Investment Analysis 7 by AhsanTareen

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									                    Investment Analysis




  Lecture 7

Industry Analysis
                                                       Investment Analysis

                   Financial Statement Information & IAS

                         Global Industry Analysis

      Country Analysis                              Industry Analysis

                                        Return Elements          Risk Elements
Forecasting Economic Growth            • Demand              •    Market
                                          Analysis                Competition
                                       • Industry Life       •    Value Chain
                                          Cycle Analysis          Competition
 Short-run:     Long-run:              • Competition         •    Rivalry Intensity
                                          Structure          •    Substitutes
 Business      Sustainable             • Competitive         •    Buyer Power
   Cycle        Economic                  Advantage          •    Supplier Power
                 Growth                • Competitive         •    New Entrants
                                          Strategies         •    Government
                                       • Coopetition              Participation
                                       • Sector Rotation     •    Risks
                              Equity Analysis
                                     Investment Analysis




             Industry Analysis
  Return Elements          Risk Elements

• Demand Analysis       • Market Competition
• Industry Life Cycle   • Value Chain
  Analysis                Competition
• Competition           • Rivalry Intensity
  Structure             • Substitutes
• Competitive           • Buyer Power
  Advantage             • Supplier Power
• Competitive           • New Entrants
  Strategies            • Government
• Coo petition            Participation
• Sector Rotation       • Risks
                                                                  Investment Analysis




Return Analysis
•   The investor’s ultimate goal should be to earn excess returns on a risk adjusted
    basis. Therefore, it is important to consider both return potential and risk
    characteristics when conducting the industry analysis. In general terms, to
    assess return potential we need to look at the firm’s sources of growth and how
    it maintains a competitive advantage. The following points should be
    considered:

•   Demand Analysis: Analysts should perform a local/global demand analysis by
    predicting how changes in GDP will affect sales using a regression framework.

•   Industry Life Cycle Analysis: Analysts should determine where the industry
    falls within the stages of the standard life cycle: pioneer, growth, mature or
    decline. The actual stage the industry is in will affect the potential investment
    returns, so it is important that the analyst makes an assessment that is as
    accurate as possible based on the available information.
                                                      Investment Analysis




Return Analysis (cont’d …)
• Competition Structure Analysis: Analysts should assess the
  degree of industry concentration. There are two methods to achieve
  this assessment.

1. “N” firm concentration ratio, which the combined market share of the
   largest N firms in the industry.

1. Herfindahl Index, which is the sum of the squared market shares of
   the firms in the industry.
                                                        Investment Analysis




Return Analysis (cont’d …)
• Both the N firm and Herfindahl measures are used to estimate the
  amount of cooperation versus competition within the industry. If the
  values for both measures are low, then it is more likely that there is a
  high level of competition and less cooperation within the industry.
  All other things being equal, this results in modest or no economic
  profits for each firm within the industry.

• In applying the N firm concentration ratio, assume we have a
  situation where the 20 largest firms have a combined share of 40%.
  This suggests a competitive industry environment in which excess
  returns are not likely. In contrast, suppose we have another industry
  in which two firms have a combined share of 100%. This suggests an
  oligopoly in which excess returns are likely. At best, this ratio gives a
  big picture but not precise sense of the level of competition within the
  industry, partly because not all firms are considered.
                                                          Investment Analysis




Return Analysis (cont’d …)
 • The Herfindahl Index (H) is similar but more precise. It reflects all of
   the firms in the industry, and greater emphasis is given to firms that
   hold relatively large market shares .
n
Herfindahl Index =   ∑ MSi2
i=1

Where:
• MSi = Market Share of Firm i
• n = Number of Firms in the Industry
                                              Investment Analysis




Return Analysis (cont’d …)

• A value below 0.1 suggests low concentration, a value of
  0.1 to 0.18 suggests moderate concentration and a
  value of 0.18 suggests high concentration.

• As long as there are at least two firms in the industry,
  Herfindahl Index should be less than one.
                                                                     Investment Analysis




Return Analysis (cont’d …)
Example 1
 • Assume there are 20 firms in the industry, each with a 5% market share. Calculate
    and interpret the Herfindahl Index.
Solution:
 • H = (0.05)^2 x 20 = 0.05
 • (0.05 < 0.1, therefore, low concentration)
 • A low H (below 0.1) suggests that the industry is competitive, that there are no
    dominant firms and that the cooperation between firms is not likely.

