Understanding the Business

Question 1

What is the first step in firm valuation according to FSAV?

Answer 1

Understanding the business - how it operates, its strategy and its value drivers.

Question 2

Why is it important to understand a company’s strategy before analyzing numbers?

Answer 2

Because numbers reflect strategic choices - understanding strategy helps you interpret financial outcomes.

Question 3

What is the difference between strategic and tactical decisions?

Answer 3

Strategic is long-term, top-level direction, while tactical is short-term, operational adjustments.

Question 4

What are the three steps of equity valuation in FSAV?

Answer 4

Understanding the past
Forecasting the future
Valuation

Question 5

What is meant by “value drivers”?

Answer 5

Factors like profitability, growth and risk that determine a firm’s ability to generate value.

Question 6

What are the three types of competitive advantage?

Answer 6

Supply-side (cost advantages)
Demand-side (customer lock-in)
Economies of scale (less fixed costs)

Question 7

Why does competitive advantage matter in valuation?

Answer 7

It enables firms to earn ROE > r sustainably - the basis of value creation.

Question 8

What is the key question to ask when analyzing how a firm makes money?

Answer 8

What customer need is being addressed, how, and with what economics?

Question 9

What are barriers to imitation, and why do they matter?

Answer 9

They prevent competitors from copying success, preserving abnormal profitability.

Question 10

What is meant by “macro vs micro” in return variation?

Answer 10

While macro trends matter, most return variation comes from firm-specific (micro) factors.

Question 11

Why are industry averages not enough for firm valuation?

Answer 11

Because firm-specific strategy, execution, and accounting play a larger role in performance.

Question 12

What are key components of financial statements to analyze first?

Answer 12

Income statement, balance sheet, then cash flow statement - in that order.

Question 13

What can segment reporting reveal about a business?

Answer 13

Where revenues and margins come from - across products, industries, or regions.

Question 14

What is the role of the MD&A?

Answer 14

It provides context, management’s interpretation, and forward-looking insights.

Question 15

What is the danger of skipping business analysis before jumping to ratios?

Answer 15

You risk misinterpreting the meaning and sustainability of the financial performance.

Question 16

What does ROE measure?

Answer 16

Return on equity: how much profit a firm generates relative to shareholders’ equity.

Question 17

What is the formula for ROE?

Answer 17

ROE = Net Income / Book Equity (t-1)

Question 18

Why is ROE a useful metric for analysts?

Answer 18

It shows how efficiently the firm is using shareholder capital to generate profits.

Question 19

What does a high ROE imply in theory?

Answer 19

That the firm is creating value by earning more than its cost of equity (r).

Question 20

What is a major limitation of ROE?

Answer 20

It is sensitive to accounting distortions and does not reflect cash flows.

Question 21

What’s the difference between ROE and IRR?

Answer 21

ROE is a short-term accounting return; IRR is the long-term return on a full project.

Question 22

When does ROE approximate IRR well?

Answer 22

When accounting accurately reflects economic performance and investments are steady.

Question 23

What is the “old plant trap” in ROE analysis?

Answer 23

Older assets are undervalued on the books, which can inflate ROE artificially.

Question 24

How can rapid growth temporarily depress ROE?

Answer 24

New investments increase equity before they generate returns, lowering the ROE denominator.

Question 25

Why does declining growth inflate ROE?

Answer 25

Because older investments dominate the equity base, and their earnings are overstated relative to book value.

Question 26

Should ROE always be used as-is in valuation models?

Answer 26

No - it should be adjusted or interpreted carefully based on the accounting context.

Question 27

Why does capital structure impact ROE?

Answer 27

More debt reduces equity, potentially boosting ROE (but also risk).

Question 28

What's a better profitability measure if accounting is unreliable?

Answer 28

Return on Invested Capital (ROIC) or cash-based metrics like FCF.

Question 29

Why is consistency in ROE more important than level?

Answer 29

Sustained positive spread (ROE > r) drives long-term value more than one good year.

Question 30

What's the risk of using ROE cross-sectionally without context?

Answer 30

You may misjudge firms with different growth phases or accounting policies.

Question 31

What is conservative accounting?

Answer 31

An approach that recognizes losses/expenses earlier and revenues later.

Question 32

What is aggressive accounting?

Answer 32

An approach that delays expenses or accelerates revenues to boost reported income.

Question 33

How does conservative accounting affect ROE?

Answer 33

Lowers ROE early, then overstates it later due to understated equity.

Question 34

How does aggressive accounting affect ROE?

Answer 34

Inflates ROE early, then causes a decline when overcapitalized costs are written off.

Question 35

What is the matching principle in accounting?

Answer 35

Costs should be recognized in the same period as the revenues they help generate.

Question 36

Which accounting treatment best reflects economic value?

Answer 36

Matched accounting (capitalizing and amortizing over time)

Question 37

Why can expensing R&D or marketing upfront distort ROE?

Answer 37

It depresses income in early years, even if the investment creates long-term value.

Question 38

What does it mean to "capitalize" a cost?

Answer 38

Record it as an asset to be expensed gradually, rather than all at once.

Question 39

What's the impact of under-depreciated assets on ROE?

Answer 39

ROE may be artificially high because asset base is understated.

Question 40

Why is it dangerous to compare ROEs across firms without checking accounting policies?

Answer 40

Different capitalization and depreciation choices can make them incomparable.

Question 41

What's the relationship between accounting conservatism and investment growth?

Answer 41

Conservative accounting tends to penalize firms that are investing heavily.

Question 42

What is an accounting write-off?

Answer 42

Recognizing the loss of value of an asset all at once in the income statement.

Question 43

How do write-offs affect financial statements?

Answer 43

They reduce net income sharply in one period and may distort ROE.

Question 44

What is capitalized marketing cost?

Answer 44

Marketing spending recorded as an asset due to expected future benefits.

Question 45

When should a cost be capitalized under good accounting standards?

Answer 45

When it provides a probable future economic benefit and can be reliably measured.

Question 46

Why do firms prefer aggressive accounting during IPOs or fundraising?

Answer 46

To show higher profitability and attract investors, even if unsustainable.

Question 47

What is the main tradeoff in accounting choices?

Answer 47

Accuracy vs timing - being truthful today vs smoothing over time.

Question 48

What's the danger of focusing only on income statement metrics?

Answer 48

You may miss out on long-term liabilities or hidden risks in the balance sheet.

Question 49

Why do smart investors read footnotes and accounting policies?

Answer 49

To detect where management may be stretching accounting or hiding red flags.

Question 50

What is an analyst's job when it comes to accounting?

Answer 50

Not just to read numbers, but to understand how they were produced and what they mean economically.