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Security Analysis
Lecture 5
Answer to Question 1
It is necessary to conduct strategy analysis when one wants to carry out a
financial statement analysis for the following reasons:
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Questions 1-5 on page 61 of PHP (cont’d)
Answer to question 1 (cont’d)
An analyst can then use the information that it obtains about a company’s
profit drivers and the risks that the company faces to assess the company’s
performance in the past, at the present as well as make forecasts of the likely
future performance of the company.
An analyst can also use the information obtained about the strategy of the
company to assess its capital structure and dividend policies to see whether
they make sense or not.
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Questions 1-5 on page 61 of PHP (cont’d)
Question 2
What are the critical drivers of industry profitability?
Answer to Question 2
The critical drivers of industry profitability are as follows:
Rivalry among existing companies: The greater the rivalry, the lower average
profitability is likely to be. The factors that usually influence rivalry among
existing firms are growth rate, concentration and balance of competitors, degree
of product differentiation and switching costs, scale/learning economies, the
ratio of fixed to variable costs, excess capacity and exit barriers.
Threat of new entrants: Threat of new entrants can make the companies in an
industry to set prices that will keep profit low. The threat of new entry can be
mitigated by economies of scale, first mover advantages, better access to
distribution channels, relationships with existing customers, legal barriers to
entry, etc.
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Questions 1-5 on page 61 of PHP (cont’d)
Answer to Question 2 (cont’d)
Threat of substitute products: Also, the threat of substitute products can
make companies set lower prices and reduce industry profitability. The
importance of substitutes will depend on the price sensitivity of buyers and
the degree of substitutability among the products.
Bargaining power of buyers: The greater the bargaining power of buyers, the
lower will be the industry’s profitability. Bargaining power of buyers will be
determined by the buyers’ price sensitivity and their importance to the
individual company.
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Questions 1-5 on page 61 of PHP (cont’d)
Question 3
One of the fastest growing industries in the last twenty years is the memory
chip industry, which supplies memory chips for personal computers and other
electronic devices. Yet the average profitability has been very low. Using the
industry analysis framework, list all the potential factors that might explain
this apparent contradiction.
Answer to Question 3
Low concentration and balance of power: Concentration of the memory chip
market is relatively low. There are many players that compete on a global
basis, none of which has a dominant share of the market. Due to this high
degree of fragmentation, price wars are frequent as individual companies
lower prices to gain market share.
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Questions 1-5 on page 61 of PHP (cont’d)
Answer to Question 3 (cont’d)
Low degree of differentiation and switching costs: In general, memory chips
are a commodity product characterised by little product differentiation While
some product differentiation occurs as chip makers squeeze more memory on
a single chip or design specific memory chips to meet manufacturers’ specific
power and/or size requirements, there differences are typically short-lived
and have not significantly reduced the level of competition within the
industry.
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Questions 1-5 on page 61 of PHP (cont’d)
Answer to Question 3 (cont’d)
Scale/learning economies and the ratio of fixed to variable costs: Scale and
learning economies are both important in the memory chip market. Memory
chip production requires significant investment in “clean” production
environments. Consequently, it is less expensive to build larger
manufacturing facilities than to build additional ones to satisfy additional
demand.
Also, the yield of acceptable chips goes up as employees learn the intricacies
of the extremely complicated and sensitive manufacturing process.
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Questions 1-5 on page 61 of PHP (cont’d)
Answer to Question 3 (cont’d)
Excess capacity: Memory chip plants tend to be built in waves. Consequently,
several plants will open at the same time. This tends to lead to periods of
significant excess capacity where manufacturers will cut price engage in price
competition among themselves in order to increase their capacity utilisation.
Price sensitivity: There are two main groups of buyers, namely, computer
manufacturers and computer owners. Faced with an undifferentiated product
and low switching costs, buyers are very price sensitive.
All the factors stated above cause returns to memory chip manufacturers to be
relatively low.
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Questions 1-5 on page 61 of PHP (cont’d)
Question 4
Joe argues, “Your analysis of the five forces that affect industry profitability is
incomplete. For example, in the banking industry, I can think of at least three
other factors that are also important, namely, government regulation,
demographic trends and cultural factors.” His classmate, Jane, disagrees and says
“These three factors are important only to the extent that they influence one of
the five forces.” Explain how, if at all, the three factors discussed by Joe affect the
five forces for the banking industry.
Answer to Question 4
Government regulation, demographic trends and cultural factors will each impact
the analysis of the banking industry. While these may be important, they can
each be recast using the five forces framework to provide a deeper understanding
of the industry. The power of the five forces framework is its ability to
incorporate industry-specific characteristics into the analysis for any industry. To
see how government regulation, demographic trends and cultural factors are
important in the banking industry, we can apply the five forces framework as
follows: 10
Questions 1-5 on page 61 of PHP (cont’d)
Answer to Question 4 (cont’d)
Rivalry among existing companies: Government regulation has played a
central role in promoting, maintaining and limiting competition among banks.