Example 2
 • Now assume that there are 5 firms in the industry, each with a 20% market share.
    Calculate and interpret the Herfindahl Index. Contrast the results with those of the
    previous example.
Solution:
 • H= (0.20)^2 x 5 = 0.2
 • (0.2 > 0.18, therefore, high concentration)
 • A high H (above 0.18) suggests that the industry is dominated by a few firms that
    have an incentive to cooperate to maximize their returns.
                                                               Investment Analysis




Return Analysis (cont’d …)
•   Value Chain: Analysts should also examine the value chain. The value chain
    involves a set of ongoing changes in moving from raw materials to the final
    product. Return opportunities may be examined by analyzing the entire
    industry’s value chain and how each company plans to create profits throughout
    the chain. Firm managers often try to predict the sources of profits within the
    industry’s value chain. The analyst must do the same in an attempt to predict
    the timing and amount of dividends as well as dividend growth rates.

•   Degree of Industry Cooperation: Analysts should examine the level of
    coordination (known as coopetition) among the participants who produce value
    along the value chain. Analysts should try to quantify the level of increased
    returns achieved through cooperation. However, such returns may be unstable,
    especially if a firm derives higher-than-normal profits due to cooperation. In
    good economic times, this is usually not a problem. In bad economic times, the
    profits may completely disappear due to sudden competition. Analysts must
    always be aware of the potential for wide fluctuations in returns when firms
    engage in cooperation.
                                                             Investment Analysis



Return Analysis (cont’d …)
• Competitive Advantage: Certain locations in the world/country may
  have a competitive advantage in producing or providing specific goods
  and services. High workforce education levels, efficient production
  methodologies and low competition are examples of way in which a
  country/region could gain a competitive advantage. The analyst should
  identify those countries/regions that have a competitive advantage in an
  attempt to maximize return opportunities.

• Generic Competitive Strategies: The analyst should identify generic
  competitive strategies (e.g., cost leadership, differentiation, cost focus)
  that firms in the industry are pursuing. In determining whether excess
  returns are possible, the analyst will need to consider how likely it is that
  the firm’s strategy will succeed. This could be achieved by examining the
  firm’s commitment to the strategy and anticipated reactions from its
  competitors.
                                                                     Investment Analysis



Risk Analysis
•   Although it is important to consider the return aspects, it is just as important to
    consider the risk aspects of investments also. The concepts of risk and return
    are interrelated. Only when industry risk is examined an analyst might obtain a
    full picture of the merits of investing in a particular industry by analyzing the
    following main factors:

•   Buyer power
•   Supplier power
•   Rivalry intensity
•   New entrants
•   Substitutes
•   Market competition
•   Government participation
•   Value chain competition
•   Risk & covariance
                                                        Investment Analysis




Risk Analysis (cont’d …)
• Competition within the industry: Analysts should examine
  competition within the industry. Firms compete using various price
  strategies in order to maintain a competitive advantage. For example,
  pricing below average cost and holding excess capacity would deter
  entry of new firms. Pricing below average cost might also drive
  existing competitors out of business.

• Government intervention: Government intervention comes in the
  form of financial assistance to domestic firms and regulations to
  control competition. As a result, foreign firms bear the risk of
  increased competition in domestic markets. Also, there is always the
  risk that the chosen regulations will not be in a firm’s or industry’s
  favor.
                                                        Investment Analysis




Risk Analysis (cont’d …)
• Value chain competition: Analysts should also examine competition
  along the value chain. Participants have a choice either to compete
  or to cooperate. The analyst must consider the risk that firm’s along
  the value chain may not always cooperate with one another.
  However, vertical integration may mitigate some of that risk.

• Overall risk: Analysts should examine a firm’s or industry’s overall
  risk by estimating standard deviation of returns. Analysts could also
  look at a firm’s or industry’s covariance of returns with the overall
  economy through an analysis of historical regressions of company
  returns against market returns.

								
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