Joe states, "I can see how ratio analysis and valuation help me do fundamental analysis, but I don't see the value of doing strategy analysis.". Can you explain to him how strategy analysis could be potentially useful?

Answer 1

Strategy analysis could aid fundamental analysis in two primary ways—by providing better insight into a firm's future performance and by offering a more complete picture of a strategy's risks. Strategy analysis helps an analyst evaluate the impact of strategy on a firm's future performance, measured by sales, earnings, and other measures. As these performance measures change, the fundamental value of the company will also change. Consider a computer company that decides to switch from a differentiatedproduct strategy to a low-cost product strategy. Such a change in strategy would have a significant impact on firm revenues, cost structure, and potential sales growth. An analyst following the company will have to understand how each of these implications of the change in strategy will affect the firm's fundamental value. Thus, understanding the impact of strategy on future performance can be an integral part of an analyst's fundamental analysis.
Strategy analysis can also help highlight potential risks associated with a change in strategy. As the firm's risks change, the firm's fundamental values will also change. First, there is the risk that the firm will not be able to implement the strategy as promised. Consider again the change in strategy from product differentiation to low-cost production. If the firm cannot reduce its cost structure, it faces the unenviable task of selling undifferentiated products at higher prices than its competitors. Hence, the fundamental value of the firm will depend on the likelihood of its strategy being successfully implemented. Second, there may be changes in firm risk caused by the successful implementation of the strategy change. If the strategy change involves entry into a new market or industry, the firm may be changing the risk of its operations. Being either the low-cost producer of an undifferentiated product or the producer of a differentiated product both entail risks to the firm. The likelihood that competitors will be able to produce at a lower cost or develop differentiated products superior to the firm's, suggests the risk involved with following a particular strategy. Finally, the analyst must evaluate the firm's chances for success given the current industry structure and profitability as well as the strategies of other firms in the industry. In each of these cases, strategy analysis can be used to identify and evaluate the risks the firm faces which, in turn, will affect the fundamental value of the firm.