Equity Valuation【 Reading 37】Sample 2012, industry

tango_gs

Which of the following elements least likely belongs in an industry analysis model?

A) The Life Cycle Phase.

B) A macroeconomic forecast.

C) An industry dividend payout ratio.

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Other elements listed are part of the six-factor industry analysis model. These six factors are: industry classification, external factor review, demand analysis, supply analysis, profitability analysis, and international competition and markets review. A dividend payout ratio does not belong to any of these six factors.

tango_gs

Which of the following is NOT a factor that is typically considered in an industry analysis model?

A) Profitability analysis.

B) Demand analysis.

C) Yield curve analysis.

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Yield curve analysis is not a factor that is typically considered in an industry analysis model.

tango_gs

All of the following factors should be included in an industry analysis EXCEPT:

A) international competition and markets review.

B) industry weaknesses.

C) industry classification.

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The factors that should be included in an industry analysis are: industry classification, external factor review, demand analysis, supply analysis, profitability analysis, and international competition and markets review. Industry weaknesses are implicitly considered in the analysis but are not a separate category.

tango_gs

Which of the following factors is least likely to be included in an industry analysis?

A) International competition.

B) External factor review.

C) Static-tradeoff theory.

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The factors that should be included in an industry analysis are: industry classification, external factor review, demand analysis, supply analysis, profitability analysis, and international competition and markets review. Static trade off theory states that each firm has an optimal debt structure which balances the value of debt’s tax shield and the costs of potential financial distress.

tango_gs

Darius Jackson was just hired as an entry-level analyst at Zinsser Securities. On his first day, investment director Marvin Campbell assigns Jackson the task of analyzing some companies and their industries. The first two companies Jackson must consider are Smith Co. and Jones Inc.

After a little research, Jackson has acquired the following information about Smith and Jones:

	Smith	Jones
Profit growth	Below industry average	Above industry average
Acceptance of products	High	Moderate
Demand for products	Low	Low
Profit margins	High	Low
Performance during expansion	Sales rise	Sales rise

After assessing the characteristics of the industries to which Smith and Jones belong, Jackson decides to prepare a supply-and-demand analysis for the industries. To that end, he e-mails a co-worker and longtime friend, Emily Stanton, a senior analyst at the firm. Jackson asks Stanton for Zinsser’s files on the relevant industries.

Stanton sends over a bulky folder on each industry, and Jackson inventories the contents:

• Item 1: Information on weather patterns and political unrest in key production regions.
• Item 2: Studies on the relationship between inflation and buying patterns.
• Item 3: Recent regulatory changes and projections of what is likely to happen in the event of a change in the party controlling Congress.
• Item 4: A breakdown of the new products recently launched or under development by major players in the industry.
• Item 5: Analysis of the economic and business pressures facing major end markets.
• Item 6: A report on industry concentration and the capacity of major companies in the industry.
• Item 7: Reports on companies Zinsser covers, including Smith and Jones.

In his review of the information provided by Stanton, Jackson learns the following about Smith:

• The Federal Trade Commission is considering the revocation of a tariff on one of Smith’s most important products.
• Smith’s biggest concern is that rivals’ products will render its own obsolete.
• Because of environmental concerns, permits for factories that produce Smith’s main output are difficult to acquire.
• The consumer products Smith makes are quite expensive, catering to an upscale clientele.
• Smith differentiates itself based on quality.

After completing his analysis of Smith and Jones, Jackson turns to his next task. He must calculate the expected growth rate of Cobbleman’s Curious Commodities. Jackson reviews some information about Cobbleman’s. However, since the company’s business is an unusual niche, with minimal information available, he is having trouble determining the life cycle of its industry. At the moment, there is little demand for the company’s products, and those products are not capturing the imagination of the market. Cobbleman’s has also issued new stock several times in the last five years. He suspects the company’s industry is in either the pioneer or decline stage. Based solely on Jackson’s initial research, and assuming the economy is contracting, how are Smith and Jones best classified?

Smith

Jones

A) Growth Cyclical

B) Defensive Defensive

C) Growth Defensive

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The key to answering this question is profit margins. Acceptance of products is relevant to the life-cycle model, which we are not using here. Profit growth relative to the industry also does not tell us anything about cyclicality, and most companies’ sales rise during expansions. However, growth companies can keep profit margins high even in contracting economies. So can some defensive industries. However, cyclical industries tend to have weak profit margins during difficult economic times. Thus, the most logical combination is to classify Smith as a growth company and Jones as a cyclical company. (Study Session 11, LOS 37.c)

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Based solely on Jackson’s initial research, how are the industries to which Smith and Jones belong best classified?

