ACCT6101 – Session #1: Introduction to Valuation
PART 1 – Background
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ACCT7106 – Session #4: The Valuation Process II
Issue #1 – discount rate (k):
Issue #2 – investment horizon (n):
Issue #3 – choice of flow measure (x): (e.g., dividends, free cash flow, earnings)
Issue #4 – estimating future values of ‘x’ (on a year-by-year basis for ‘n’ years, and then the ‘on average’ growth rate, g, over the extended period)
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Issue #1 – discount rate:
The CAPM, which is one relatively well accepted approach to developing a discount rate, predicts that the required rate of return on common equity as:
ke = RF + [E(RM) – RF]
[E(RM) – RF] ‘market price of risk’ (historic range approximately 5% 7%)
measure of the firm’s systematic risk (broadly available for most major companies)
RF = risk-free rate of return yield on 10-year government bonds
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Issue #2 – investment horizon:
predict future year-by-year flows for some finite number of years and then estimate the terminal value at the end of this forecast horizon.
determination of an appropriate forecast horizon involves trade-offs (between ability to forecast year-by-year accurately and the weight placed on the terminal value component)
Analysts typically select a forecast horizon in the range of 3 to 5 years
Issue #3 – flow measure:
earnings
cash flow
– cash flows to the firm
cash flows to the investor (dividends)
Conceptually, the choice of a ‘flows measure’ should not matter (i.e., the dividend, free cash flow, and abnormal earnings valuation models should lead to identical estimates of value!)
Practically – for equivalence, application must be based on consistent estimates which adhere to the ‘clean surplus’ relation (‘equivalence’ also underscores defensible estimates)
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+ ……
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fundamental analysis represents an exercise designed to determine ‘intrinsic value’
it involves analyzing both quantitative and qualitative data about the company and the environment within which it operates including –
macroeconomic & industry factors (e.g., the state and prospects of the overall economy; industry conditions and prospects)
company-specific factors (e.g., financial conditions; effectiveness of management; strategic initiatives; consumer behaviour)
Issue #4 – estimating future values of ‘x’
on a year-by-year basis over the forecast horizon (‘n’ years)
the ‘on average’ growth rate, g, that applies over the foreseeable future post the forecast horizon
As investors / analysts (external to the firm), to estimate the firm’s ‘intrinsic value’ through an application of ‘fundamental analysis’, we need to develop an understanding of the firm’s value drivers including the policies and strategies implemented by management
assumed objective of management = maximize shareholders’ wealth
maximize share price!
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roles / functions management executes in generating value –
1. Controller function asset efficiency (efficient use of working capital)
2. Treasury function long-term funds acquisition (debt or equity?)
3. Capital budgeting real (productive) asset acquisition (fixed productive assets)
the fundamental decisions that ultimately determine the firm’s profitability and its operating risk
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There are a number of templates that detail the type of information that is necessary for the development of an understanding of the firm’s value drivers
One such template is represented in the ‘top down approach that might be used by analysts, as well as a schematic representation of process (reproduced from Session #3)
Other templates include the structures and coverage detailed under what I called ‘Approaches A & B’ in Session #3 (slides #50 – #58)
Ultimately these templates distill down to a coverage of 3 basic aspects / dimensions:
external environment e.g., macroeconomic factors, regulatory factors, social / environmental factors, etc.
industry setting and dynamics
firm specific factors e.g., management, product and technology, financial performance
Understanding how each of these dimensions affects the firm’s performance is critical to developing an understanding of the firm’s value drivers, and then translating that understanding into projections of the firm’s future performance – the proforma F/S
Typical analyst’s report – Top down approach
Macroeconomic factors e.g.,
GDP; Interest rates; Inflation
Foreign exchange (FOREX) rates; Oil and commodity prices
Hedging
Business cycle
Industry factors e.g.,
Sensitivity to macroeconomic factors
Industry operation, ratios and stats
Competition
Firm level e.g.,
Strategy
Synergy
Financial Performance
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Bradshaw, 2011
“Analysts’ forecasts: What do we know after decades of work?”
