Learning Module 10 of Equities 11–14% of the exam

Company Analysis

5 lessons. About 30 minutes in cram mode, 140 minutes in full.

Start with lesson 1 Learn with Sensei Read the module summary Practice this module

Lessons

1
Competitive strategy: cost leadership, differentiation and focus
explain 5 min cram, 26 min full
2
Company life cycle and the addressable market
explain 5 min cram, 24 min full
3
Revenue drivers and pricing power
evaluate 6 min cram, 28 min full
4
Operating profitability and working capital
evaluate 7 min cram, 32 min full
5
Capital investments and capital structure
evaluate 7 min cram, 30 min full

What the exam expects you to do

Explain a company’s competitive strategy and position within an industry.Competitive strategy: cost leadership, differentiation and focus
Evaluate a company’s revenue drivers, operating profitability, and pricing power.Revenue drivers and pricing power
Evaluate a company’s working capital, capital investments, and capital structure.Operating profitability and working capital

Module summary

The whole module on one sheet, organised by lesson: what to memorize, how the ideas fit together, the formulas and the key terms. No paragraphs, just what you need to revise.

Hide what I know

How deeply to learn each part

Know the idea: Understand it in general. It frames other topics, but you will not calculate with it.
Use it: Understand it well enough to solve a question with it. Recognize when it applies.
Memorize: Learn it by heart. The exam will not give it to you.

Competitive strategy: cost leadership, differentiation and focus

Known

MemorizeGeneric strategies compared

	Cost leadership	Differentiation	Focus
Win by	lowest cost in the industry	a product worth a premium	one niche, on cost or difference
Defends against	entrants, customers, rivalry	entrants, substitutes, customers, rivalry	entrants, substitutes, customers
Typical forms	scale, scope, supply chain, cost control	quality, brand, IP, experience, bundling	cost-based or differentiation-based
Main risks	cost inflation; technology; premiumization	imitation; premium too high; capped share	large rivals undercut; groups converge

Memory hook Cheapest, different, or niche. Niche asks one more question: cheapest in the niche, or special in the niche?

Know it cold Scale and scope economies belong to cost leadership. Differentiation is the only one that adds rivalry to entrants, substitutes and customers.

MemorizeEvaluating a strategy

Test	Ask
Forces	does it defend against the Five Forces?
PESTLE	does it fit the outside trends?
Execution	does the company have the resources and capabilities?

Memory hook Forces, Trends, Capabilities: is it protected, is it in step, can it be done?

Know it cold Value creation shows only after time passes, so judge looking forward. Intentional strategies set measurable goals and feed results back.

Key terms

competitive strategy Use it
intentional and unintentional strategy Know the idea
three tests of a competitive strategy Memorize
cost leadership Memorize
economies of scale Know the idea
economies of scope Know the idea
capacity utilization Use it
load factor Use it
cost per available seat kilometer (CASK) Know the idea
differentiation Memorize
subscription model Know the idea
focus Memorize
cost-based focus Memorize
differentiation-based focus Memorize
stuck in the middle Memorize

Three tests of a competitive strategy

Is the strategy sound?forward-looking: value creation is clear only after time has passed

1. Defense against the Five Forces Memorize does it blunt entrants, substitutes, customers, suppliers and industry rivalry?
2. Fit with PESTLE influences Memorize does it benefit from, or at least not fight, outside trends?
3. Resources and capabilities Memorize can the company actually carry it out?

Strategies of established firms

Generic strategiesnone of the three: stuck in the middle

Cost leadership Memorize lowest-cost provider in the industry
- How scale, scope, supply chain, cost control, aggressive pricing, low-cost distribution
- Defends against Memorize entrants, customers, industry rivalry
- Suits capital-intensive, price-conscious, little difference or innovation
- Risks cost inflation, technology, premiumization
Differentiation Memorize a product customers pay more for
- How quality, brand, service, intellectual property, experience, premium price, bundling
- Defends against Memorize entrants, substitutes, customers, industry rivalry
- Suits customers value uniqueness; changing features
- Risks imitation, sophisticated buyers, excessive premium, capped share
Focus Memorize one group, region or product
- Cost-based focus Memorize lowest price in a narrow segment
- Differentiation-based focus Memorize unique product, premium price, niche
- Defends against Memorize entrants, substitutes, customers
- Risks large rivals undercut, groups converge, sophisticated buyers

Formulas

Load factor Use it

\text{Load factor} = \dfrac{\text{revenue passenger kilometers (RPK)}}{\text{available seat kilometers (ASK)}}

Quick example

Revenue passenger kilometers (RPK) of 1,440 million on available seat kilometers (ASK) of 1,800 million: 1,440 ÷ 1,800 = 80.0%.