Smith

Jones

A) Mature Pioneer

B) Growth Decline

C) Growth Pioneer

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Demand for the products is low, but we cannot read much into that, because we do not know the state of the economy, and demand for most products declines when the economy is weak. The key factors to assess are acceptance of products and profit margins. Moderate acceptance of products is a hallmark of a pioneer industry, as are low profit margins. Smith’s product acceptance is high, which could indicate either a mature or growth industry. But high profit margins are indicative of a growth industry. Profit growth is a red herring, as within any industry in any stage of the business cycle, there will be companies with growth higher or lower than the industry average. (Study Session 11, LOS 37.b)

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Which of the items in the company research folder is of the least use in analyzing demand?

A) Item 3.

B) Item 4.

C) Item 1.

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Item 1 is useful for assessing supply issues, but not demand. Both of the other items could have value in demand analysis. Both regulatory changes and the addition of new products to the market can affect demand. (Study Session 11, LOS 37.e)

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Jackson wants to conduct a supply analysis for Jones. He should rely most heavily on:

A) Item 2.

B) Item 5.

C) Item 6.

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A report on industry concentration and capacity directly bears on supply analysis. Items 2 and 5 are of more use on the demand side. (Study Session 11, LOS 37.e)

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Based solely on Jackson’s review of Smith’s industry using Stanton’s data, which of the following conclusions is safest to draw?

A) Smith should enjoy substantial pricing power over the next year.

B) Smith’s industry is in the mature stage of its life cycle.

C) Smith is more susceptible to foreign influences than to changes in the inflation rate.

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In the mature stage of an industry, the chief worry regarding technology is whether new technology will supplant the old. Smith’s concerns suggest it is in a mature industry. While the information on differentiation by quality and barriers to entry (permit problems) are indicative of current pricing power, pending action on the tariff could have a significant effect. Given the uncertainty, we can’t assume Smith will have pricing power going forward. Furthermore, we do not have enough information to assess whether foreign influences are more important than inflation. (Study Session 11, LOS 37.b)

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Jackson should know that Cobbleman’s industry is in the pioneer stage because of its:

A) high requirements for capital.

B) low profit margins.

C) low demand for products.

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Both the pioneer and decline stage are often accompanied by low profit margins and low demand. However, industries in decline do not generally have high capital requirements. (Study Session 11, LOS 37.b)

tango_gs

Life cycle phases in industry analysis are pioneer, growth:

A) mature, decline.

B) mature, defensive.

C) defensive, decline.

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These are the different phases of industry life cycle. Other answers include business cycle reactions by a firm.

tango_gs

Which of the following is a typical sequence in the industrial life cycle?

A) Pioneer, growth, maturity, decline.

B) Pioneer, start-up, cash cow, growth.

C) Start-up, cash cow, growth, maturity.

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The typical stages of the industrial life cycle are pioneer, growth, maturity, and decline.

tango_gs

Samantha Cole teaches economics and finance at the Southwestern Central Wyoming College of Business. Her first class of the day is an economics primer for freshman. This morning, she is discussing industry analysis. In her opening lecture, she lists the following factors that should be included in any industry-analysis model:

• Industry classification.
• Supply analysis.
• Demand analysis.
• International competition and markets review.
• External factor review.

Cole then asks her students for the characteristics of a mature industry. She gets four responses:

• Aaronson said, “Mature industries tend to have an overall growth rate slower than that of the overall economy.”
• Blisterman said, “The companies that generate the most growth in a mature industry are those selling to new markets.”
• Clendenning said, “Demand for the products made by a mature industry is usually starting to decrease.”
• Dresdler said, “Some companies in a mature industry may perform well during the weak parts of the business cycle.”

In the next portion of her class, Cole tells the students about two companies, Lightnight Corp. and Quicklag Inc. Lightnight earned a profit margin higher than the industry average last year. The company also grew faster than the industry average, with sales growth of 9 percent and profit growth of 13 percent. The company gained market share at the expense of its competitors through a combination of innovative products and a superior cost structure that allowed for aggressive discounting of existing products. Quicklag lost money last year. The company is very concerned about technological change. Quicklag counts on its marketing to differentiate itself from competitors. The company expects GDP to decline sharply next year but still plans to increase its spending on marketing and research. Salaries represent more than 60 percent of Quicklag’s total expenses.
Cole then asks the class to deduce the nature of the industries in which Lightnight and Quicklag operate.Which of the following factors is least likely to affect the fortunes of an industry in the pioneer stage?

A) Demography.

B) Government.

C) Social change.