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Penman presents an overview of the ‘process of fundamental analysis’ in Figure 3.1 (page 85)
Step #1 Knowing the business
Step #2 Analyzing information
Step #3 Forecasting payoffs
Step #4 Converting forecasts to valuation
Step #5 Trading on valuation
Step #3 involves interpretation of the information developed in the first two steps (subjective ‘the art’)
Steps #4 & #5 are then mechanical in nature
Steps #1 & #2 are critical to the process of developing the inputs for use in implementing of the fundamental valuation model(s)
WHY? they are critical to development of the ‘pro forma’ financial statements
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Step #1 Knowing the business
the products
the knowledge base
the competition
the regulatory constraints
Step #2 Analyzing information
in financial statements
outside financial statements
PART 2 – Strategy Analysis
As a further alternative template (‘check list’), Penman summarises six categories covering ‘details of the business’ he deems necessary to understand before making forecasts (pg. 16):
Know the firm’s products
Know the technology required to bring products to market
Know the firm’s knowledge base
Know the competitiveness of the industry
Know the management
Know the political, legal, regulatory, and ethical environment
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external environment
political
regulatory
social
technological
macroeconomic
PEST analysis
Political forces
Economic forces
Social changes
Technological change
SWOT
Strengths
Weaknesses
Opportunities
Threats
Situational Analysis – general external environment
political / legal
socio-cultural
technological
demographic
global
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For Coles, how might we summarise the various factors that potentially affect the company, its policies and strategies, and ultimately its performance?
Political:
Regulatory:
Socio-cultural:
Technological:
Macroeconomic: e.g., exposure, hedging strategy
Strategy analysis involves judgement – interpretations and conclusions regarding the firm’s circumstances and exposures will differ
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industry environment setting and dynamics
Porter’s five forces model
the bargaining power of suppliers
the bargaining power of the buyers
the threat of potential new entrants
the threat of substitutes
the extent of competitive rivalry
Why is industry analysis important?
the level industry competition tends to determine how profitable the industry is
i.e., if the Five Forces are favourable to firms in the industry, they will tend to be profitable
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You can start to think about each of the industry sectors in terms Porter’s ‘five forces model’
suppliers; buyers; new entrants; substitutes; rivalry
and then juxtapose your interpretations against the historic profitability of the various sectors
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“How competitive forces shape strategy” M.E. Porter, Harvard Business Review, 1979 March/April
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PART 3 – Porter’s Five Forces
1. Bargaining power of suppliers
substitutes (lack of substitutes increases the power of suppliers relative to the buyers)
product differentiation
numbers of suppliers versus numbers of buyers (fewer suppliers compared with buyers increases the power of the suppliers)
where suppliers have alternative customers, industries and channels they have greater power
switching costs
suppliers could bypass buyer and sell directly to customer
what suppliers could do:
increase prices
alter the quality of goods and services supplied
not supply goods or services
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Suppliers are more powerful if:
The supplier’s industry is more concentrated than the industry it sells to
e.g., Microsoft used to dominate the operating systems industry, so it had a lot of power over PC manufacturers, which was a fragmented industry
The supplier group does not depend heavily on the industry for its revenues. In this case the suppliers are more powerful, because they have the option of selling their goods/services to another industry
Industry participants face switching costs in changing suppliers,
e.g., because they have invested in using a particular product/service and it is costly for customers change
e.g., many trading firms have trained their staff on how to use Bloomberg terminals. It is costly to change to a competitor like Factset or Thomson Reuters Eikon
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Suppliers offer products that are differentiated, i.e. offer unique quality, features, service, etc.
e.g., pharmaceutical companies that offer unique and patent-protected drugs have power over hospitals, since the hospital cannot easily substitute another drug.
On the other hand, suppliers that sell a ‘commodity’ product with many substitutes will have less power, e.g. suppliers of stationery
There is no substitute for what the supplier group provides
e.g., train drivers can threaten to strike, knowing that they cannot be replaced
The supplier group can credibly threaten to integrate forward into the industry
e.g., an iron ore company might start smelting its own steel, and therefore start competing directly with its customers
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2. Bargaining power of buyers (customers)
volume of purchases (larger volume of purchases better prices)
limited number of buyers
undifferentiated products or substitute products
product discretionary/ not essential
if the product makes up a larger portion of total cost of item, buyers will be more price sensitive
low switching costs
where margins are high – buyers will be more pro-active in negotiating lower prices.
in-house production
more information, better position to bargain
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Customers are more powerful if:
There are few buyers, or each purchases in volumes that are large relative to the size of a single vendor
e.g., Australian supermarkets are very powerful buyers, because the two biggest supermarkets (Coles and Woolworths) have large market shares, whereas their suppliers are more fragmented
The industry’s products are standardized or undifferentiated
e.g., this is true of a lot of non-luxury, basic car brands. Most of us are indifferent between buying a basic Honda, Ford, VW, etc. This tends to keep the price of basic cars down
Buyers face few switching costs in changing vendors
e.g., you can switch from Pepsi to Coca Cola fairly easily, so their prices stay quite similar! UQ vending machines sell both!
