Question

Industry and company analysis are essential tools of fundamental analysis for equity valuation.

Explain how you would use this type of analysis when developing the inputs in an equity valuation forecast model.

Answer 1

A company analysis is carried out to examine the growth forecasts of a company. To do this, the financial statements, as well as the future prospects of the company's investments of the company, are taken into account. Since the growth forecasts are impossible to be studied independently, industry analysis along with the company analysis is carried out for the fundamental analysis.

To carry out the fundamental analysis, the analyst may use a top-down, a bottom-up or a hybrid approach to forecasting the growth and earnings. The top-down approach involves analyzing the industry and its broad parameters are then zeroing down to a particular company and then estimating the growth forecasts with respect to the overall industry. For eg. a company in an FMCG space is analyzed first by the FMCG industry, its growth rate and challenges and then the growth prospects pertaining to that particular company are taken into account. The market share and market growth of the company in that particular industry is an important parameter to build an equity valuation forecast model. Suppose the growth rate of the FMCG industry is 3%, however the market share of the company is increasing rapidly, we would add a premium in addition to the growth rate of the industry while valuing the equity of the company. Also, the inflation factor must be added into valuation estimates as sales and revenue figures are expected to increase with inflation. The comparison on the company with the industry must be done of relative factors measured by ratios such as Price to cash flows, price to sales, price to book value, price to earnings and these must be compared with the industry average to arrive at an estimated relative valuation.This valuation can be assigned a weight while developing an equity valuation forecast model.

On the company analysis, operating margins when are positively correlated with sales give an indication of the prevalence of economies of scale in the industry. Net operating profit, ROIC, ROE are some of the important parameters under company analysis used in an equity forecasting model. A company with better than average financial ratios enjoys a higher valuation and accordingly, they must be allotted a premium while estimating the value of equity. The company must be evaluated basis the technological changes and whether such changes would benefit the company's future earnings forecast or not.  Also, the reference used in estimating the growth rate must be the company and the industry's historical growth rate. Any parameters or forecast may increase or decrease the fundamental value of a stock and accordingly must be incorporated into the model by assigning a variable for each factor being taken into account.