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Government regulation can have a huge effect on industry, but the government is not likely to regulate a new industry that has not yet achieved any market power. Pioneer industries are often worried about technology because their products have not yet gained popular acceptance. They must be concerned not only about the acceptance of their technology, but also the chance that someone else could come up with a better way to accomplish the same goal and kill their industry before it even gets started. Social and demographic changes affect what people purchase, and are key elements to determining the success of unproven products. (Study Session 11, LOS 37.d)

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Which student’s statement about mature industries is most accurate?

A) Blisterman’s.

B) Aaronson’s.

C) Dresdler’s.

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While industries in the growth cycle can perform well even in weak economies, mature industries generally grow in accordance with the economy, which means that when the economy is weak, most companies will also be weak. However, there can be one or more growth companies in a mature industry, and growth companies are capable of performing well when the economy is weak. Dresdler’s statement is correct. Aaronson is incorrect because mature industries tend to have a growth rate equivalent to that of the broader economy. Blisterman’s statement is incorrect because mature industries by definition don’t have a lot of expansion potential. If there were large chunks of the market not yet penetrated, the industry would be able to grow faster than the economy. Most growth in mature industries stems from market-share gains and acquisitions. Clendenning is describing an industry in the decline stage.(Study Session 11, LOS 37.b)

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In what stages are the industries of Lightnight and Quicklag?

Lightnight's industry

Quicklag's industry

A) Growth Decline

B) Mature Pioneer

C) Growth Pioneer

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The competitive advantages enjoyed by Lightnight could apply to companies in both growth and mature industries. But Lightnight’s industry grew sales at less than 9 percent and profits at less than 13 percent, numbers that don’t suggest a growth industry. Quicklag’s lack of profits and concern about technology could apply to companies in both pioneer and declining industries. And differentiating oneself through marketing is important in both stages. However, the fact that Quicklag is willing to boost marketing and research spending in the teeth of an economic downturn suggests it is not on the decline. Companies on the decline can consolidate, reinvent themselves, or fail. Thus, a company willing to invest heavily in marketing and research is more likely to be a pioneer. (Study Session 11, LOS 37.b)

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Movements of the business cycle are likely to have the greatest effect on a:

A) mature industry.

B) cyclical industry in the pioneer stage.

C) growth industry.

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Mature industries tend to follow the economy. As such, they are highly sensitive to changes in the business cycle. Cyclical industries are by definition beholden to economic forces, but industries in the pioneer stage are still struggling for acceptance in the market. Such companies are likely to live and die with technical advancements rather than economic moves, if only because many of the companies don’t have much of a market for their products and are likely to lose money regardless of the economic conditions. Industries in the decline stage are likely to lose ground even if the economy does well, and defensive industries tend to be fairly insulated from economic forces anyway. Growth industries can prosper even when the economy is weak, and as such are not likely to be affected by economic forces as much as would a mature industry. (Study Session 11, LOS 37.c)

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In her lecture on industry-analysis models, Cole left out which of the following factors?

A) Profitability analysis.

B) Market-share comparison.

C) Financial-structure analysis.

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In addition to the factors Cole mentioned, a crucial piece of any industry-analysis model is the profitability analysis.(Study Session 11, LOS 37.a)

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Assuming Quicklag has pricing power, which of the following is most likely to be a reason for that power?

A) Barriers to entry.

B) Product segmentation.

C) Input prices.

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Quicklag is a pioneer company, and in that stage, there are probably a number of competitors trying different strategies. At that stage, the ability to make your product seem special or superior could be the difference between creating a market for yourself or going bankrupt. Because Quicklag spends so much of its money on salaries, it seems likely the company is in an information-related business. Because they have lower fixed costs, information businesses tend to have lower barriers to entry than industries like retailing, manufacturing, or telecommunications. Input prices generally take away pricing power, as companies cannot control those prices. Capacity utilization is not likely to be a company-specific issue in a pioneer industry, which usually sees minimal demand for its products. (Study Session 11, LOS 37.f)

tango_gs

Which of the following types of industries is typically characterized by profitability tracking the business cycle, often in an exaggerated manner?

A) Cyclical.

B) Counter-cyclical.

C) Growth.

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A cyclical industry is typically characterized by profitability tracking the business cycle, often in an exaggerated manner.

tango_gs

Food, beverage, and utility companies are examples of:

A) cyclical industries.

B) declining industries.

C) defensive industries.

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This question tests your understanding of the business cycle reaction approach. Food, beverage, and utility companies provide basic necessities of life and are considered to be defensive industries. In a recession, the demand for their products will not fall as much as for some of the other industry groups.