Company Analysis: Past, Present, and Future

This reading moves from industry analysis to the individual company: its business model, competitive strategy, life-cycle stage, market potential and Porter's generic strategies. It then links strategy to the financial statements through revenue drivers, operating margins, pricing power and operating leverage, and through FCFE, the cash conversion cycle, net capital expenditure, ROIC and financial leverage.

LOS 48.a — Competitive strategy and position within an industry

Where company analysis fits

Industry and competitive analysis ends with a look at the individual company. After studying the industry (for example, with Porter's five forces and a PESTLE analysis), the analyst turns to the firm itself and evaluates its competitive strategy: its competitive advantage, its position within its industry, and the resources and capabilities it brings. The goal is to find what drives the company's value creation and then to check those drivers against its financial statements.

Business model versus competitive strategy

• A business model explains how a company defines and creates value: whom it serves (existing and potential customers), what it sells (products and services), how it prioritizes resources (key assets, supplier network) and how it protects itself from competitors.
• A competitive strategy is one part of the business model: how the firm wins against rivals. Every company has one, whether it chose it deliberately or not.

Good strategies are easiest to spot in hindsight, once they have produced consistent positive economic profits. To judge a strategy looking forward, the analyst asks three questions:

1. Can the strategy respond to the threats found with Porter's five forces?
2. Is it neutral to, or helped by, the external influences in the PESTLE analysis?
3. Can the company actually execute it, given its resources, its stage of development and the industry's stage?

Strategy and the company life cycle

Changes in consumer preferences and technology breakthroughs can lift a start-up or growth firm to above-trend growth, but the same forces can push a firm that loses market share into decline.

Market potential for start-up and growth companies

For young firms entering established markets, the analyst estimates how big the opportunity is, product by product:

• The total addressable market (TAM) is the largest possible market for the goods or services.
• The serviceable market is the part of the TAM the company can reach, given its focus, technology or geographic footprint.
• The obtainable market is the share of the serviceable market that the company can realistically win given its current scale and strategy, for example as limited by production capacity.

Porter's generic competitive strategies (mature companies)

Michael Porter argued that a firm must pick one of three strategies. A firm with no clear advantage is "stuck in the middle".

• Cost leadership (low-cost strategy): the lowest production costs in the industry, the lowest prices, and enough volume to earn a superior return. Common in mature or commoditized industries. It may serve a defensive purpose (holding on to market share) or an offensive one (e.g., aggressive price cuts to win share). Customers focus on cost; managerial incentives reward operating efficiency (scale, utilization, vertical integration).
• Differentiation strategy: products or services that are distinctive in type, quality or positioning and earn a price premium. It must create an economic moat (patents, brand, customer engagement) that rivals find hard to copy.
• Focus strategy: targeting a niche, such as a narrow group of customers, a region or a product stage. It is a hybrid that can combine elements of both cost leadership and differentiation.

LOS 48.b — Revenue drivers, operating profitability and pricing power

Revenue drivers

Linking performance to strategy starts with revenue on the income statement. Revenue can be broken into revenue drivers in two ways:

Best practice is to use both. Analysts track the level of drivers and how they change (recurring vs. episodic revenue), how they evolve over time (product mix, share of the obtainable market), and expected changes relative to other industry participants.

Operating profitability

Dividing each by revenue gives the EBITDA margin, the EBIT margin (operating margin) and the net margin.

Because EBITDA sits above interest, a jump in interest expense (e.g., after a shift from equity to debt financing) can push the net margin down even while the EBITDA margin rises. Analysts also compare the parts of the cost structure over time and against peers.

Pricing power

Pricing power is a company's ability to change the economic terms of its offer (mainly price) in its favor without hurting sales. It depends on price elasticity, market structure and competitive position.

• Price elasticity measures how much quantity demanded changes when price changes. It is the basic gauge of pricing power.
• Inelastic demand means high pricing power: buyers barely react to price (necessities such as health care, products with no substitutes).
• Elastic demand means little pricing power: buyers react strongly (luxuries and discretionary items such as leisure travel).
• Pricing power grows with product differentiation, switching costs, brand loyalty, barriers to entry and a lack of substitutes. Relative market share can matter more than absolute share.
• Less competitive structures (monopoly, oligopoly, monopolistic competition) allow more pricing power. In highly competitive markets with identical products, firms are price takers. In the long run price is driven to marginal cost and returns on capital to the cost of capital. A very low-cost producer can still keep its margins when price is set by the world market.

Operating leverage

where $Q$ = units sold, $P$ = price per unit, $VC$ = variable cost per unit (materials, direct labor), $FC$ = total fixed costs (rent, management salaries, insurance).

Operating leverage comes from fixed operating costs. The larger the share of fixed costs, the faster operating profit rises when volume rises, and the faster it falls when volume falls.