Buyers can credibly threaten to integrate backward and produce the industry’s product themselves if vendors are too profitable
e.g., Apple recently announced it will produce its own chips for its Mac computers, rather than using Intel chips
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Customers are more price-sensitive if:
the product it purchases from the industry represents a significant fraction of its cost structure or procurement budget
e.g., people shop around a lot when looking for a home mortgage
the buyer group earns low profits, is strapped for cash, or is otherwise under pressure to trim its purchasing costs
the quality of buyers’ products or services is little affected by the industry’s product
e.g., the movie industry has the opposite situation. They do not mind paying a lot for cameras, because they need high quality equipment
the industry’s product has little effect on the buyer’s other costs
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3. Threat of New Entrants (new competition)
Barriers to entry
product differentiation – brand identification
economies of scale
capital requirements
other cost disadvantages
access to distribution networks
government policy
Retaliation by existing competitors
increase productive capacity, protect distribution channels and customers (first mover advantage)
cut prices
industry has slow growth – impacting all competitors
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new entrants threaten the profitability of existing companies
e.g., Toys R’ Us, once a very successful toy store, has gone out of business in the U.S. because Walmart and Amazon started selling toys
the treat of entry depends on how difficult it is for a new company to enter the industry
barriers to entry
Seven major barriers to entry:
1. Supply-side economies of scale: do existing firms benefit from spreading fixed production costs over a large number of units?
e.g., in the car industry it costs of millions of dollars to develop a new vehicle – some car firms have resorted to partnerships to achieve greater economies of scale, such as Renault and Nissan
e.g., service industries have relatively low economies of scale, such as consulting firms
2. Demand-side benefits of scale: do existing firms benefit from large networks of consumers that are difficult to replicate?
e.g., consumers want to use ebay or Facebook because so many other people use these platforms – a new auction site or social media site would struggle to replicate their network
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3. Customer switching costs: are customers locked in to a product/service because it would be very expensive to change?
e.g., changing from Microsoft Office to a competitor’s software would be costly for many consumers
4. Capital requirements: is a large amount of capital needed up-front to enter the industry?
e.g., most manufacturing industries require building a large factory and warehouse, and buying equipment
e.g., most software products now have low relatively capital requirements, so the Google PlayStore and Apple AppStore have many competing applications
5. Incumbency advantages independent of size: e.g. proprietary technology, access to the most favourable locations, establish brand name, etc.
e.g., Coles and Woolworths tend to have the best locations, because they have been operating for decades. Aldi, which entered Australia in 2001, has had to struggle to find good locations.
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6. Unequal access to distribution channels: e.g. existing companies might have already locked in the best retail channels
e.g., major airlines historically had agreements with travel agents, locking up this distribution channel; but discount airlines bypassed this by selling directly to consumers online
7. Restrictive government policy: the government might somehow restrict access to the industry
e.g., Australian governments limit the number of casinos, which is a barrier to entry that protects casino companies (Crown Group and Star Entertainment Group)
Restrictive government policy is not always effective – Uber has been able to push governments into allowing it to compete with taxi companies in many countries
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4. Threat of substitutes
existence of substitutes puts a ceiling on the price that can be charged for a product.
the cost for customers to switch to the substitute product
the likelihood that buyers will purchase substitute products.
A substitute product is more of a threat if:
It offers an attractive price-performance trade-off to the industry’s product
e.g., Skype (which is a freemium product) put severe pressure on long-distance telephone companies by providing a good substitute to expensive telephone calls. Now Skype is under pressure from a variety of competitors (e.g. Facebook Messenger, WeChat, WhatsApp) mainly because it lacked any patents or other barriers to entry
The buyer’s cost of switching to the substitute is low
e.g., once the patent expires on drugs, other pharmaceutical firms can make ‘generic’ substitute drugs that are identical
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5. Rivalry among existing competitors
Outcomes of rivalry
aggressive pricing
aggressive marketing
battles for customers
battles for distribution channels
increased service levels
Factors likely to lead to rivalry
many and/or equally balanced competitors
slow industry growth
high fixed costs and asset bases
products perceived as a commodity and low switching costs
diversity of competitors
high exit barriers and excess capacity
no product differentiation
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Industry rivalry is greater if:
Competitors are numerous or are roughly equal in size and power
e.g., the budget Android segment of the smartphone market is like this
e.g., the opposite is industries where large companies have near-monopolies, such as Google in search engines
Industry growth is slow, as slow growth precipitates fights for market share
e.g., Coles and Woolworths are always fighting each other over grocery market share, since the industry grows slowly (basically at GDP growth)
Exit barriers are high, e.g. the company cannot easily shift to another industry/market because its assets are specialised or because of government regulation
e.g., newspapers are moving online – companies will struggle to redeploy their printing presses
Rivals are highly committed to the business and have aspirations for leadership, especially if they have goals that go beyond economic performance in the particular industry
e.g., state-owned companies (or state supported industries) might attempt to maximise production/employment/exports rather than profit. This has tended to happen with steel in recent years
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Competition can take place on price or on other dimensions such as quality, features, brand image, etc.
