CHAPTER 4

INDUSTRY AND COMPANY ANALYSIS

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APPROACHES TO MODELING REVENUE

Top-Down Approach
Start with the
economy
Look at
successively more
narrowly defined
levels

Bottom-Up Approach
Begin with
individual product
lines, locations, or
business segments
Aggregate
projections over
products or
segments to reach
the company level
Aggregate
company revenues
to reach the
industry level

Hybrid Approach
Combine top-down
and bottom-up
approaches

TOP-DOWN APPROACHES TO FORECASTING REVENUE

Growth relative to GDP growth approach
Forecast the
growth rate of
nominal gross
domestic
product (GDP)

Relate the
companys
growth rate to
the growth of
nominal GDP

Forecast real
GDP and
inflation

Forecast
companys
revenues

Apply the
expected
market share
to the forecast

Forecast
companys
revenues

Market growth and market share approach

Forecast
growth in a
particular
market

Evaluate the
companys
current and
anticipated
market share

INCOME STATEMENT MODELING:

OPERATING COSTS
Analyst can take a top-down, bottom-up, or hybrid approach to analyzing and
forecasting costs.
- Consider fixed and variable cost components of operating costs
Economies of scale is present if the average cost per unit falls as revenues
increase.
- Indicative of economics of scale: operating margins positively correlated with
revenues.
Costs are challenging to estimate based on reported accounts
- For example, companies reserve against losses based on estimates, but the
actual losses may differ from the estimates

FORECASTING COSTS

BALANCE SHEET MODELING

Balance sheet modeling is the process of forecasting a companys balance
sheet based on the following:
- Items that flow from the income statement (e.g., retained earnings)
- Items that vary with revenues (e.g., accounts receivable)
- Items that are the result of investment or financing decisions (e.g., gross
plant, property, and equipment)
Items affected by the level of revenues can often be forecasted by using
historical or projected efficiency (e.g., turnover) ratios.
Forecasts of long-term assets are a function of forecasted capital expenditures
and depreciation. Capital expenditures include
- maintenance capital expenditures, needed to sustain the business, and
- growth capital expenditures, needed to expand the business.

EVALUATING PROFITABILITY
Using forecasted income statement and balance sheet accounts, an analyst
can evaluate the companys forecasted profitability.
Useful measures of profitability include:
- Return on invested capital (ROIC)

- Return on capital employed (ROCE)

Because of the uncertainty associated with forecasting, analysts can use

sensitivity analysis or scenario analysis to evaluate the forecasted profitability.

ROIC AND COMPETITIVE ADVANTAGE

Understanding the competitive strength of the industry in which a company
operates helps an analyst forecast profitability and, hence, ROIC.
Tools to assess the competitive structure of an industry include Porters five
forces.

Forecasted
ROIC

COMPETITIVE PRESSURES AFFECTING

PRICES AND COSTS
Ability to control costs affects a companys ROIC
- A company that has weak bargaining power with suppliers has less ability to
control costs
Ability to control prices affects a companys ROIC
- A company that has weak bargaining power with customers is less able to
control prices
- If there are lower barriers to entry for an industry, companies in the industry
are not be able to control prices
- If there is a strong threat of substitutes, a company has less ability to control
prices
- A company in an industry with intense rivalry will not be able to control prices

JUDGING THE COMPETITIVE POSITION:

EXAMPLES
Industry
Fast food industry
Many convenient locations
Low start-up costs
Alternatives available
Mobile phone industry
Capital requirements for manufacturing
Patents for hardware and software
Innovation-driven market
Many substitutes
Ties to service providers

Competitive position

?
?

Please note these examples do not feature in text.

