Corporate Valuation - Massari Mario

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      1.4.1 Organizing the Analysis

Financial analysts approach the issue of uncertainty in forecasting by adopting logical tools and models developed in the area of industrial economics and of strategy. Exhibit 1.3 shows a simplified description of a typical analysis workflow.

Exhibit 1.3 Uncertainty analysis

      Business Model Analysis

      Typically, analysts use the expression business model to assess the characteristics of the products or services offered by a firm, the marketing choices adopted, and the production decisions. In the business model analysis, analysts seek to understand the cost/revenues structure of the firm or of the investment project. An example can help clarify the concept.

      Alpha is the European leader in automated equipment for manufacturing and packaging for the pharma industry (blisters, boxes, wrappers, case packers, and palletizers). In the pharma industry, a fundamental feature of production equipment is reliability while price is a secondary issue. Alpha has consolidated its leadership position by systematically investing a significant portion of its revenues in improving equipment for specific functions and researching innovative technical solutions. Non-core components production has been assigned to different companies. Equipment is marketed by a European and North American distribution network. Technical support, spare parts sales, and equipment updates represent a significant fraction of the overall gross margin.

      This scant information defines the “business model” and lets us understand that the revenue share emerging from equipment sales, being related to the pharmaceutical industry, is only marginally affected by cycles and is complemented by further revenues, with high margins and no cyclicity (as, for instance, in the after-sales support business).

      Under the cost structure planning, assembly, setup, and a significant share of the R&D costs are largely inelastic, because they require a highly specialized staff, which is a strategic resource of the company and is fundamental to the growth outlook for Alpha.

      Production costs are, on the other hand, relatively flexible: as previously noted, Alpha assigns the manufacturing of noncore components of its own products to a small selected number of suppliers, mostly located in the same geographical area.

      Market and Competitors Analysis

      The next step consists of the analysis of the environment external to the company, in order to understand the firm's market positioning relative to competitors and therefore the prospects for growth and profit. At this stage the analysis focuses on the business lifecycle and the competitive pressure which characterize the industry, the threat of substitute products, the entry barriers and potential competitors, and the relationship between customers and suppliers.

      In the Alpha case, the pharmaceutical industry is characterized by a sustained growth rate, both in Europe and in the USA (over 7 % per year in real terms). Industry analysts believe this trend is destined to last in the future.

      By examining balance sheets for the most important pharmaceutical firms, one observes a strong correlation between revenue growth rate and spending on technical investments.

      Just a small number of competitors are active in Alpha's market niche. Potential supply is represented by packaging equipment firms, which generally develop less reliable technologies than the standard pharma industry requirements.

      Risk Profile Analysis

      Typically the assessment of risk profile begins with a classical SWOT analysis of the competitive environment and the competitors.4

      The case under consideration doesn't show significant risk factors: entry in the industry is limited by specific technical competence needed to produce the equipment targeted for the pharmaceutical industry and by the market reputation of Alpha. Thus, there are no reasons to induce the analyst to delineate alternative competitive scenarios (for instance, the entry of a newcomer with resulting reduction of market share or margin squeezes). Yet, this approach can be easily shared provided Alpha can keep up with a growth rate consistent with the pharma industry rate and can complete its product range by acquiring competitors working in related market niches.

      Consolidating Alpha's market share could allow for an extension of the product range offered: from mere equipment sales to planning the whole production cycle as a general contractor. Moreover, Alpha could step into the business machines used in the cosmetic industry that, although not as demanding in terms of the technological specifications as the pharma industry ones, show significant similarities.

      1.5 UNCERTAINTY AND MANAGERIAL FLEXIBILITY

      In a traditional approach, closer to financial modeling than strategic analysis, estimate of value stems from a passive attitude toward risk. Yet, we have observed that in reality businesses are by far more articulated: in fact, up to a certain level, the phenomena of change can be managed or turned to one's favor through opportune intervention.

      1.5.1 Static versus Dynamic Assumption

      As a first step, when facing the valuation of an investment plan, acquisition, or firm, it is worth asking which standpoint should be adopted:

      ● A static view assuming that the current business model will continue to work as it is

      ● A dynamic view which takes into account the adaptation of the business model to new scenarios

      If we want to frame the issue in general terms, the valuation boundaries are determined – with regard to the choice of the correct standpoint – by two main factors:

      1. The level of uncertainty, which characterizes the estimate measured as the impact that information unavailable at the time of the valuation can have on the valuation result itself; or, in other words, how far it is from the idea of probability based on the repetition of past results

      2. Managerial flexibility – that is, how much the business model allows management to handle unfavourable scenarios or pick new opportunities in favorable situations

Exhibit 1.4 presents a graph that permits us to frame the context that drives the valuation with respect to the degree of uncertainty and management flexibility.

Exhibit 1.4 Valuation framework as a function of uncertainty and managerial flexibility

      Limited Uncertainty and Flexibility

      In Exhibit 1.4, area A identifies situations in which the frame of reference of the estimate is delineable in clear terms and the business model does not permit significant room to manoeuvre. A typical example is the business of gas and electricity grids; in these business areas, results emerge from a model in which relationships between macroeconomic variables, tariffs, transported volumes, and costs are definable with a close approximation and can be consistently projected in the future with a high degree of credibility.

      Uncertainty factors consist of the evolution of energy consumption that, as is well known, is a function, in the short term, of climate factors and, in the long term, of the general trend of the industry as a whole; changes in industry regulations; and the intensity of competitive pressure from the supply side.

      In these businesses, shifts in consumption translate directly into operating margin decreases/increases since the cost structure is extremely rigid and management has very limited flexibility to keep up with unfavorable trends in demand.

      In the previously sketched framework, the representation of uncertainty is consistent with the assumptions generally adopted by finance

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