Price competition is more likely if:
products or services of rivals are nearly identical and there are few switching costs for buyers
e.g., cheap Android phones. There are few switching costs since they all run the same operating system and can run the same apps. They tend to have similar features as well.
fixed costs are high and marginal costs are low. This encourages overproducing to benefit from economies of scale
capacity must be expanded in large increments to be efficient
the product is perishable, meaning it must be sold quickly or becomes worthless
e.g., fruits and vegetables. They can be canned rather than selling them fresh, but the market for canned fruits/vegetables is limited
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For Coles, we can possibly summarise the Five Forces analysis as follows:
Power of Suppliers: extremely low
Power of Buyers: moderate – price sensitive
Threat of New Entrants: low, but possible
Threat of Substitute Products: very low
Rivalry Among Existing Competitors: moderate
You are welcome to disagree! Strategy analysis involves judgement
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Strategic analysis
1. key success factors e.g., first mover advantage; marketing & distribution; production efficiencies
2. strategies business level, competitive level, corporate level
e.g., high price strategy; market penetration strategy; first mover into industry; diversification into new areas; core business
3. core competencies
resources tangible – financial; physical; human
intangible – resources for innovation; reputation
capabilities re: operations; marketing and sales; management; technology
PART 4 – Firm specific factors
Performance appraisal
historical financial performance (e.g., ratios)
concerns regarding the historical financial statements
i.e., needs for restatement and/or restructuring of the financial statements as presented
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‘Step 1’ – Competitive Strategy
firm’s position within industry and sustainability of its competitive advantage
competitive strategy involves looking for a profitable and sustainable position in a competitive industry
factors that contribute to a competitive position are innovation, cohesiveness of a business culture, and good implementation
considerations in determining a competitive strategy are:
long-term profitability of the industry
the position of a business within the industry, relative to competitors
these two considerations are dynamic, in that, performance of an industry and a firm’s competitive position within the industry change over time, with individual firms having the ability to influence these factors
the greatest influence an individual firm can have is on its positioning within the industry
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Porter – Competitive Strategy
Porter’s ‘five forces’ provide insights into the attractiveness of an industry
further, they help identify the causes of these forces; explains how they change over time; and how businesses can use strategies to influence them
they analyse competitors in order to predict and explain their behaviour
they group competitors on the basis of strategy in order to identify a competitive position within the industry
they examine specific structural settings and applies this framework to those settings
competitive advantage grows from a business creating value in excess of the cost of creating value (similar to residual income concept)
value represents what buyers are willing to pay and stems from
offering goods/services at lower prices than competitors (cost leadership)
providing a unique product that buyers are willing to pay more for (differentiation)
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‘Step 1’ – Competitive Strategy
firm’s position within industry and sustainability of its competitive advantage
Cost leadership
Differentiation
Focus
Most businesses compete on the basis of either cost leadership or differentiation, or a mix of both
Having an effective and sustainable cost leadership or differentiation strategy is the source of a company’s competitive advantage
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1. Cost Leadership
strategy – firm aims to be the lowest cost producer in its industry
the firm needs to have a broad scope, serving many industry segments and perhaps related industries.
sources of cost advantage include
economies of scale
proprietary technology, efficient production
simpler product designs
lower input costs
low-cost distribution; good supply relations
little R&D or brand advertising
product will be standard
cost benefits will come from all sources
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2. Differentiation
strategy – aims to be unique on some dimension that is highly valued by customers, which then allows the company to charge a higher price
premium priced product
some bases for uniqueness
superior product quality; superior product variety
superior customer service; more flexible delivery
investment in brand image; commitment to extensive marketing
investment in R&D; control system focus on creativity and innovation
need to ensure that costs are similar to competitors in all areas that do not affect differentiation
note – many Australian companies compete on ‘differentiation’ because of Australia’s high labour costs
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3. Focus
narrow scope within an industry – focus on a particular segment or groups of segments within an industry.
cost focus – strategy is to have lowest cost in focus segment
differentiation focus – strategy is to have uniqueness in focus segment
need to be special requirements for target segment that differentiates it from the rest of the industry.
