Review-answers

Chapter1AFrameworkforBusinessAnalysisandValuationUsingFinancialStatements3.JoeSmitharguesthat“learninghowtodobusinessanalysisandvaluationusingfinancialstatementsisnotveryuseful,unlessyouareinterestedinbecomingafinancialanalyst.”Comment.Businessanalysisandvaluationskillsareusefulnotonlyforfinancialanalystsbutalsoforcorporatemanagersandloanofficers.Businessanalysisandvaluationskillshelpcorporatemanagersinseveralways.First,byusingbusinessanalysisforequitysecurityvaluation,corporatemanagerscanassesswhetherthefirmisproperlyvaluedbyinvestors.Withsuperiorinformationonafirm’sstrategies,corporatemanagerscanperformtheirownequitysecurityanalysisandcomparetheirestimated“fundamentalvalue”ofthefirmwiththecurrentmarketpriceofshare.Ifthefirmisnotproperlyvaluedbyoutsideinvestors,corporatemanagerscanhelpinvestorstounderstandthefirm’sbusinessstrategy,accountingpolicies,andexpectedfutureperformance,therebyensuringthatthestockpriceisnotseriouslyundervalued.Second,usingbusinessanalysisformergersandacquisitions,corporatemanagers(acquiringmanagement)canidentifyapotentialtakeovertargetandassesshowmuchvaluecanbecreatedthroughacquisition.Usingbusinessanalysis,targetmanagementcanalsoexaminewhethertheacquirer’sofferisareasonableone.Loanofficerscanalsobenefitfrombusinessanalysis,usingittoassesstheborrowingfirm’sliquidity,solvency,andbusinessrisks.Businessanalysistechniqueshelploanofficerstopredictthelikelihoodofaborrowingfirm’sfinancialdistress.Commercialbankerswithbusinessanalysisskillscanexaminewhetherornottoextendaloantotheborrowingfirm,howtheloanshouldbestructured,andhowitshouldbepriced.4.Fourstepsforbusinessanalysisarediscussedinthechapter(strategyanalysis,accountinganalysis,financialanalysis,andprospectiveanalysis).Asafinancialanalyst,explainwhyeachofthefourstepsisacriticalpartofyourjob,andhowtheyrelatetooneanother.Managershavebetterinformationonafirm’sstrategiesrelativetotheinformationthatoutsidefinancialanalystshave.Superiorfinancialanalystsattempttodiscover“insideinformation”fromanalyzingfinancialstatements.Thefourstepsforbusinessanalysishelpoutsideanalyststogainvaluableinsightsaboutthefirm’scurrentperformanceandfutureprospects.1.Businessstrategyanalysisisanessentialfirststepbecauseitenablestheanalyststoframethesubsequentaccounting,financial,andprospectiveanalysisbetter.Forexample,identifyingthekeysuccessfactorsandkeybusinessrisksallowstheidentificationofkeyaccountingpolicies.Assessmentofafirm’scompetitivestrategyfacilitatesevaluatingwhethercurrentprofitabilityissustainable.Finally,businessstrategyanalysisenablestheanalyststomakesoundassumptionsinforecastingafirm’sfutureperformance.2.Accountinganalysisenablestheanalyststo“undo”anyaccountingdistortionbyrecastingafirm’saccountingnumbers.Soundaccountinganalysisimprovesthereliabilityofconclusionsfromfinancialanalysis.3.Thegoaloffinancialanalysisistousefinancialdatatoevaluatetheperformanceofafirm.Theoutcomefromfinancialanalysisisincorporatedintoprospectiveanalysis,thenextstepinfinancialstatementanalysis.4.Prospectiveanalysissynthesizestheinsightsfrombusinessstrategyanalysis,accountinganalysis,andfinancialanalysisinordertomakepredictionsaboutafirm’sfuture.1Chapter2StrategyAnalysis4.Ratethepharmaceuticalandlumberindustriesashigh,medium,orlowonthefollowingdimensionsofindustrystructure.Pharmaceuticalfirmshistoricallyhavehadsomeofthehighestratesofreturnintheeconomy,whereastimberfirmshavehadrelativelylowreturns.Thefollowinganalysisrevealswhy.PharmaceuticalIndustryLumberIndustryRivalryMediumHighFirmscompetefiercelytodevelopandpatentdrugs.However,onceadrugispatented,afirmhasamonopolyforthatdrug,dramaticallyreducingcompetition.Competitorscanonlyenterthesamemarketbydevelopingadrugthatdoesnotinfringeonthepatent.Industrygrowthratesarelow.Productstypicallyhaveverylittledifferentiationandswitchingcostsarelow.ThreatofNewEntrantsLowLowEconomiesofscaleandfirstmoveradvantagesareveryhighfortheInaddition,drugfirms’salesforceshaveestablishedrelationshipswithdoctors,whichactasafurtherdeterrentforanewentrant.Thisdistributionadvantageischangingasmanaged-carefirmshavebegunnegotiatingdirectlywithdrugcompaniesonbehalfofthedoctorsintheirnetwork.EntryintothelumberindustryrequiresaccesstotimbersuppliesThreatofSubstituteProductsLowHighNewdrugsareprotectedbypatentsgivingmanufacturersamonopolytoinventaroundthepatentortowaituntilthepatentexpires.Oncethepatentexpires,acompanywillreducepricesasothermanufacturersenterthemarket.Thethreatofsubstituteproducts,however,islikelytoincreaseasbiotechproductsenterthemarket.Therearemanysubstitutesforlumber,includingsteel,plastic,andincreases,useofthesesubstitutesalsoincreases.BargainingPowerofBuyersLowMediumHistorically,doctorshavehadlittlebuyingpower.However,managed-powerfulrecently,andhavebegunnegotiatingsubstantialdiscountsfordrugpurchases.Manybuyersareverylarge,suchasHomeDepot,andcanchoosefromcareprovidershavebecomemoreIndependentlumberyardsandsmallerchainshavemuchlesslow,givingbuyersadditionalleverage.BargainingLowHighPowerofSuppliersThechemicalingredientsfordrugscanbeobtain