When framing an M&A transaction discussion, it would be remiss to not bring up the main competitors in the industry and assess the existing competitive environment, specifically the steps they are taking to remain viable themselves. There are many reasons to benchmark a company against its competitors, whether it is to display comparable valuations, find similarities in strategy, or compare lines of business.
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Later in these series, we will be discussing the role of comparable financial metrics analysis, but in the context of providing an overview of competitors, we are mainly concerned with valuations. If we accept the assumption that stock prices reflect expectations of future performance, and that future performance is largely predicated on management’s ability to continue executing, then we have a common basis to compare companies.
The valuation metrics will differ from industry to industry, but generally, they will be ratios that incorporate market prices. The valuations are not only useful in determining a range of values, but they also tell a story about the overall business cycle of the industry at large and provides insight into each of the rival companies’ strategies. Ultimately, these ratios should be appropriate to the peer group selected, and the group should generally be trading within similar valuation ranges. There will certainly be discrepancies in valuations, and further investigation will be required to provide an explanation to justify abnormal valuations.
The economy continually adapts, and business cycles are perpetually dynamic. By analyzing the competitive environment, we can identify overarching trends by identifying similarities in business strategy. For example, if a new technology became available to a certain industry, and if it is tested and proven that such technology can add value to the industry’s operations, the first to adapt to the change in the technological environment often creates a competitive advantage for itself.
While it may be hard to deduce a company’s strategy at face value, a great place to start looking is equity research reports. Equity research analysts frequently meet with companies in their coverage list, and these analysts arguably have the strongest understanding of their companies out of anyone else in the public domain. Investment bankers often look at equity research reports for inspiration and guidance when formulating strategic alternatives for companies.
If the business strategy is the destination, business operations are like the vehicle. While the strategy is important to consider when thinking about transaction opportunities, it is equally as important to think about the implications of a transaction on the company’s key activities. By comparing the key activities of competitors, we can identify where each company’s strengths and weaknesses lie and get an idea of which activities are worth mimicking and which activities should be avoided. Ideally, the transaction opportunity would be one that is yet to appear on the competitors’ radars that would give the company that you are pitching an attractive competitive advantage by allowing the company to significantly improve one or more of their most important key activities.
At a higher level, comparing business segments is another way to compare operations between businesses. No two businesses are exactly the same, and the smallest differences in the way a competitor may organize its business can have great implications on the overall performance of the company. For example, Hill-Rom and Teleflex are companies that develop and sell medical devices and serve the same customer segments. However, these companies differ greatly in their product divisions, which have implications on their performance. Teleflex sells equipment that is much more commoditized, while Hill-Rom is a lot more specialized. Each offers their own benefits, but despite tighter margins, a larger share of the commoditized market bodes well for Teleflex going into budget cuts across US hospitals.
There is no one correct way to perform a cross-sectional analysis of the competitive environment. And again, the way this analysis is performed in a real-world application is largely dependent on the story that the senior bankers wish to convey to management. Ultimately, the analysis of the competitive environment is very important to the pitching process and is an important basis that management teams will make decisions on.
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