On your calculator

1440÷1800= 0.8

1440ENTER1800÷ 0.8

ENTER enter (on the HP, puts the number on the stack)

Company life cycle and the addressable market

Known

MemorizeLife-cycle stages

Stage	Marks	Typical strategy
Start-up	little or no revenue, negative cash flow, few assets, very high risk	business model, prototype; innovation, partnerships, equity for research and development
Growth	turning profitable, above-trend growth	expand within the serviceable market; business model innovation
Mature	established model and track record	cost leadership, differentiation or focus
Decline	revenue falling, or growing well below the economy or rivals; excess capacity	cost management, restructuring, downsizing or exit; sometimes reinvention

Memory hook Build, scale, defend, shrink (or reinvent).

Know it cold Excess capacity in decline intensifies rivalry.

MemorizeThe three markets

Market	Narrowed by
Total addressable market (TAM)	nothing: the largest possible market
Serviceable market	the company's focus and geographic presence
Obtainable market	the company's current scale and strategy

Memory hook T-S-O: Total, then where and what it Serves, then what it can Obtain now.

Know it cold Growth = expanding within the serviceable market, within operational constraints.

Key terms

company life cycle Memorize
start-up company Memorize
growth company Memorize
mature company Know the idea
company in decline Memorize
business model innovation Know the idea
total addressable market (TAM) Memorize
serviceable market Memorize
obtainable market Memorize
operational constraints Use it
excess capacity Use it
creative destruction Know the idea

The company life cycle

Company life cyclerevenue rises, levels off, falls; cash flow negative early

Start-up Memorize little or no revenue, negative cash flow, few assets; build the business model; innovation, partnerships, equity for research
Growth Memorize above-trend growth, turning profitable; size the market; expand within constraints
Mature Know the idea established model and record; cost leadership, differentiation or focus
Decline Memorize revenue falling or lagging the economy; excess capacity; cut costs, restructure, exit or reinvent

From the largest market to the reachable one

Total addressable market (TAM)the largest possible market

Serviceable market Memorize narrowed by focus and geographic presence
- Obtainable market Memorize narrowed by current scale and strategy

Revenue drivers and pricing power

Known

MemorizeRevenue drivers

Approach	Drivers	Watch
Top-down	economy → industry → share of the obtainable market	project the three markets first
Bottom-up	volume, price, mix, geography	growth rates compound: (1 + g_vol)(1 + g_price) − 1
Share	revenue ÷ the matching market	same measure, same period

Memory hook Top-down ends in a market share; bottom-up starts from units and prices.

Know it cold Market share is top-down; product mix and geography are bottom-up.

MemorizePrice taker or pricing power?

Feature	Price taker	Pricing power
Product	near-identical	differentiated
Entry	easy	barriers
Substitutes	many	few
Customers	switch easily	switching costs, loyal
Demand	elastic	inelastic
Relative share	one of many	leader

Memory hook Ask: if I raised price, would customers walk? If yes, price taker.

Know it cold Pricing power = setting prices and terms without hurting demand; it lets a company offset rising costs.

Key terms

revenue drivers Use it
top-down approach Memorize
bottom-up approach Memorize
product mix Use it
recurring and episodic revenue Know the idea
same-store sales Know the idea
market share Memorize
share of the obtainable market Use it
pricing power Memorize
price elasticity Memorize
relative market share Use it
price taker Use it
price war Know the idea
low-cost producer Use it

Two ways to analyze revenue

Revenue analysiscombine both views

Top-down approach Memorize economy → industry → market share
- Economy and industry outlook growth of the total, serviceable and obtainable markets
- Market share Memorize share of the obtainable market
Bottom-up approach Memorize the company's own drivers
- Volume and price Memorize by product line, segment or region
- Product mix shifts change profitability too
- Geography where it sells
- Recurring or episodic same customers or new ones

