Identify the Economic Characteristics and Competitive Dynamics of the Industry in Which a Particular Firm Participates

Six steps

1. Identify the economic characteristics and competitive dynamics of the industry in which a particular firm participates.

• Grocery store chain: difficult to differentiate, low barriers to entry—low net income to sales (profit margin); need few assets to generate sales
• Pharmaceutical company: invest in R&D, government permits- high entry barriers –higher profit margin – risk is high—have less debt financing
• Electric utility – capital intensive generating plants, PPE dominate the BS – monopoly, high profit margin, low total assets turnovers-low risk, invest large amount in long lived assests and debt
• Commercial banks- profit margin on margin is small, high profit margin on financial services
• Analysis tool

• Value Chain analysis –
• Porter’s five forces - Horizontal competition (might affect strategy for differentiation)- Rivalry among existing firms (industry concentration ratio- Greater the industry, the lower the competition between existing rivals and thus the more profitable the firms will be) + Threat of new entrants (barrier to entry)+Threat of substitutes(how easy to switch) Vertical competition (going to affect the profit margin, anything is too high on this dimension) Buyer power (# if buyers and sellers in the industry, sensitivity to the price change)+ Supplier power(# of suppliers in the industry)
• Competition in the soft drink/beverage industry rates low on supplier power,threat of new entrants, and threat of substitutes. The industry rates low on buyer power of consumers but moderate on buyer power of fast-food chains and large retail and grocery chains. The industry rates moderate on rivalry within the industry. high profitability
• Economic Attributes Framework

• Demand

• Incentive demand - high margins Sensitive demand - low margins
• The growth rate of demand
• Demand is going to move with the economic cycle but not as not as other retailers

• Supply 

Similar products - low margin; Unique - high margin

• High barrier to entry and exit - branded products, domination of distribution chanel

• Manufacturing

• Capital intensive - manufacturing companies  (PP&E) low assets turnover ; Labor intensive - investment banking , high asset turnover
• Is the manufacturing process simple or complex

• Marketing

• Promote to other business (sales staff key role) or market to consumer (principal promotion mechanics). Entertainment industry： high sg&a, Gasoline-low SGA

• Investing and Financing

• Long term or short term financing. Risks in the assets. Generating more cash from financing or operation? Lof of PP&E, you will see high level of leverage ratios

1. Identify strategies the firm pursues to gain and sustain a competitive advantage.

• Framework for strategy analysis

• Nature of Product or Service.

• product differentiation strategy – high margin, low turnover
• low-cost leadership strategy
• creating brand loyalty or technological innovation and being price competitive by maintaining tight control over costs

• Degree of Integration in Value Chain

• Is the firm pursuing a vertical integration
  strategy, participating in all phases of the value chain, or selecting just certain
  phases in the chain; is the firm maintaining control over the distribution function or outsourcing it

• Degree of Geographical Diversification.
• Degree of Industry Diversification.

1. Assess the quality of the firm’s financial statements and, if necessary, adjust them for such desirable characteristics as sustainability or comparability.

• Balance sheet (economic position): Noncurrent Assets + (Current Assets - Current Liabilities) -Noncurrent Liabilities = Shareholders’ Equity

• Certain valuable resources of a firm that generate future cash flows, such as a patent for a pharmaceutical firm or a brand name for a consumer products firm,
  appear as assets only if they were acquired from another firm and therefore have
  a measurable acquisition cost.
•  Nonmonetary assets are reported at acquisition cost, net of accumulated depreciation or amortization, even though some of these assets may have current market
  values that exceed their recorded amounts.
•  Certain rights to use resources and commitments to make future payments may
  not appear as assets and liabilities. On the balance sheet of airlines, you generally
  do not see, for example, leased aircraft or commitments to make future lease payments on those aircraft. Also, on the balance sheets of steel, tire, and automobile
  companies, you do not see the rights to receive labor services or the commitments to make future payments for labor services under labor union contracts.
• Noncurrent liabilities appear at the present value of expected cash flows discounted at an interest rate determined at the time the liability initially arose
  instead of at a current market interest rate.
• Income Statement
• Under a cash basis of accounting, a firm recognizes revenue when it receives cash from customers and recognizes expenses when it pays cash to suppliers, employees, and other providers of goods and services.

The FASB and IASB have determined that four particular types of valuation adjustments represent unrealized gains or losses that should be reported in a statement of comprehensive (1) currency translation adjustments; (2) cash flow hedges, net of tax; (3) certain changes in pension and retiree medical plan obligations, net of tax; and (4) unrealized losses/gains on securities, net of tax.

• . Other comprehensive income items are accumulated over time in a special equity account titled Accumulated Other Comprehensive Income or Loss (AOCI). These other comprehensive income items are not recognized in net income until they are realized in an economic transaction. The segregation of AOCI acts as a temporary ‘‘holding area’’ for such gains or losses until their ultimate settlement.

1. Analyze the current profitability and risk of the firm using information in the financial statements. Commonsize percentage change ratios
2. Prepare forecasted financial statements.
3. Value the firm.

Annual Report to Shareholders

Form 10-K Annual Report