• The valuation of common stock is usually conducted in several steps.
• Country and industry analysis is necessary since a company belongs to _______.
• Since a company is based in a country, country analysis is the proper starting point to analyse company and industry.

Global Industry Analysis

Industry Analysis Approach

Return Expectation Elements

• To achieve excess equity returns on a risk-adjusted basis, an investor must find companies that can earn return on equity (ROE) above the required rate of return and do this on a sustained basis.
• Hence, global industry analysis focuses on an examination of sources of growth and sustainability of competitive advantage.
• The analysis of the industry’s value chain and each company’s strategy lead to current and future profit opportunities within the chain which has an implications on the equity valuation.
• Conceptual issues in valuing a company within its global industry:

1. Demand analysis
2. Value creation
3. Industry Life Cycle
4. Competition structure
5. Competitve Advantage
6. Competitive Strategies
7. Co-opetition and the Value Net
8. Sector Rotation

Return Expectation Elements

• To achieve excess equity returns on a risk-adjusted basis, an investor must find companies that can earn return on equity (ROE) above the required rate of return and do this on a sustained basis.
• Hence, global industry analysis focuses on an examination of sources of growth and sustainability of competitive advantage.
• The analysis of the industry’s value chain and each company’s strategy lead to current and future profit opportunities within the chain which has an implications on the equity valuation.
• Conceptual issues in valuing a company within its global industry

• - value analysis begins with an examination of demand condition.

• ____ is the target for all capacity, location, inventory, and production decisions.
• Oftenly, analyst tries to find the leading indicator to forecast demand.

1. Demand analysis

• – sources of value come from using inputs to produce outputs in the _____.
• _____ is the set of transformation in moving raw maerials to product and service delivery.
• For intermediate goods producer, basic raw materials are considered upstream in the _____, and tranformation closer to the consumer are considered downstream.
• Each tranformation within each _____ adds value and in each step how much value added can be determined through Value Chain analysis.

Four major factors that affect value added at each transformation stage:

1. The learning (experience) curve.
2. Economies of scale.
3. Economies of Scope.
4. Network externalities.

2. Value creation

Value chain

Through experience, companies can find ways to reduce cost per unit produced in the course of output increases.

The learning (experience) curve.

Fixed cost are spread over a larger output and average costs decline on range of output as company expands.

Economies of scale.

With the production of related products, the experience and reputation with one product may spill over to another product.

Economies of Scope.

As more consumers use the products and services and shared its popularity, the producs and services increases value.

Network externalities.

• It is categorized into stages.
• Defining industry must be done carefully since different firms of different products can be group in different ways such as by
• growth, by sales, by products, by size, and others.
• ______ are usually categorized by rates of growth in sales, and those stages of growth vary in length such as:

1. Pioneering development.
2. Rapid accelerating growth.
3. Mature growth.
4. Stabilization and market maturity.
5. Deceleration of growth and decline.

Industry Life Cycle.

• A stage of low but slowly increasing sales growth rate.
• Substantial development on costs and acceptance by only early adopters can lead to low profit margins.

Pioneering development.

• A stage wherein industry sales growth rate is still modest yet increasing rapidly.
• High profit margins are possible because firms from outside the new industry may face barriers to entering the new established markets.

Rapid accelerating growth.

• A stage of high but more modestly increasing industry sales growth rate.
• The entry of competitors lowers profit margins, but the return on equity is high.

Mature growth.

• A stage of high but slowly increasing sales growth rate.
• Increasing capacity and competition may cause declining returns on equity to the level of average returns on equity in the economy.

Stabilization and market maturity.

• A stage with a decreasing industry sales growth rate.
• Industry may experiencing overcapacity and eroding profit margins.

Deceleration of growth and decline.

• Analyzing the amount of industry concentration.
• Fragmented industry means many firms compete and theories of competition and product differentiation are most applicable.
• More concentration means fewer firms in the industry, oligopolitics competition and game theories become important.

Competition structure.