Pricing power by market type

Can the company set prices?market structure, competitive position, sales channels, elasticity

Highly competitive: price taker Memorize price set by supply and demand
- Little differentiation near-identical products
- Low barriers to entry new rivals arrive
- Substitutes, no loyalty, low switching costs customers leave easily
- Price war undercutting invites matching cuts
- Exception: low-cost producer can earn above its cost of capital if the cost lead lasts
Less competitive: some pricing power Memorize monopolistic competition, oligopoly, monopoly
- Product differentiation brand, convenience, service
- Barriers to entry patents, scale, regulation
- Few economical substitutes little to switch to
- Switching costs and loyalty customers stay
- Inelastic demand Memorize necessities: demand barely moves
- High relative share Use it a leader among many small rivals

Formulas

Revenue, bottom-up Use it

\text{Revenue} = \sum \text{volume} \times \text{price per unit}

Quick example

Segment A sells 3.0 million units at 20; segment B sells 1.2 million units at 35. 3.0 × 20 + 1.2 × 35 = 60 + 42 = 102.

On your calculator

(3×20)+(1.2×35)= 102

3ENTER20×1.2ENTER35×+ 102

ENTER enter (on the HP, puts the number on the stack)

Revenue growth from volume and price Memorize

g_{rev} = (1 + g_{vol})(1 + g_{price}) - 1

Quick example

Volume +12%, average price −2%. 1.12 × 0.98 − 1 = 9.76%. Adding the rates (10%) is the trap.

On your calculator

1.12×0.98−1= 0.0976

1.12ENTER0.98×1− 0.0976

ENTER enter (on the HP, puts the number on the stack)

Market share Memorize

\text{Market share} = \frac{\text{company revenue}}{\text{market size}}

Quick example

Revenue 360 in a market of 4,500 (same units, same period). 360 ÷ 4,500 = 8.0%. Rearranged, market size = revenue ÷ share.

On your calculator

360÷4500= 0.08

360ENTER4500÷ 0.08

ENTER enter (on the HP, puts the number on the stack)

Revenue, top-down Use it

\text{Revenue} = \text{obtainable market} \times \text{share of the obtainable market}

Quick example

An obtainable market of 800 that grows 5%, and a share rising to 15%: 800 × 1.05 × 0.15 = 126.0.

On your calculator

800×1.05×0.15= 126

800ENTER1.05×0.15× 126

ENTER enter (on the HP, puts the number on the stack)

Operating profitability and working capital

Known

MemorizeWhich margin when?

Margin	Use it for	Watch out
Net	the full result for shareholders	leverage, taxes, one-offs, losses
Operating	core profit across firms and years	D&A differs with investment policy
EBITDA	firms with different leverage, taxes, investment	not IFRS or GAAP; adjustments vary

Memory hook Peel from the bottom: net adds financing and tax, operating adds D&A, EBITDA strips both.

Know it cold Different leverage, taxes and investment policies → compare EBITDA margins.

MemorizeOperating leverage and the cycle

Item	Rule
Operating profit	$Q \times (P - VC) - FC$
More fixed costs	profit moves more than revenue, both ways
CCC	$DOH + DSO - DPO$
Higher DPO	shorter cycle, less cash tied up
Longer cycle	more financing needed

Memory hook Inventory and receivables hold cash; payables lend it to you.

Know it cold Only variable costs → profit moves exactly with revenue.

Key terms

net margin Memorize
operating margin Memorize
EBITDA margin Memorize
cost components as a share of sales Use it
operating leverage Memorize
fixed costs Memorize
variable costs Memorize
operating cycle Know the idea
days of inventory on hand Use it
days sales outstanding Use it
days payable outstanding Use it
cash conversion cycle Memorize
negative working capital Use it
program accounting Know the idea

Three ways to measure profit

Revenueeach level expressed as a margin of revenue

EBITDA Memorize before D&A; compares leverage, taxes, investment policies; not IFRS or GAAP
- Operating income Memorize after D&A; core profit; distorted by investment policy
  - Net income Memorize after financing, non-operating items, taxes; complete but hard to compare

