Ch. 4 - CFA Institute
Ch. 4 - CFA Institute
INDUSTRY AND COMPANY ANALYSIS
dd Month yyyy
APPROACHES TO MODELING REVENUE
• Start with the
• Look at
• Begin with
lines, locations, or
segments to reach
the company level
to reach the
• Combine top-down
TOP-DOWN APPROACHES TO FORECASTING REVENUE
“Growth relative to GDP growth” approach
growth rate of
growth rate to
the growth of
to the forecast
“Market growth and market share” approach
growth in a
INCOME STATEMENT MODELING:
• Analyst can take a top-down, bottom-up, or hybrid approach to analyzing and
- Consider fixed and variable cost components of operating costs
• Economies of scale is present if the average cost per unit falls as revenues
- Indicative of economics of scale: operating margins positively correlated with
• 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
•Cost of goods sold: focus on gross margins
• Generally forecasted as a percentage of sales and can be broken down by
product line or segment
• Consider a company’s hedging activity that may affect costs of raw materials
• Compare with competitors’ gross margins.
Selling, general, and administrative (SG&A) expenses:
focus on type of expense
• Some SG&A expenses vary with cost of goods sold, whereas other SG&A
expenses are relatively fixed (e.g., overhead)
• Benchmarking against competitors may be useful
Nonoperating costs: depends on the type of cost
• Interest income varies with cash and investments, whereas interest expense
varies with debt
• Taxes are affected by the jurisdiction and the type of business
BALANCE SHEET MODELING
• Balance sheet modeling is the process of forecasting a company’s 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.
• Using forecasted income statement and balance sheet accounts, an analyst
can evaluate the company’s forecasted profitability.
• Useful measures of profitability include:
- Return on invested capital (ROIC)
Net operating profit less adjusted taxes (NOPLAT)
Operating assets − Operating liabilities
- 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 Porter’s five
Threat of substitute products
Intensity of rivalry
Bargaining power of suppliers
Bargaining power of customers
Threat of new entrants
COMPETITIVE PRESSURES AFFECTING
PRICES AND COSTS
• Ability to control costs affects a company’s ROIC
- A company that has weak bargaining power with suppliers has less ability to
• Ability to control prices affects a company’s ROIC
- A company that has weak bargaining power with customers is less able to
- 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
- A company in an industry with intense rivalry will not be able to control prices
JUDGING THE COMPETITIVE POSITION:
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
Please note these examples do not feature in text.
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 company’s 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.
• 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)
Begin with base year
Use alternative scenarios to forecast revenues,
including possible cannibalization
Analyze the cost structure
(i.e., fixed versus variable)
Project costs and expenses
Forecast net income and earnings per share (EPS)
based on forecasts of revenues and expenses
• Factors affecting forecast horizon include the following:
- Investment strategy for which the stock is being considered
- Cyclicality of the industry
- Company-specific factors
- Analyst’s employer preferences
• Longer-term projections may give a better picture of the normalized earnings of
- Normalized earnings are the expected level of sales mid-cycle, but without
unusual or temporary factors.
PROJECTIONS BEYOND THE SHORT-TERM
• 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)
- When will the future look different than the past—that is, where is the
- Economic disruptions
- Sustainable long-term growth
PRO FORMA INCOME STATEMENT
of goods sold
CONSTRUCTING THE PRO FORMA CASH FLOW
STATEMENT AND BALANCE SHEET
pro forma cash
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.
• 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
• In a “market growth and market share” approach, an analyst forecasts revenue
growth of markets and the company’s 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.
• Return on invested capital (ROIC) is an after-tax measure of profitability. A
related measure is the return on capital employed (ROCE).
• Porter’s 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 industry’s 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 investor’s
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.