ABV ABV Economic & Industry Analysis 2 — Questions and Answers
Question 1: Which of the following sources is commonly used by ABV practitioners to obtain industry financial ratios for benchmarking?
- Federal Reserve Economic Data (FRED)
- Risk Management Association (RMA) Annual Statement Studies (Correct answer)
- U.S. Census Bureau population reports
- IRS Statistics of Income publications only
Correct answer: Risk Management Association (RMA) Annual Statement Studies
RMA Annual Statement Studies provide industry-level balance sheet and income statement ratios widely used in business valuation benchmarking.
Question 2: What does 'market concentration' measure in an industry analysis performed as part of a business valuation?
- The geographic distribution of customers
- The degree to which a small number of firms control most of the industry's output or revenue (Correct answer)
- The total addressable market size in dollars
- The ratio of domestic to foreign competitors
Correct answer: The degree to which a small number of firms control most of the industry's output or revenue
Market concentration indicates competitive intensity; highly concentrated industries often have fewer competitors and higher barriers to entry.
Question 3: How does an industry in the 'decline' stage of its life cycle typically affect the valuation of a business operating within it?
- It increases value because cash flows are maximized in decline
- It reduces value because future growth prospects are limited and risk is elevated (Correct answer)
- It has no effect on value if the company is profitable today
- It always triggers use of the asset approach instead of the income approach
Correct answer: It reduces value because future growth prospects are limited and risk is elevated
Declining industries face shrinking demand and pricing pressure, which limits future cash flow growth and increases business risk.
Question 4: Which economic concept best describes a situation where an industry's barriers to entry are very low?
- Oligopoly pricing power
- Contestable market (Correct answer)
- Monopsony demand
- Vertical integration
Correct answer: Contestable market
A contestable market is one where low barriers allow new entrants to compete freely, limiting incumbent firms' pricing power and long-run profitability.
Question 5: Why is an industry risk premium sometimes added to the discount rate in a business valuation build-up model?
- To account for the subject company's specific management risk
- To adjust for risks inherent to the specific industry that are not captured by the broad equity risk premium (Correct answer)
- To replace the small company size premium
- To eliminate the need for a company-specific risk premium
Correct answer: To adjust for risks inherent to the specific industry that are not captured by the broad equity risk premium
Certain industries (e.g., healthcare, oil & gas) carry systemic risks beyond general equity risk, warranting a premium adjustment to the discount rate.
Question 6: In performing economic analysis for a valuation, what is a 'normalization adjustment' for a cyclical company?
- Replacing GAAP net income with cash basis income
- Adjusting revenues and earnings to reflect mid-cycle or through-the-cycle performance rather than peak or trough conditions (Correct answer)
- Eliminating owner compensation from operating expenses
- Restating depreciation to straight-line from accelerated method
Correct answer: Adjusting revenues and earnings to reflect mid-cycle or through-the-cycle performance rather than peak or trough conditions
For cyclical companies, mid-cycle normalization removes temporary distortions caused by economic booms or recessions to reflect sustainable earning power.
ABV ABV Economic & Industry Analysis 2
Which of the following sources is commonly used by ABV practitioners to obtain industry financial ratios for benchmarking?