Working capital measures

Working capitalcash tied up in the operating cycle

Days of inventory on hand how long stock sits
Days sales outstanding how long customers take to pay
Days payable outstanding how long the company takes to pay
Cash conversion cycle Memorize DOH + DSO − DPO; shorter frees cash, longer needs financing

Formulas

Profit margins Memorize

\text{Net margin} = \dfrac{\text{net income}}{\text{revenue}},\quad \text{Operating margin} = \dfrac{\text{operating income}}{\text{revenue}},\quad \text{EBITDA margin} = \dfrac{\text{EBITDA}}{\text{revenue}}

Quick example

Revenue 500, EBITDA 100, D&A 45, interest 25, tax 25%. EBITDA margin 20.0%; operating income 55, 11.0%; net income (55 − 25) × 0.75 = 22.5, 4.5%.

On your calculator

100−45=÷500= 0.11
55−25=×0.75=÷500= 0.045

100ENTER45−500÷ 0.11
55ENTER25−0.75×500÷ 0.045

ENTER enter (on the HP, puts the number on the stack)

Operating profit Memorize

\text{Operating profit} = [Q \times (P - VC)] - FC

Quick example

A firm sells 2.0 million units at 12 with variable cost of 7 and fixed costs of 6.0 million. 2.0 × (12 − 7) − 6.0 = 4.0 million.

On your calculator

2×(12−7)−6= 4

12ENTER7−2×6− 4

ENTER enter (on the HP, puts the number on the stack)

Cash conversion cycle Memorize

CCC = DOH + DSO - DPO

Quick example

DOH 58, DSO 32, DPO 40. 58 + 32 − 40 = 50 days. Negative means suppliers fund the operating cycle.

On your calculator

58+32−40= 50

58ENTER32+40− 50

ENTER enter (on the HP, puts the number on the stack)

Days measures (from Financial Statement Analysis) Use it

DOH = \dfrac{\text{inventory}}{\text{cost of sales}} \times 365,\quad DSO = \dfrac{\text{receivables}}{\text{revenue}} \times 365,\quad DPO = \dfrac{\text{payables}}{\text{cost of sales}} \times 365

Quick example

Inventory 1.2, receivables 1.5, payables 1.0; revenue 18.0, cost of sales 10.0. DOH 1.2 ÷ 10.0 × 365 = 43.8; DSO 1.5 ÷ 18.0 × 365 = 30.4; DPO 1.0 ÷ 10.0 × 365 = 36.5 days. Inventory and payables go with cost of sales, receivables with revenue.

On your calculator

1.2÷10×365= 43.8
1.5÷18×365= 30.4167
1÷10×365= 36.5

1.2ENTER10÷365× 43.8
1.5ENTER18÷365× 30.4167
1ENTER10÷365× 36.5

ENTER enter (on the HP, puts the number on the stack)

Capital investments and capital structure

Known

MemorizeFCFE and capital investment

Measure	Formula	Reading
FCFE	NI + D&A − ΔWC − ΔLT assets + ΔDebt	new debt raises it this year
Net capital expenditure	capital expenditure − D&A	positive: capacity growing
ROIC	NOPAT ÷ average (LT liabilities + equity)	after-tax return to all investors
Excess accounting return	ROIC − WACC (or ROIC ÷ WACC > 1)	value created across all assets

Memory hook Shareholders get what is left: earn it (NI), add back the non-cash (D&A), pay for growth (WC, LT assets), borrow the rest (ΔDebt).

Know it cold ROIC goes with WACC, never with the cost of equity.

MemorizeFinancing risk

Measure	Formula	Riskier when
DFL	%Δ NI ÷ %Δ operating income	higher
Total debt to total assets	debt ÷ assets	higher
EBITDA to interest	EBITDA ÷ interest expense	lower
Debt to equity	debt ÷ equity	higher

Memory hook Fixed interest is to net income what fixed costs are to operating profit.

Know it cold Deleveraging = debt down, coverage up. Debt raised for a plant raises financial leverage before the plant earns anything.