_____ means many firms compete and theories of competition and product differentiation are most applicable.

Fragmented industry

Two methods in analyzing industry concentration

a. Concentration ratio

b. Herfindahl Index.

• ____ means the combined share of the largest N firms in the industry,
• example, a market in which the three largest firms have a combined share of 80 percent indicate oligopolistic competition.

Concentration ratio

• _____ The sum of the squared market shares of the firms in the industry,
• Example, if two firms have a 15 percent market share each and one has a 70 percent market share, 2 2 2

H= 0.15 + 0.15 + 0.7 = 0.535

• The _____ has a value that is always smaller than one.
• A small index indicates a competitive industry with no dominant players.
• If all firms have an equal share,
• H= H (1 over N to second power) = 1/N,
• and the reciprocal of the index shows the number of firms in the industry.

• When firms have unequal shares, the reciprocal of the index indicates the “equivalent” number of firms in the industry.
• Example, market structure is equivalent to having 1.87 firms of the same size,
• 1/H = 1/.535 = 1.87.
• One can classify the competition structure of the industry to this ratio.
• The measure is used to search the degree of cooperation versus competition within the industry.

Herfindahl Index.

• ______, In Michael Porter’s The competitive advantage of Nations, the notions of economic gography is used that different locations have different competitive advantages.

• National factors that can lead to a competitive advantage:
• Factor conditions.
• Demand conditions.
• Related suppliers and support industries.
• Strategy, structure, and rivalry.

5. Competitve Advantage.

Human capital, maybe measured by years of schooling or others.

Factor conditions.

Size and growth of domestic market.

Demand conditions.

Computer software industry to support the hardware industry.

Related suppliers and support industries.

Corporate governance, management practices, and the financial climate.

Strategy, structure, and rivalry.

• Means a set of actions that a firm is taking to optimize its future ______.

• Three generic _____, according to Porter:

1. Cost leadership.
2. Differentiation.
3. Focus

Competitive Strategies.

The firm seeks to be the low-cost producer in its industry.

Cost leadership.

The firm seeks to provide product benefits that others do not provide.

Differentiation

The firm targets a niche with either a cost or a benefit (differentiation) ____.

focus.

• _____ refers to cooperation along the value chain and is an application of game theory.
• The Concept of the _____ is the set of participants involved in producing value along the value chain: suppliers, customers, competititors and firms producing complementary goods and services.
• In the context of equity valuation, co-optition analysis is an important element of risk analysis.

Co-opetition and the Value Net.

• Many commercial providers sell reports on the relative performance of industries or sectors over the business cycle, and _____ is a popular investment-timing strategy.
• Different industries behave differently over the business cycle such as durable and nondurables industries and defensive consumer staples(necessities) industries.
• A successful _____ strategy depends on an intensive analysis of the industry and faces many pitfalls.

Sector Rotation.

• To achieve excess equity returns on risk-adjusted basis, investors must be able to distinguish sources of risk in the investments they make.
• Example, increase in ROE may be attributable solely to an increase in leverage (gearing).
• Such increase in leverage raises financial risk and hence the required rate of return, the increased ROE then does not yield an excess risk-adjusted return.
• Although return expectations can be established by evaluating firm strategies within the industry, the analysts must always examine the risk that the strategy may be flawed or that the assumptions about competition and co-opetition may hold only in a good economic environment.
• What seems to be attractive in good times can turn into a dangerous one in bad times.
• The risk can differ widely.
• Not only between firms with the same industry, but also across industries.
• Some industries are more sensitive to technological change and the business cycle than are others.
• So, the outline growth factors that affect return expectations should also be taken into account to assess industry risk.
• The firms that follow high-risk strategies in an industry that is also risky will have higher ex ante(that is before the fact) stock market risk, and this should be incorporated in expected risk measures.
• Ex-post (that is after the fact), this stock market risk will eventually be measured by looking at volatility and covariance measures.