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INFLATION AND DEFLATION

Inflation is the overall increase in the prices of goods and services, and
deflation is the overall decrease in the prices of goods and services.
Inflation and deflation affect companies differently and can affect revenues and
expenses within a company differently.
Industry structure can affect prices
- In a concentrated market, companies can exert pressure on suppliers against
price increases for goods and services because of inflation, whereas
companies in a more fragmented market cannot exert such pressure.
- A companys ability to pass on increased prices to customers depends on the
bargaining power of customers and the degree of rivalry among competitors.
- In a highly competitive industry, pricing is influenced by input prices.

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TECHNOLOGICAL DEVELOPMENTS
Technological developments can affect the demand for a product, the quantity
of a product, or both.
- Technology can reduce the cost of manufacturing
- Technology can create substitutes
Pre- and Post-Cannibalization of PC Unit Sales
Consumer PC shipments (pre-cannabilzation)

Consumer PC shipments (post-cannabilzation)

Non-consumer PC shipments (pre-cannabilization)

Non-consumer PC shipments (post-cannabilization)

Unit Projections
(thousands)

200,000
180,000
160,000
140,000
120,000
100,000

FY2011

FY2012E

FY2013E

FY2014E

Fiscal Year

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FORECASTING CONSIDERING
TECHNOLOGICAL DEVELOPMENTS

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FORECAST HORIZON
Factors affecting forecast horizon include the following:
- Investment strategy for which the stock is being considered
- Cyclicality of the industry
- Company-specific factors
- Analysts employer preferences
Longer-term projections may give a better picture of the normalized earnings of
a company.
- Normalized earnings are the expected level of sales mid-cycle, but without
unusual or temporary factors.

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PROJECTIONS BEYOND THE SHORT-TERM

HORIZON
Beyond the short-term horizon, an analyst estimates a terminal value.
Methods of estimating a terminal value include
- multiples (historical or adjusted historical) and
- discounted cash flow (DCF)
Considerations
- When will the future look different than the pastthat is, where is the
inflection point?
- Economic disruptions
- Regulation
- Technology
- Sustainable long-term growth

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CONSTRUCTING THE
PRO FORMA INCOME STATEMENT

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CONSTRUCTING THE PRO FORMA CASH FLOW

STATEMENT AND BALANCE SHEET
Forecast
capital
investments
and
depreciation

Build the
pro forma cash
flow statement

Forecast
working capital
accounts

Build the
pro forma
balance sheet

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USING THE PRO FORMA FINANCIALS

Once pro forma income, cash flow, and balance sheet statements are
constructed, an analyst can use this information in valuation metrics, such as
free cash flow, EPS, EBITDA, or EBIT.
Company-specific information would be required to build a discounted cash
flow (DCF) model using these metrics, but these statements and the
information used to construct these statements contribute significantly to the
basic data needed for a DCF valuation.

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SUMMARY
Analysts can use a top-down, bottom-up, or a hybrid approach to forecasting
income and expenses.
In a growth relative to GDP approach, an analyst forecasts the growth rate of
nominal GDP as well as industry and company revenue growth relative to GDP
growth.
In a market growth and market share approach, an analyst forecasts revenue
growth of markets and the companys share in these markets.
Operating margins correlated with sales is evidence of economies of scale.
Some balance sheet items are related to revenues, whereas others flow from
the income statement.
Efficiency ratios are commonly used to model working capital accounts.

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SUMMARY
Return on invested capital (ROIC) is an after-tax measure of profitability. A
related measure is the return on capital employed (ROCE).
Porters five forces can be used to identify competitive factors that may affect
the price of goods and services the company needs and the price of goods and
services the company provides.
The effect of inflation on pricing depends on the industrys structure,
competitive forces, and the nature of consumer demand.
The possibility of product cannibalization as new products are introduced
requires forecasting the effect of such cannibalization.
Forecast horizons are affected by the projected holding period, the investors
average portfolio turnover, cyclicality of an industry, company specific factors,
and employer preferences.
The process of developing pro forma income, cash flow, and balance sheet
statements provides an analyst with information that can be used in the
valuation of a company.
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