Key terms

free cash flow to equity (FCFE) Memorize
net debt issuance Use it
capital investments Know the idea
net capital expenditure Memorize
asset-heavy and asset-light business models Know the idea
return on invested capital (ROIC) Memorize
net operating profit after taxes (NOPAT) Use it
excess accounting return Memorize
weighted average cost of capital (WACC) Use it
capital structure Use it
degree of financial leverage Memorize
financial distress Know the idea
total debt to total assets Use it
EBITDA to interest expense Use it
debt-to-equity ratio Use it
deleveraging Use it

FCFE from the statements

FCFEcash left for shareholders

Sources Memorize
- Net income
- D&A (non-cash)
- Net debt issuance
Uses Memorize
- Increase in working capital
- Investment in long-term assets

Measuring financing risk

Is the capital structure risky?fits the business model, asset life and life-cycle stage?

Leverage ratios
- Total debt to total assets Use it
- Debt to equity Use it
Coverage
- EBITDA to interest expense Use it
Sensitivity
- Degree of financial leverage Memorize %Δ net income ÷ %Δ operating income
Direction
- Leverage rising debt-funded acquisition or expansion
- Deleveraging debt falls, coverage rises

Formulas

Free cash flow to equity Memorize

FCFE = \text{NI} + \text{D\&A} - \Delta\text{WC} - \Delta\text{LT assets} + \Delta\text{Debt}

Quick example

Net income (NI) 60, depreciation and amortization (D&A) 30, increase in working capital 10, investment in long-term assets 55, net borrowing 15: 60 + 30 − 10 − 55 + 15 = 40.

On your calculator

60+30−10−55+15= 40

60ENTER30+10−55−15+ 40

ENTER enter (on the HP, puts the number on the stack)

Net capital expenditure Memorize

\text{Net capital expenditure} = \text{capital expenditure} - \text{D\&A}

Quick example

Capital expenditure 2.0, D&A 1.2: 2.0 − 1.2 = 0.8, so capacity is growing. Negative means the asset base is shrinking.

Return on invested capital Memorize

ROIC = \dfrac{\text{NOPAT}_t}{\text{Average invested capital}}

Quick example

Net operating profit after taxes (NOPAT) 54, invested capital 420 at the start and 480 at the end. 54 ÷ 450 = 12.0%.

On your calculator

420+480=÷2=STO1 450
54÷RCL1= 0.12

STO store · RCL recall a stored number

54ENTER420ENTER480+2÷÷ 0.12

ENTER enter (on the HP, puts the number on the stack)

Excess accounting return Memorize

\text{Excess accounting return} = ROIC - WACC

Quick example

ROIC 12.0%, weighted average cost of capital (WACC) 9.5%: 12.0 − 9.5 = +2.5 points. As a ratio, 12.0 ÷ 9.5 = 1.26, above 1.

On your calculator

0.12−0.095= 0.025

0.12ENTER0.095− 0.025

ENTER enter (on the HP, puts the number on the stack)

Degree of financial leverage Memorize

DFL = \frac{\%\Delta \text{net income}}{\%\Delta \text{operating income}}

Quick example

Operating income rises 10% and net income rises 14%. 14 ÷ 10 = 1.4.

On your calculator

14÷10= 1.4

14ENTER10÷ 1.4

ENTER enter (on the HP, puts the number on the stack)

Degree of financial leverage with fixed interest Use it

DFL = \frac{EBIT}{EBIT - I}

Quick example

Operating income (EBIT) 70, fixed interest 20. 70 ÷ (70 − 20) = 1.4. A shortcut that follows from the definition when interest is fixed and the tax rate constant.

On your calculator

70÷(70−20)= 1.4

70ENTER70ENTER20−÷ 1.4

ENTER enter (on the HP, puts the number on the stack)

Total debt to total assets Use it

\dfrac{\text{total debt}}{\text{total assets}}

Quick example

Debt 10.0, total assets 22.0: 45.5%.

On your calculator

10÷21= 0.4762

10ENTER21÷ 0.4762

ENTER enter (on the HP, puts the number on the stack)

EBITDA to interest expense Use it

\dfrac{\text{EBITDA}}{\text{interest expense}}

Quick example

Earnings before interest, taxes, depreciation, and amortization (EBITDA) 4.2, interest 1.0: 4.2 times.

On your calculator

4.2÷1= 4.2

4.2ENTER1÷ 4.2

ENTER enter (on the HP, puts the number on the stack)