Item	Volume down 10%	Base case	Volume up 10%
Units sold	18,000	20,000	22,000
Revenue ($15 per unit)	270,000	300,000	330,000
Variable costs ($9 per unit)	162,000	180,000	198,000
Fixed operating costs	80,000	80,000	80,000
Operating profit	28,000 (−30%)	40,000	52,000 (+30%)
Interest expense	10,000	10,000	10,000
Net income (no taxes)	18,000 (−40%)	30,000	42,000 (+40%)

A 2,000-unit change in volume moves operating profit by $2,000\times 6=\$12,000$, which is 30% of $40,000 and three times the 10% change in volume.

Regressing expenses on revenue helps separate fixed costs (low sensitivity) from variable costs (high sensitivity); this assumes the cost structure has not changed over the sample period.

LOS 48.c — Working capital, capital investments and capital structure

Free cash flow to equity

where:

• Capital expenditures are the gross cash investment in long-term (fixed) assets, before depreciation. D&A is added back because it is a noncash charge. When the data give the increase in net (book value) long-term assets instead, depreciation has already been netted out and D&A is not added back: $\text{FCFE}=\text{NI}-\text{net investment in long-term assets}-\Delta \text{working capital}+\text{net borrowing}$.
• $\Delta \text{working capital}$ is the increase in operating (noncash) working capital: current assets excluding cash and marketable securities, minus current liabilities excluding short-term debt and the current portion of long-term debt. Those debt items belong in net borrowing, and the change in cash is what FCFE measures.
• Net borrowing (net debt issued) = new borrowing − debt repaid.

Positive terms are sources of cash; negative terms are uses. Exam convention: the formula is written $\text{FCFE}=\text{NI}+\text{D\&A}-\Delta \text{working capital}-\Delta \text{LT assets}+\Delta \text{debt}$, with $\Delta \text{working capital}=\Delta \text{current assets}-\Delta \text{current liabilities}$. Current practice: the D&A add-back is correct only if $\Delta \text{LT assets}$ is the gross investment in long-term assets, and the working capital change leaves out cash and short-term debt, as defined above.

FCFE is often negative for start-ups and growth firms (heavy investment, no stable debt capacity) and typically positive for mature firms.

Working capital management

Working capital management is how a company uses current assets and current liabilities to run the business efficiently (working capital = current assets − current liabilities). The operating cycle (from receiving materials to collecting cash) is measured with efficiency ratios such as days of inventory on hand, days sales outstanding, days payables outstanding and receivables turnover. The cash conversion cycle narrows this to the cash gap (from paying for materials to collecting cash):

• A longer CCC means a greater need to finance working capital. A shorter CCC reduces financing needs and improves market position and returns.
• A negative CCC means operations fund the company, because suppliers are paid after customers pay.
• Industry examples: retailers use high turnover and bargaining power with suppliers; manufacturers are capital-intensive (production problems can swell inventory); service and software firms need little working capital; some brewers use long payables periods to run negative working capital, which works best while revenue grows and suppliers stay financially sound. Makers of long-lived products such as heavy equipment may measure inventory with program accounting, which looks at the profitability of the whole program rather than at unit costs.

Capital investments

Long-lived assets are capitalized and expensed through depreciation and amortization. Net capital expenditure shows whether a firm is keeping or expanding its productive capacity and future earnings growth:

Software and licensing businesses hold mostly intangible (amortized) assets; manufacturers expanding capacity buy tangible, depreciated assets.

Return on invested capital (ROIC) measures whether the company has created economic value from investors' capital:

Average invested capital = (beginning + ending) / 2. The long-term liabilities plus equity measure is an approximation; a fuller definition is total debt plus total equity minus cash and equivalents. Value is created when ROIC exceeds WACC. Example. NOPAT is $15 million, and invested capital is $140 million at the start of the year and $160 million at the end, so ROIC is $15/150=10\%$. With a WACC of 8.5%, the firm created value. Judging a single project against the WACC is capital budgeting, a different use of the WACC.

Capital structure

A firm's capital structure reflects its business model, its stage in the life cycle and its asset conversion cycle.

• Firms in the early or growth stage whose cash flow is still negative rely mainly on equity capital.
• Mature firms with stable, predictable cash flows use more debt (e.g., public or private bonds).
• Capital-intensive industries (manufacturing, utilities) use more long-term debt; service and retail firms use more short-term debt.

The degree of financial leverage (DFL) shows how sensitive net income is to operating income:

When judging debt, the analyst looks at loans outstanding, the type and maturity of the company's bonds, and its capacity to borrow more. Borrowing adds interest expense and raises DFL. Profits are magnified in good years and losses compounded in bad ones, and the risk of financial distress rises. When strategy changes (an acquisition, a restructuring, a large new investment), disaggregated financial models help confirm that cash will be there to service and repay debt. Other ratios: debt ratio $=\text{debt}/\text{assets}$ and interest coverage $=\text{EBITDA}/\text{interest expense}$.