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Strategy Analysis

Industry analysis Five forces

Rivalry among Existing Firms
Industry growth rate.
Concentration and balance of competitors.
Degree of differentiation and switching costs.
Scale/Learning economies and ratio of fixed costs to
variable costs. Excess capacity and exit barriers.
Threat of New Entrants
Factors affecting the barriers to entry are:
Economies of scale First mover advantage
Relationships with suppliers and customers Legal
Threat of Substitute Products
Which affects the industrys bargaining power with
Buyers willingness to switch
Bargaining Power of Buyers
Switching cost;
Differentiation; Importance of
product for costs and quality;
Number of buyers;
Volume per buyer
Bargaining Power of Suppliers
few substitutes; suppliers few;
Competitive Strategy Analysis
Cost leadership Product/ service differentiation
Resources and capabilities to implement strategies.
Activities, infrastructure, and other operating elements
consistent with its competitive strategy.
Corporate Strategy Analysis
Companies with multiple business segments may
generate synergy benefits
Transaction costs may be lower
Headquarter coordination
Assets/capital sharing
But synergy benefits are difficult to achieve
Conflicting culture/bureaucracy Lack of expertise
SWOT Analysis
What are the companys strengths and weaknesses?
Management competence
Cost leadership or
product differentiation Market leadership
financial risk
What are the opportunities and threats?
New products/markets


Economy/policy changes
Accounting analysis
Managers accounting discretions
Managers have intimate knowledge of their firms
Accounting discretions allow managers to reflect inside
information in reported financial statement
Managers can use the discretions to report distorted
accounting information
Managers compensation contracts
Performance based pay Stock options Personal
Contracts with lenders
Loan covenants
Credit ratings
(Social) Contract with stakeholders
Employees and Employees, customers
Regulators, and competitors
Pressure from financial markets
Avoid negative news/image Maintain share prices
Avoid volatility in earnings Meet analyst and investor
Positive earnings
Earnings in the same quarter last year
Analysts earnings forecasts
Earnings = Cash Flows + Accruals
Characteristics of manipulating firms (Evidence)
Strong performance prior to the manipulations
Abnormally high P/E and P/B ratios
Pressure from the market to maintain high growth rate
In manipulation years
Cash profit margins and earnings growths decline
Accruals increase
Demand decreases for their products
Free cash flows drops Financing activity increases

Asset distortion: Overstated assets

Delayed write-down of current assets
Growing days inventory and days receivables
Write-down by competitors
Business difficulties for its major clients
Delayed write-down of long-term assets
Underestimated provisions
Accelerated recognition of revenues
Understated depreciation/amortization
Understated assets
To deflate reported earnings
Save for the future Take a big bath
Overstated write-down of assets
Overstated depreciation
Reasons of big drop revenue
Outside condition-economy
strategy focus on
particular product
tax benefit credit policy
financial analysis
Profit margins Measures how much the firm can keep
as profit from one dollar sales
Gross profit margin: gross profit / sales
Net profit margin: net income / sales
ROE = Operating ROA + Spread x Net financial
Operating ROA = NOPAT / Net Assets
Spread=Operating ROAEffective after-tax interest
Net financial leverage = Net debt / Equity
Turnovers ratios evaluate investment management:
how effectively the firm uses its assets
Low turnover ratios imply inefficient use of assets
Very high turnover ratios may indicate over-turnover or
insufficient assets
Short-term liquidity ratios
Measure ability to repay its short-term liabilities
Current ratio (current assets)
Quick ratio (cash + receivables)
Cash ratio Operating cash flow ratio
Debt and Long-term Solvency
Debt to equity ratio
Debt to net capital ratio
Interest coverage
: Sales; Profit margin; Assets turnover; Capital structure
for companies with stable operations
Turnover ratios will remain stable
Assets will grow at the same rate of sales
Capital structure will remain stable
Debt to-Equity ratio will be the same
Interest rate will not change
Discounted Dividend Model (DDM)
Discounted Abnormal Earnings Model
D1= B0+ E1B1
RE = E (re*BVE) = (ROE re)*BVE
P/B ratio is driven by the level of RE while P/E ratio is
driven by the change or growth in RE
Discount rate = required rate of return
CAPM: Re= rf + [E(rm) rf] expected risk premium
Multifactor model: re= rf +[E(rm) rf] + rsize + rbm +
firms capital structure changasset=wd*d+ (1-wd)*e
Sensitivity Analysis
Make different assumptions and re-do the valuation
Normal case, worst case and best case
Equity Security Analysis
Market Efficiency
Weak Form; Semi-Strong Form; Strong Form
Fundamental analysis
based projections(historical data& current information)of
future earnings& cash flows.
Quantitative analysis
Technical Analysis(historical share price; predict shortterm price movement; rules)