Risk Elements (expectations)

9 Risk elements

1. Market competition.
2. Value Chain competition.
3. Intense Rivalry
4. Substitutes
5. Buyer Power
6. Supplier Power
7. New Entrants
8. Government participation
9. Risk and covariance.

• Microeconomics examines the various types of competition in markets.
• The question is always to look at the price versus average cost.
• Preservation of competitive position and competitive advantage involves entry-deterring or exit-promoting strategies.
• Limit pricing that is pricing below average cost and holding excess capacity deter entry.
• Risks are always present that the company’s strategy will not sustain its competitive advantage.

1. Market competitionn

• Companies compete not just in markets but also along the value chain..
• Suppliers can choose to compete rather than simply cooperate with intermediate company.
• Suppliers of commodity raw materials have less ability to squeeze profits out of a downstream company than do suppliers of differentiated intermediate products.
• Co-opetition risks are presented by the possibility that the company’s supply maybe held up or that its distributors may find other sources of products and services.

2. Value Chain competition.

• This is the degree of competition among companies in the industry.
• Coordination can make rivalry much less intense.
• There is an possibility of changes in coordination and rivalry intensity that are not reflected in equity prices.

3. Intense Rivalry

• This is the threat of product or services that are ___ for the products or services in the industry.
• There is an possibility of changes in _____ that are not reflected in equity prices.

4. Substitutes

• This is the bargaining power of buyers of products and services.
• There is a possibility of changes in the ____ that are not reflected in equity prices.

5. Buyer Power

• This is the bargaining power of suppliers to the producers.
• There is a possibility of changes in the _____ that are not reflected in equity prices.

6. Supplier Power

• This is the threat of ______ into the industry.
• There is a possibility of changes in the ______ threats that are not reflected in equity prices.

7. New Entrants

• Governments control competition, and participate indirectly through their involvement in the social contract.
• Government subsidies can be favorable or unfavorable to businesses.
• Risks are presented by the uncertainty involved in trying to predict government policy.

8. Government participation

• The two levels of risk:

1. total risk of a company or an industry which is usually measured by the standard deviation of stock returns of that company or industry; and, the
2. risk of how the returns of a company vary with global market indexes which is measured by the covariance with the aggregate economy.

• In analyzing an industry, there is the presence of continuing challenge of determining diversifiable and nondiversifiable risk.

Risk and covariance.

2 Equity Analysis :

1. Market efficiency
2. stock valuation

• The _____ is central to finance theory and is important for valuing securities.
• The question in company analysis is whether a security is priced correctly, and if not, how long will it remained mispriced.
• In an ______, any new information would be immediately and fully reflected in prices.
• Since all current information is impounded already in the asset price, only unanticipated information could cause a change in price in the future.

1. Market Efficiency

• An efficient financial market quickly discounts all available information.
• Any new information will immediately be used by some investors, who will take positions to capitalize on it, which will lead the asset price adjust instantaneously to such piece of information.
• Just for an example, a new balance of payment statistics would immeditely be used by foreign exchange traders to buy or sell currency until the foreign rate reached a level considered consistent with the new information, or investors might use surprise information about a company ,
• such as a new contract or changes in forecasted income, to reap a profit until the stock price reached a level consistent with the news.
• The adjustment in price would be so rapid it would not pay to buy information that has already been available to other investors.
• So, many expert financial analysts and professional investors all over the world search for information and make the world markets close to fully efficient.

MARKET EFFICIENCY (2.1)

• In a perfectly _____, the typical investors could consider an asset price to reflect its true fundamental value at all times that means at each point in time, each asset has an intrinsic value that all investors try to discover.
• As such, the analyst tries to find mispriced securities by choosing from a variety of valuation models and by carefully researching the inputs for the model.
• Researching to forecast cash flows and risk is very critical.