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Competitive advantage from being both a Cost leader and Differentiator
three conditions under which a firm can be both a cost leader and have product differentiation:
competitors are stuck in the middle
when costs are determined by market share or there are interrelationships between industries that the business can exploit.
major innovation
Sustainability
to benefit from the competitive strategies they need to be sustainable
need barriers to stop imitation
need to ensure that differentiation proximity or cost proximity is not lost
there may be some industries where it is very difficult to be either a cost leader or differentiate from competitors.
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Australian supermarkets provide an example of somewhat different strategies
Aldi competes purely on cost leadership
offers few alternative brands and products
never advertises
in store displays are generally basic
fewer staff in store
efficient supply chain
less expensive locations
Coles and Woolworths compete on a mixture of cost leadership and differentiation
offer a wider range of brands and products than Aldi
spend a lot of money on brand image, e.g. advertising, magazines with recipes, elaborate displays in-store
have stores all around Australia, even in fairly remote areas (especially Woolworths)
on the other hand, Coles and Woolworths also compete on low prices. They use their buying power, economies of scale and ‘home brands’ to drive down costs, as well as encouraging use of ‘Self Check Out’
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PART 5 – Summary: Sessions #1 #4
overarching focus – fundamental value
requires an understanding of the ‘value drivers’
Firm – Management
assumed objective maximize share price
value created through execution of 3 roles
Controller function operations level (management of NWC)
Capital budgeting composition of long-term productive assets
Treasury function acquisition of long-term finance to support asset acquisition (debt, equity)
relevant factors / forces for management to consider when making strategic decisions –
external environment
industry setting
firm specific
Investor / Analyst
focus – ‘intrinsic value’
approach – fundamental analysis
application of the fundamental valuation model
required inputs/decisions:
discount rate (k):
investment horizon (n):
choice of flow measure (x): (D, FCF, and/or E)
estimating future values of ‘x’ (yearly for ‘n’ years, and then the ‘on average’ growth rate, g, post ‘n’)
+ … + +
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re: investor / analyst
fundamental analysis estimation of ‘intrinsic value’ fundamental valuation model
Application –
discount rate (k) CAPM ke = RF + [E(RM) – RF] ke = 0.03 + [0.06]
investment horizon (n) 3 – 5 years depending upon circumstances (‘predictability’)
choice of flow measure (x) conceptually and practically valuation based on dividends (D), free cash flow (FCF), and earnings / accounting (AE) will lead to the same estimate but requires internally consistent estimates adhering to ‘clean surplus’
estimating future values of ‘x’ and of ‘g’ developing an understanding of the firm’s value drivers external environment, industry dynamics, firm-specific factors
sources of information include – analysts, management, press, Financial Statements
= + … + +
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re: estimating future values of ‘x’ and ‘g’
developing an understanding of the firm’s value drivers
external environment
e.g., macroeconomic factors, regulatory factors, social / environmental factors, etc.
industry setting and dynamics Porter’s ‘five forces’
the bargaining power of suppliers
the bargaining power of the buyers
the threat of potential new entrants
the threat of substitutes
the extent of competitive rivalry
firm specific factors
e.g., management, product and technology, financial performance
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Stage 1 – Understanding the Business
‘Strategy Analysis’
product market
competition
regulatory constraints
business strategies
technology
Stage 2 – Analysing Information
Accounting Analysis & Financial Analysis
quality of accounting information
reformulating the F/S to uncover business activities
ratio and cash flow analysis
Stages of the Analysis
Stage 3 – Prospective Analysis: Forecasting
pro-forma – Income Statement
– Balance Sheet
– Statement of Cash Flows
Stage 4 – Prospective Analysis: Valuation
Abnormal Earnings Model
Alternative Valuation Models
Statement of Cash Flows
Stage 5 – Prospective Analysis: Application
Investment decision
investor – decision to buy, hold, sell
manager – decision to adopt strategy or not
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