Question: George Tolkien, our boss at Planet Forecasting, needs to present a couple of potential investments to the Portfolio Selection Committee in the coming annual meeting
11 Sep 2023,8:41 PM
George Tolkien, our boss at Planet Forecasting, needs to present a couple of potential investments to the Portfolio Selection Committee in the coming annual meeting. He wants us to form a group of three and cover as many industries as possible. Each group needs first to select one industry and then find and compare two companies in this industry so that he can choose a list of firms with potential to present. Mr. Tolkien wants each group to respond to his request in the form of a research report. Here are his instructions.
The Portfolio Selection Committee is looking for undervalued firms with strong upside potential in the foreseeable future to add to our firm’s investment portfolio and to recommend to clients. Since our time is limited, I would like you to form a group of three and research as many industries as possible. I would like each group to select two companies in the same industry and decide which firm has such potential by doing a complete analysis.
To select your companies, you should go through some “stock screening” procedure. These two firms you choose should be close competitors or otherwise comparable firms. Make sure that the firms you choose are in the same industry and have a business model that you understand
Your report should contain the following sections.
- Executive Summary. You should begin with a short executive summary that provides an overview of the content of your report.
- Stock Selection Procedure. Describe briefly, but clearly, the screening process and criteria you used to select your firms.
- Business/Industry Analysis. You should summarize and evaluate the strategies of the two firms that you choose and the competitive environment in which they operate. This analysis should include the main opportunities available to the company and the main risks to its future success. Note that many assumptions that you will use for forecasting are derived from this analysis. This section should not be longer than one page.
- Accounting Analysis. You should summarize your overall evaluation of the credibility of the financial statements and their usefulness in representing the underlying economics of the firm. This includes how each firm uses the flexibility allowed within Generally Accepted Accounting Principles (GAAP), whether there is a pattern of using that discretion or other “red flags” that casts doubt on the usefulness of the statements. You should also describe any adjustments that you have made either to make the statements more comparable for these two firms or to make them more useful for valuation.
- Financial Statement Analysis. This should include common-size analysis, percentage change analysis, and financial ratios analysis. Calculate financial ratios related to profitability, financial flexibility, and risk. Choose the ratios that add value for your analysis and disaggregating ROA and ROCE is required. You should compare ratios for these two companies for the most recent five years and also against industry medians. In all cases, ratios should be based on financial statement numbers that are adjusted to either making them more useful or more comparable. This portion of the report should include both exhibits (tables and/or graphs) and narrative discussion in whatever way you think would communicate your analysis most efficiently.
- Financial Statement Forecasts. Forecasts of financial statements (income statements, balance sheets, and statements of cash flows) are a critical element of estimating value and it is important that the Portfolio Selection Committee can understand how you made your forecast in order to form an independent opinion of the reliability of your value estimate. Thus, in addition to providing exhibits with the forecasted statements themselves, you should also summarize the important assumptions that you made in the process of forecasting, as well as the rationale for those assumptions. Forecasts should be provided for five years or until the firm is in a steady state, whichever is longer. The steady state growth rate, ROCE, and how does your group balance the balance sheets should be clearly reported. You should also provide a test of your forecast validity by providing an analysis of the key financial ratios using your projected financial statements.
- Value Estimates. You should clearly describe the methods that you used to make your estimation, as well as the assumptions you made about growth after the forecasting period and the cost of capital you used to discount future payoffs. A copy of your Excel spreadsheet that clearly demonstrates your valuation should be submitted as an appendix. This spreadsheet should include five sheets: “Data”, “Analysis”, “Forecasts”, “Forecast Development” and “Valuation”. In addition, you should conduct a sensitivity analysis to show the effect on your estimates if you change your assumptions of growth and discount rate. Finally, you should also compare your estimated value with current market parameters such as the current price-earnings ratio or market-to-book ratio, and you should discuss your estimated share price in the context of the company’s actual share price movement over the last two years. All of the discussion of value estimates should be on a per share basis.
- Summary and Recommendation. This section should be brief, no more than half of a page, but it should clearly summarize your recommendation.
Your report should be no longer than fifteen single-spaced pages including tables and exhibits, but excluding references (if applicable) and appendix. (Appendix, an Excel spreadsheet, should be separately submitted.)
Mr. Tolkien's instructions provide a comprehensive framework for conducting research and preparing a report on potential investments in different industries. Here is an outline of how you can approach each section of the report:
1. Executive Summary:
- Provide a concise overview of the report's content, highlighting the key findings and recommendations.
2. Stock Selection Procedure:
- Describe the specific screening process and criteria used to select the two companies within the same industry.
- Explain why these companies were chosen, emphasizing their comparability and potential for upside.
3. Business/Industry Analysis:
- Summarize and evaluate the strategies of the two chosen firms.
- Analyze the competitive environment in which they operate.
- Highlight the main opportunities and risks affecting the firms' future success.
4. Accounting Analysis:
- Evaluate the credibility of the financial statements of each firm.
- Assess how each firm utilizes flexibility within Generally Accepted Accounting Principles (GAAP).
- Identify any red flags or concerns related to the financial statements.
- Describe any adjustments made to ensure comparability and usefulness for valuation.
5. Financial Statement Analysis:
- Perform common-size analysis, percentage change analysis, and financial ratios analysis.
- Calculate profitability, financial flexibility, and risk-related ratios.
- Compare the ratios of the two companies over the past five years and against industry medians.
- Present the analysis using tables, graphs, and narrative discussion.
6. Financial Statement Forecasts:
- Provide forecasts for income statements, balance sheets, and statements of cash flows for at least five years or until the firm reaches a steady state.
- Clearly state assumptions and rationale for forecasting.
- Report the steady state growth rate and ROCE.
- Conduct a validity test by analyzing key financial ratios using the projected financial statements.
7. Value Estimates:
- Describe the methods used for estimating the value of the two companies.
- Explain assumptions regarding growth after the forecasting period and the cost of capital used for discounting.
- Include an Excel spreadsheet in the appendix with sheets for data, analysis, forecasts, forecast development, and valuation.
- Conduct a sensitivity analysis to demonstrate the impact of changing growth and discount rate assumptions.
- Compare estimated value with market parameters such as price-earnings ratio and market-to-book ratio.
- Discuss the estimated share price in the context of the company's recent share price movements.
8. Summary and Recommendation:
- Provide a concise summary of the findings and recommendations.
- State which of the two companies you recommend for investment based on your analysis.
- Ensure the report is no longer than fifteen single-spaced pages, excluding references (if applicable) and the separately submitted Excel appendix.
- Follow a clear and organized structure throughout the report, with headings and subheadings for each section.
- Use data visualization tools effectively to present key information.
- Cite relevant sources and references for data and analysis.
By following this structure and conducting a thorough analysis, your group should be able to provide Mr. Tolkien with valuable insights and recommendations for potential investments in various industries.
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