Statistical Analysis(regressions& historical data to

screen stocks; mathematical models ;predict share price
interest rates
Investment Industry
Financial analysts
Analysts may issue biased (over-optimistic)
recommendations in order to
Generate trading volume for brokerage house
Gain access to private information from managers
Win investment banking business
Fund managers
Approaches to invest herd
Passive& Active management; Style investing
Size, value, growth, momentum; Mutual funds and
hedge funds
Credit Analysis and Distress Prediction
Consider nature& purpose of the loan(amount;
time horizon; Sole financing , syndication &
Consider type of loan& available security(Open&
revolving lines of credit; term deposit; Mortgage loans;
working capital Load; Lease financing; hybrid debt)
(receivables, inventory, P&E, real estate)
Short term Liabilities
Current Ratio = CA/CL
Quick Ratio= Cash + Mkt. secs + Recs)/CL
Operating Cash Flow Ratio = (Cash Flow from
Continuing Ops.)/ Average CL
Working Capital Commitments
Accts. Receivable Inventory Accts. Payable
Long term Debt Commitment
Long Term Debt/Total (Equity) Assets
[ Adjust for off-balance sheet liabilities (Leases,
contingencies, etc.)]
Cash flow coverage =(Op. Cash Flow + Int. Paid + Tax
Paid)/Interest Paid
Interest coverage =Operating EBIT/Interest Expense
Utilize forecasts to assess payment prospects
Assemble the detailed loan structure
Loan pricing
Lenders cost of borrowing funds
Lenders cost of admim. & serving of loan
Premium for exposure to default risk
At least a normal ROE (e.g. 1.5% above prime orLIBOR)
Debt Ratings Determinants
Kaplan-Urwitz Models:
Profitability measures (return on capital)
Leverage measures (long-term debt to capitalisation)
Profitability (interest coverage) & leverage
Firm Size (sales, total assets)
Other (risk- std. dev. of returns/, subordination)
Recent research finds that corporate governance and
accounting quality affect debt ratings.
Mergers & Acquisitions
Synergy: The whole is greater than the sum of its parts
Economies of scale Improved management
Increased market power
Tax Considerations
A profitable firm in the highest tax bracket could
acquire a firm with large accumulated tax losses.
Acquisition can serve as a way of minimizing taxes
when disposing of excess cash.
Signaling Effect
Corporate events as signals to the market
Issuing new shares signals over-valuation
Share repurchases signal under-valuation
Stock mergers signal over-valuation of acquirers
Stock mergers also provide a way for acquirers
shareholders to share risk with targets shareholders
Target firms can defend hostile takeover by many
Change company bylaws requiring super-majority for
takeover approval
Try to convince shareholders not to approve the
Raise antitrust issues to regulators
Get a white knight who is friendly to compete with the
hostile bidder
Get a white squire who is friendly to be major
Take poison pills by granting options to sell assets at
bargain prices to a friendly third party

Grant golden parachutes to their executives

Red flag
Unexplained changes in accounting, especially when
performance is poor. Unexplained transactions that
boost profits. Unusual increases in accounts
receivable in relation to sales increases. Unusual

increases in inventories in relation to sales increases.

An increasing gap between a firms reported income
and its cash flow from operating activities. An
increasing gap between a firms reported income and
its tax income A tendency to use financing

partnerships and the sale of receivables with recourse.

Unexpected large asset write-offs. Large
opinions or changes in independent auditors that are
not well justified.; Related-party transactions or
transactions between related entities