbf{Example} & \textbf{Potential Interpretation}\\ \hline{\text{Recognizing revenue too early. For}\\ \text{example, bill & hold of sales and}\\ \text{recording sales before acceptance by the}\\ \text{customer.}} & {\text{Reported income.}\\ \text{Future income.}}\\ \hline{\text{Recognizing too much or too little}\\ \text{reserves in the current period, e.g., bad}\\ \text{debt provisions, restructuring reserves.}} & {\text{Current income.}\\ \text{Future income.}\\ \text{Leading to the probable poor underlying}\\ \text{performance.}}\\ \hline{\text{Use of off-balance-sheet financings like}\\ \text{leasing assets or securitizing receivables.}} & \text{Balance sheet assets and liabilities may}\\ \text{not be properly reflected on the balance sheet.} \\ \hline{\text{Characterization of bank overdraft as an}\\ \text{operating cash flow.}} & \text{Operating cash flow may be inflated.}\\  \end{array}}$$

Question

Which of the following is most likely one of Porter’s five forces that are used to analyze an industry?

1. Supplier power.
2. Top-down forecasting approach.
3. Cost leadership.

Solution

The correct answer is A.

Supplier power is one of Porter’s five factors that are used to analyze industry. An industry with many suppliers reduces suppliers’ power to increase the prices of their products because industry participants can easily switch suppliers. This enhances industry profitability. The other factors include buyer power, substitutes, new entrants, the intensity of industry rivalry.

B is incorrect. The top-down approach is one of the methods that is used in forecasting company performance.

C is incorrect. Cost leadership is one of the strategies companies use to create and sustain a competitive advantage relative to the competition. The other strategies are differentiation and focus.

Reading 22: Equity Valuation: Applications and Processes

LOS 22 (e) Describe questions that should be addressed in conducting industry and competitive analysis.