Banks are regulated at the national and European levels. In the past, national
regulations restricted banks from operating across (some European) borders.
However, European deregulation of the industry has made it easier for banks
to expand into new geographical areas. This has increased the level of
competition.
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Questions 1-5 on page 61 of PHP (cont’d)
Answer to Question 4 (cont’d)
Threat of new entrants: Government regulations have limited entry of new
players into the banking industry. New banks must meet the requirements
set by regulators before they can begin operation.
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Questions 1-5 on page 61 of PHP (cont’d)
Answer to Question 4 (cont’d)
Threat of substitute products: The primary functions of banks are lending
money and providing a place to invest money. Potential substitutes for these
functions are provided by thrifts, credit unions, brokerage houses, mortgage
companies, and the financing arms of companies, such as car manufacturers,
departmental stores, etc. Government regulation of these entities varies
dramatically, affecting how similar their products are to those of banks.
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Questions 1-5 on page 61 of PHP (cont’d)
Answer to Question 4 (cont’d)
Bargaining power of buyers: Business and consumer buyers of credit have
little direct bargaining power over banks and financial institutions. The
buying power of customers is probably also stronger in relationship banking
than under a transaction approach, where consumers seek the lowest-cost
lender for each new loan. Because the use of these approaches varies across
countries (due to differences in law), the bargaining power of buyers may also
vary.
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Questions 1-5 on page 61 of PHP (cont’d)
Question 5
Examples of European firms that operate in the pharmaceutical industry are
GlaxosmithKline and Bayer. Examples of European firms that operate in the
tour-operating industry are Thomas Cook and TUI. Rate the pharmaceutical
and tour operating industries as high, medium or low n the following
dimensions of industry structure:
(1) Rivalry;
(2) Threat of new entrants;
(3) Threat of substitute products;
(4) Bargaining power of suppliers; and
(5) Bargaining power of buyers.
Given your ratings, which industry would you expect to earn the highest
returns?
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Questions 1-5 on page 61 of PHP (cont’d)
Answer to Question 5
Historically, pharmaceutical companies have had some of the highest rates of
return in the economy whilst tour-operators have had moderate returns. The
following analysis why:
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Questions 1-5 on page 61 of PHP (cont’d)
Answer to Question 5 (cont’d)
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Questions 1-5 on page 61 of PHP (cont’d)
Answer to Question 5 (cont’d)
Pharmaceutical industry Tour operating industry
Bargaining power of Low High
buyers Historically, doctors have had little The online offering of
buying power. However, in some accommodation, flight services,
countries, managed-care providers car rentals, etc., has increased
have become more powerful price transparency and,
recently, and have begun negotiating consequently, increased buyers’
substantial discounts for drug bargaining power.
purchases.
Bargaining power of Low Medium
suppliers The chemical ingredients for Tour operators are large and
drugs can be obtained from a concentrated relative to
suppliers of accommodation
the
and
variety of chemical suppliers. other services. However, the
suppliers have the ability to
“bypass” tour operators by selling
their accommodation directly
through the internet. Tour
operators respond to this threat by
means of vertically integrating their
activities (e.g. owning their own
hotels and airlines). 19
Problem 1 on Inditex SA on pages 209-210 of PHP
Inditex SA is the Spain-based parent company of a large number of clothing
design, manufacturing and retail subsidiaries. The company’s brands include
Zara, Pull & Bear and Massimo Dutti. At the end of the fiscal year ending on
31st January, 2009 (fiscal year 2008), the subsidiaries of Inditex operated
4,359 stores across 73 countries, making Inditex one of the three largest
clothing retailers in the world.
The following tables show the standardised and adjusted income statements
and balance sheets of Inditex for the years ended 31st January 2007 and 2008.
Operating lease obligations have been capitalised and the operating lease
expense has been replaced with depreciation and interest expense.
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Problem 1 on Inditex SA on pages 209-210 of PHP (cont’d)
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Problem 1 on Inditex SA on pages 209-210 of PHP (cont’d)
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Problem 1 on Inditex SA on pages 209-210 of PHP (cont’d)
(1) Calculate Inditex’s net operating profit after tax, operating working capital,
net non-current assets, net debt and net assets in 2007 and 2008. (Use the
effective tax rate [tax expense/profit before tax] to calculate NOPAT).
(2) Decompose Inditex’s return on equity in 2007 and 2008 using the
traditional approach.
(3) Decompose Inditex’s return on equity in 2007 and 2008 using the
alternative approach. What explains the difference between Inditex’s return
on assets and its operating return on assets?
(4) Analyse the underlying drivers of the change in Inditex’s return on equity.
