Understanding the Business

Ishter Mahal
Associate Professor
Dept. of Accounting & Information Systems
University of Dhaka

1
 The Analysis of Business
• Understanding the business

• The financial statements are a lens on the business

• Financial statement analysis focuses the lens

1-2
 Knowing the Business:
Know the Firm’s Products
• Types of products

• Consumer demand for the product

• Price elasticity of demand for the product

• (how sensitive the quantity demanded of it is to its price)

• Substitutes for the product

• It is differentiated?
• On price?
• On quality?

• Brand name association of the product

• Patent protection for the product

1-3
 Knowing the Business:
Know the Technology

• Production Process
• Marketing Process
• Distribution Channels
• Supplier Network
• Cost Structure
• Economies of Scale (proportionate savings in cost)

1-4
 Knowing the Business:
Know the Firm’s Knowledge Base
• Direction and pace of technological change and the
firm’s grasp of it

• Research and development programs

• Ability to innovate in product development

• Ability to innovate in production technology
• Economies from learning

1-5
 Knowing the Business:
Know the Industry Competition
• Concentration in the industry, the number of firms and their sizes.
• Barriers to entry in the industry and the likelihood of new entrants and
substitute products.

• The firm’s position in the industry:

• Is it the first mover, or a follower, in the industry?
• Does it have a cost advantage?

• Competitiveness of suppliers:
• Do suppliers have market power?

• Capacity in the industry:

• Is there excess capacity or under capacity?

• Relationships and alliances with other firms

1-6
 Knowing the Business:
Know the Management

• What is management’s track record?

• Is management entrepreneurial?
• Does management focus on shareholders or their own
interests?
• Do stock compensation plans serve shareholders’
interests? (Agency conflict) Goal congruence
• What is the ethical charter under which the firm operates?
• How strong are the corporate governance mechanisms?

1-7
Knowing the Business: Know the Political, Legal
and Regulatory Environment

• The firm’s political influence

• Legal constraints on the firm including the law- consumer
law, labor law and environment law
• Regulatory constraints on the firm including product and
price regulations
• Taxation of the business

1-8
 Key Questions

• Does the firm have competitive advantage?

• How durable is the firm’s competitive advantage?

• What forces are in play to promote competition?

• What protection does the firm have from competitors?

1-9
 Tenets of Sound Fundamental
• One does not buy a stock, one buys a business.

Analysis
• When buying a business, know the business.

• Value depends on the business model, the strategy.

• Part of the risk in investing is the risk of paying too much for a stock.

• Don’t mix what you know with speculation (rumor)

• Beware of paying too much for growth.

• Stick to your beliefs and be patient; prices gravitate (drop) to fundamentals,

but that can take some time.

1-10
The Process of Fundamental Analysis
Knowing the Business 1
· The Products
· The Knowledge Base
· The Competition
· The Regulatory Constraints
· The Management

Strategy

Analyzing Information 2
· In Financial Statements
· Outside of Financial Statements

Forecasting Payoffs 3
· Specifying Payoffs
· Forecasting Payoffs

Convert Forecasts to a 4
Valuation

Trading on the Valuation 5

Outside Investor
Compare Value with Price to
BUY, SELL or HOLD

Inside Investor
Compare Value with Cost to
ACCEPT or REJECT Strategy

3-11
 The Process of Fundamental Analysis
Step 5 - Trading on the Valuation
• Outside Investor
• Step 4 - Convert
Compare Value with Price to BUY,
Forecasts to a Valuation
SELL, or HOLD
• Inside Investor
Compare Value with Cost to
ACCEPT or REJECT Strategy • Step 3 - Forecasting Payoffs
• Measuring Value Added
Step 1 - Knowing the Business • Forecasting Value Added
• The Products
• The Knowledge Base
Step 2 - Analyzing Information
• The Competition
• The Regulatory Constraints
Strateg • In Financial Statements
• Outside of Financial
y Statements

• A valuation model guides the process

• Forecasting is at the heart of the process and a valuation model specifies what is to be
forecasted (Step 3) and how a forecast is converted to a valuation (Step 4). What is to be
forecasted (Step 3) dictates the information analysis (Step 2)

3-12
How Financial Statements are Used in Fundamental Analysis

Current Financial
Statements
Financial
Statements
Year 1 Financial
Statements
Year 2 Financial
Forecasts Statements
Year 3

Other Information

Valuation
of
Convert forecasts to a valuation
Equity

The analyst forecasts future financial statements and converts

forecasts in the future financial statements to a valuation.
Current financial statements are used to extract information for forecasting.

3-13