MARKET EFFICIENCY (2.2)

• The purpose of fundamental analysis is to identify stocks that are mispriced relative to some measure of the “true” value that can be derived from observable data.
• True value can only be estimated.
• Stock analysts use models to estimate fundamental value of a corporation’s stock from observabe market data and from the financial statements of the firm and its competitors.
• These valuation models differ in the specific data they use and in the level of their theoretical sophistication.
• However, most of them use the notion of valuation by comparables – they look at the relationship between price and various determinants of value of similar firms, and then extrapolate that relationship to the firm in question.

2. Equity or Stock Valuation

Valuation By Comparables

Example:

• (from Microsoft Corporation, financial highlights, year end, 2008)
• The price of a share of Microsoft common stock is $17.66, and the total market value of all 8,899 million shares outstanding is $156,979 million.
• The ratios of Microsoft’s stock price to four different items taken from its financial statements (each on a per-share basis) : operating earnings, book value, sales revenue, and cash flow.
• Microsoft’s price-to-earning ratios (P/E) ratio is 9.2, Price-to-book value is 4.6, price-to-sales is 2.5, and price-to-cash flow ratio is 8.0.
• Such comparative valuation ratios are used to assess the valuation of one firm versus others in the same industry.
• The P/E ratio for Microsoft, 9.2 can be compared to the software industry average ratio of 15.3.
• By comparison with this standard, Microsoft appears to be priced significantly below industry norms.
• The market price of a share of stock is 4.6 times its book value at the end of the year.
• For the the average firm in the PC software industry, the market-to-book ratio was 4.8.
• By comparison with this standard, Microsoft was valued in line with the rest of the industry.

2. Equity or Stock Valuation

Valuation By Comparables

3 TYPES OF STOCK VALUATION/ VALUATION BY COMPARABLES:

1. Book Value
2. Liquidation Value
3. Replacement Cost

• – The net worth of common equity according to a firm’s balance sheet.

• Sharesholders in a firm are also called “ residual claimants,” which means that the value of their stake is what left over when the liabilities of the firm are subtracted from its assets, as such shareholders’ equity is this networth.

• However, the values of both assets and liabilities recognized in financial statements are based on historical values such as the ____ of an asset
• (=) equals the original cost of acquisition (-) less some adjustment for depreciation, even if the market price of that asset has changed overtime.

• Also, depreciation allowances are used to allocate the original cost of the asset over several years, but do not reflect loss of actual value.

• ______ are based on original cost, whereas market values measure current values of assets and liabilities.

• The market value of the shareholders’ equity investment equals the difference between the current values of all assets and liabilities – the stock price is the market value of shareholders’ equity divided by the number of outstanding shares.

1. Book Value

• Net amount that can be realized by selling the assets of a firm and paying off debt, and distributing the remainder to the shareholders.
• A better measure of a floor for the stock price is the firm’s Liquidation Value per share.
• The reasoning behind this concept is that if the market price of equity drops below liquidation value of the firm, the firm becomes attractive as a takeover target.
• A corporate raider would find it profitable to buy enough shares to gain control and then actually liquidate because liquidation value exceeds the value of the business as a going concern.

2. LIQUIDATION VALUE

• _____ – Cost to replace the firm’s assets.
• Another balance sheet concept that is of interest in valuing a firm is the
• _____ of its assets less its liabilities.
• A number of analysts believe that market value of the firm cannot get too far above its _______ for long because,
• if it did, the competitors would try to replicate the firm.
• The competitive pressure of other similar firms entering the same industry would drive down the market value of all firms until they came into equality with ______.

3. REPLACEMENT COST

• The ratio of market price to ______ is known as Tobin’s q, after the Nobel Prize recipient economist James Tobin.
• According to this view, the ratio of market price to ______will tend toward 1, but the evidence is that this ratio can differ significantly from 1 for very long periods of time.

• Though balance sheet can give useful information about firm’s liquidation value, book value, and replacement cost,
• analyst turn to the future value cash flows for a better estimate of the firm’s value.
• The most popular model for assessing the value of a firm as a going concern starts from the observation that the return on a stock investment comprises cash dividends and capital gains or losses.

REPLACEMENT COST 2.1