What explains the decrease in return on equity? How strongly does Inditex
appear to be affected by the economic crisis of 2008? (In your answer, make
sure to address issues of store productivity, cost control, pricing and
leverage.)
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Problem 1 on Inditex SA on pages 209-210 of PHP (cont’d)
Answer to Question 1
€ millions
Value in Value in
Variable required Measurement 2008 2007
Operating profit As reported in the Income Statement 2,133 2,033
Effective tax rate Tax expense/Profit before tax 0.2220 0.2427
NOPAT Operating profit x (1 – effective tax rate) 1,659.47 1,539.59
Operating working (Current Assets – cash and marketable
capital securities) – (Current liabilities – current
debt - current portion of non-current
debt) – see page 187 of PHP -359 -571
Net non-current Total non-current assets – Total non- 4,208 3,915
assets current liabilities
Net debt Current debt + Non-current debt – cash 771 1,000
and marketable securities
Net assets Total assets – Total liabilities 5,081 4,438
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Problem 1 (Hugo Boss) on pages 298-9 of PHP
The problem
Hugo Boss AG is a German designer, manufacturer and distributor of men’s
and women’s clothing, operating in the higher end of the clothing retail
industry. During the period 2001-2008, the company consistently earned
returns on equity in excess of 18 percent, grew its book value of equity
(before special dividends) by 5.5 percent per year, on average, and paid out
65-70 percent of its net profit as dividends. In 2008, the company paid out a
special dividend of €345.1 million. Consequently, the company’s book value
of equity decreased from €546.8 million in 2007 to €199.0 million in 2008.
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Problem 1 (on Hugo Boss) on pages 298-299 of PHP (cont’d)
The problem (cont’d)
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Problem 1 (on Hugo Boss) on pages 298-299 of PHP (cont’d)
The problem (cont’d)
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Problem 1 (on Hugo Boss) on pages 298-299 of PHP (cont’d)
The problem (cont’d)
BALANCE SHEET (€ millions) 2008R 2009E 2010E 2011E
(1) Calculate free cash flows to equity, abnormal earnings and abnormal
earnings growth for the years 2009-2011.
(2) Assume that in 2012,Hugo Boss AG liquidates all its assets at their book
value, uses the proceeds to pay off debt and pay out the remainder to its equity
holders. What does this assumption imply about the company’s:
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Problem 1 (on Hugo Boss) on pages 298-299 of PHP (cont’d)
The problem (cont’d)
(3) Estimate the value of Hugo Boss’s equity on April 1, 2009, using the above
forecasts and assumptions. Check that the discounted cash flow model, the
abnormal earnings model and the abnormal earnings growth model yield the same
outcome.
(4) The analyst estimates a target price of €20 per share. What is the expected
value of Hugo Boss’s equity at the end of 2011 that is implicit in the analysts’
forecasts and target price?
(5) Under the assumption that the historical trends in the company’s ROE (i.e.
approximately 18 percent), payout ratio (70 percent) and book value growth (5.5
percent) continue in the future, what would be your estimate of Hugo Boss’s equity
value-to-book ratio before the company paid out its special dividend? How does
the special dividend payment change your estimate of the equity value-to-book
ratio?
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Problem 1 (on Hugo Boss) on pages 298-299 of PHP (cont’d)
Solution
Answer to Question 1
The calculations are as follows:
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Problem 1 (on Hugo Boss) on pages 298-299 of PHP (cont’d)
Solution - Answer to Question 1 (cont’d)
Calculations of net cash flow to equity, abnormal earnings and abnormal earnings
growth are as follows:
(a) 2012 free cash flow to equity (defined as net profit minus the change in net
assets plus the change in net debt) would be: (0 – (-891.0) + (-632.0)) = 259, i.e.
expected equity at the end of 2011.
(b) 2012 abnormal earnings (defined as net profit minus 12 percent of the book
value of equity at the end of 2011) would be: (0 – (0.12 x 259)) = 31.08.
In 2013 and beyond, free cash flows to equity and abnormal earnings would be
zero. Abnormal earnings growth would be 31.08 in 2013 (i.e. 0 – (-31.08)) and zero
in the years after 2013. 37
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Problem 1 (on Hugo Boss) on pages 298-299 of PHP (cont’d)
Solution – Answer to Question 5 (cont’d)
This multiple implies an equity value of €701.25 million, or €9.96 per share, on
1st January, 2009.
This is equivalent to €10.24 per share on 1st April, 2009, when Hugo Boss’s
shares traded at €11.00.
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Next week’s lecture will be on:
“Valuation Models 2
(based on decomposition of RoE and other
ratios)”
References
PHP Chs 8-9; DMD Chs. 18-24 plus 26-33 and PMN Chs. 13-19.
END OF LECTURE 5
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