1. John, who has just completed his first finance course, is unsure whether he should take a course in business analysis and valuation using financial statements since he believes that financial analysis adds little value, given the efficiency of capital markets. Explain to John when financial analysis can add value, even if capital markets are efficient.
The efficient market hypothesis states that security prices reflect all available information, as if such information could be costlessly digested and translated immediately into demands for buys or sells. The efficient market hypothesis implies that there is no further need for analysis involving a search for mispriced securities.
However, if all investors adopted this attitude, …show more content…
As discussed later in the book, the firm’s business economics is an important driver of its capital structure and dividend policy decisions.
In summary, understanding a firm’s business, the factors that are critical to the success of that business, and its key risks is critical to effective financial statement analysis.
2. What are the critical drivers of industry profitability?
Rivalry Among Existing Firms. The greater the degree of competition among firms in an industry, the lower average profitability is likely to be. The factors that influence existing firm rivalry are industry growth rate, concentration and balance of competitors, degree of differentiation and switching costs, scale/learning economies and the ratio of fixed to variable costs, and excess capacity and exit barriers.
Threat of New Entrants. The threat of new entry can force firms to set prices to keep industry profits low. The threat of new entry can be mitigated by economies of scale, first mover advantages to incumbents, greater access to channels of distribution and existing customer relationships, and legal barriers to entry.
Threat of Substitute Products. The threat of substitute products can force firms to set lower prices, reducing industry profitability. The importance of substitutes will depend on the price sensitivity of buyers and the degree of substitutability among the products.
Bargaining Power of Buyers. The