For those of you familiar with our valuation and forensic reports, you know first-hand that we use various tools to analyze and illustrate the financial capacity of a subject company. To examine financial characteristics, we often compare the subjects’ financial ratios to their peer group. For example, the subject company may report travel and entertainment expenses as 5.0% of annual sales. If the subject company reports T&E at 15.0% of sales, further investigation may indicate that this category contains excess owners’ perquisites.
To illustrate these and other financial trends, we use charts and other demonstratives. One of my favorite analytical tools is a SWOT analysis. SWOT is an acronym that stands for strengths, weaknesses, opportunities, and threats.
Strengths and weaknesses generally refer to:
• Financial resources (funding, sources of income, and investment opportunities)
• Physical resources (location, facilities, and equipment)
• Human resources (employees, volunteers, and target audiences)
• Access to natural resources, trademarks, patents, and copyrights, and
• Current processes (employee programs, department hierarchies, and software systems)
While opportunities and threats consider:
• Market trends (new products, technology advancements, and shifts in audience needs)
• Economic trends (local, national, and international financial trends)
• Funding (donations, legislature, and other sources)
• Relationships with suppliers and partners
• Political, environmental, and economic regulation
We commonly illustrate the SWOT analysis in chart form, which draws the reader’s attention to those areas of greatest significance.
Another tool we frequently use is Michael Porter’s Five Forces theory. For those of you who might not be familiar, Porter’s eponymous 5 Forces assesses an industry’s attractiveness and likely profitability. It considers the impact of supplier and buyer power, as well as the threat of both substitution and a new entry on a given industry’s competitive rivalry. In brief:
• Supplier power signifies the ease with which suppliers can increase their prices. It encompasses the diversity of suppliers available, their size, the singularity of the product and/or service they provide, your ability to substitute one supplier for another, and the potential cost of that change.
• Similarly, buyer power refers to the ease with which buyers can drive down your prices. Impacting this factor are the number of buyers, the size of each buyer’s order, their price sensitivity, and the received comparative quality of the services and/or products offered by your competitor.
• The threat of substitution signifies the client’s ability to substitute one business, product, service, or method for another and the potential cost of that change.
• While the threat of new entrants refers to the ability of your would-be rivals to enter the market, it constitutes the time and cost of entry, the level of required specialist knowledge and/or experience, the availability of protections for key technologies, and the prevalence of entry barriers, such as industry-specific regulations.
These four elements ultimately drive competitive rivalry. Rivalry is the conventional point of focus of many theories of business strategy both pre and post Porter and refers to the number and capability of competitors in the market. It has long been established that in circumstances where the number of rivals is significant, profitability will be reduced. What makes Porter’s theory so innovative is its capacity to encompass not only the number of participants in a particular industrial stage, but the number and strength of the relationships which inevitably interconnect them.
Understanding how a business performs in each of these five evaluative categories is essential to the formation of a nuanced understanding of its place in the market and will aid in the determination of its value. But the key takeaway here is that to survive and thrive within a given market, it is not enough to limit your strategic consideration to your number of rivals and their respective degrees of strength. It takes an in-depth evaluation of an industry’s ecosystem and its patterns of evolution to a) make a product and/or services attractive to prospective clients, and b) maximize your profitability.
For us, applying Porter’s theory has meant defining each of the factors in a legal services context, and identifying those that are most likely to pose a challenge in the current cultural environment. Let us take for example the threat of substitution. The rise of self-help sites like Rocket Lawyer and LegalZoom has meant that it is easier now more than ever for potential clients to substitute traditional legal services with fixed-rate and cost-effective online assistance. Law firms and attorneys that market to this same clientele have responded by producing their own interactive websites, providing said clientele with similar services at competitive rates.
In using both the SWOT Analysis and Porter’s Five, we as valuation experts can target those areas that make the subject company distinguishable and aid in the development of its value.