execute the strategy, and recognize the key risks that the ļ¬rm has to guard against. The
analyst also has to evaluate the sustainability of the ļ¬rmā™s strategy.
Corporate strategy analysis involves examining whether a company is able to create
value by being in multiple businesses at the same time. A well-crafted corporate strategy
reduces costs or increases revenues from running several businesses in one ļ¬rm relative
50 Strategy Analysis
to operating the same businesses independently and transacting with each other in the
marketplace. These cost savings or revenue increases come from specialized resources
that the ļ¬rm has to exploit synergies across these businesses. For these resources to be
valuable, they must be nontradable, not easily imitated by competition, and nondivisible.
Even when a ļ¬rm has such resources, it can create value through a multibusiness orga-
nization only when it is managed so that the information and agency costs inside the or-
ganization are smaller than the market transaction costs.
The insights gained from strategy analysis can be useful in performing the remainder
of the ļ¬nancial statement analysis. In accounting analysis, the analyst can examine
whether a ļ¬rmā™s accounting policies and estimates are consistent with its stated strategy.
For example, a ļ¬rmā™s choice of functional currency in accounting for its international
operations should be consistent with the level of integration between domestic and in-
ternational operations that the business strategy calls for. Similarly, a ļ¬rm that mainly
sells housing to low-income customers should have higher bad debts expenses.
Strategy analysis is also useful in guiding ļ¬nancial analysis. For example, in a cross-
sectional analysis the analyst should expect ļ¬rms with cost leadership strategy to have
lower gross margins and higher asset turnover than ļ¬rms that follow differentiated strat-
egies. In a time series analysis, the analyst should closely monitor any increases in ex-
pense ratios and asset turnover ratios for low-cost ļ¬rms, and any decreases in
investments critical to differentiation for ļ¬rms that follow differentiation strategy.
Business strategy analysis also helps in prospective analysis and valuation. First, it
allows the analyst to assess whether, and for how long, differences between the ļ¬rmā™s
performance and its industry (or industries) performance are likely to persist. Second,
strategy analysis facilitates forecasting investment outlays the ļ¬rm has to make to main-
tain its competitive advantage.
1. Judith, an accounting major, states, āStrategy analysis seems to be an unnecessary
detour in doing financial statement analysis. Why canā™t we just get straight to the
accounting issues?ā Explain to Judith why she might be wrong?
2. What are the critical drivers of industry profitability?
3. One of the fastest growing industries in the last twenty years is the memory chip
industry, which supplies memory chips for personal computers and other electronic
devices. Yet the average profitability for this industry has been very low. Using the
industry analysis framework, list all the potential factors that might explain this ap-
2-19 Part 2 Business Analysis and Valuation Tools
4. Rate the pharmaceutical and lumber industries as high, medium, or low on the fol-
lowing dimensions of industry structure:
Threat of new entrants
Threat of substitute products
Bargaining power of buyers
Bargaining power of suppliers
Given your ratings, which industry would you expect to earn the highest returns?
5. Joe Smith argues, āYour analysis of the five forces that affect industry profitability
is incomplete. For example, in the banking industry, I can think of at least three
other factors that are also important; namely, government regulation, demographic
trends, and cultural factors.ā His classmate Jane Brown disagrees and says, āThese
three factors are important only to the extent that they influence one of the five
forces.ā Explain how, if at all, the three factors discussed by Joe affect the five
forces in the banking industry.
6. Coca-Cola and Pepsi are both very profitable soft drinks. Inputs for these products
include sugar, bottles/cans, and soft drink syrup. Coca-Cola and Pepsi produce the
syrup themselves and purchase the other inputs. They then enter into exclusive con-
tracts with independent bottlers to produce their products. Use the five forces
framework and your knowledge of the soft drink industry to explain how Coca-Cola
and Pepsi are able to retain most of the profits in this industry.
7. In the early 1980s, United, Delta, and American Airlines each started frequent flier
programs as a way to differentiate themselves in response to excess capacity in the
industry. Many industry analysts, however, believe that this move had only mixed
success. Use the competitive advantage concepts to explain why.
8. What are the ways that a firm can use to create barriers to entry to deter competition
in its business? What factors determine whether these barriers are likely to be
9. Explain why you agree or disagree with each of the following statements:
a. Itā™s better to be a differentiator than a cost leader, since you can then charge pre-
b. Itā™s more profitable to be in a high technology than a low technology industry.
c. The reason why industries with large investments have high barriers to entry is
because it is costly to raise capital.
10. There are very few companies that are able to be both cost leaders and differentia-
tors. Why? Can you think of a company that has been successful at both?
11. Many consultants are advising diversified companies in emerging markets, such as
India, Korea, Mexico, and Turkey, to adopt corporate strategies proven to be of val-
52 Strategy Analysis
ue in advanced economies, like the U.S. and the U.K. What are the pros and cons
of this advice?
1. The discussion presented here is intended to provide a basic background in strategy analysis.
For a more complete discussion of the strategy concepts, see, for example, Contemporary Strategy
Analysis by Robert M. Grant (Cambridge, MA: Blackwell Publishers, 1991); Economics of Strat-
egy by David Besanko, David Dranove, and Mark Shanley (New York: John Wiley & Sons,
1996); Strategy and the Business Landscape by Pankaj Ghemawat (Reading, MA: Addison Wes-
ley Longman, 1999); and Corporate Strategy: Resources and the Scope of the Firm by David J.
Collis and Cynthia Montgomery (Burr Ridge, IL: Irwin/McGraw-Hill, 1997).
2. These data are taken from āDo Competitors Perform Better When They Pursue Different
Strategies?ā by Anita M. McGahan (Boston: Harvard Business School, working paper, May 12,
3. For a summary of this research, see Industrial Market Structure and Economic Perfor-
mance, second edition, by F. M. Scherer (Chicago: Rand McNally College Publishing Co., 1980).
4. See Competitive Strategy by Michael E. Porter (New York: The Free Press, 1980).
5. The four-firm concentration ratio is a commonly used measure of industry concentration; it
refers to the market share of the four largest firms in an industry.
6. While the discussion here uses the buyer to connote industrial buyers, the same concepts
also apply to buyers of consumer products. Throughout this chapter, we use the terms buyers and
7. The data on Dell and the personal computer (PC) industry discussed here and elsewhere in
this chapter is drawn from āDell Computer Corporationā by Das Narayandas and V. Kasturi Ran-
gan (Boston: Harvard Business School Publishing Division, 9-596-058) and āDell Onlineā by V.
Kasturi Rangan and Marie Bell (Boston: Harvard Business School Publishing Division, 9-598-
8. For a more detailed discussion of these two sources of competitive advantage, see Michael
E. Porter, Competitive Advantage: Creating and Sustaining Superior Performance (New York:
The Free Press, 1985).
10. In recent years, one of the strategic challenges faced by corporations is having to deal with
competitors who achieve differentiation with low cost. For example, Japanese auto manufacturers
have successfully demonstrated that there is no necessary trade-off between quality and cost. Sim-
ilarly, in recent years several highly successful retailers like Wal-Mart and Home Depot have been
able to combine high quality, high service, and low prices. These examples suggest that combin-
ing low cost and differentiation strategies is possible when a firm introduces a significant technical
or business innovation. However, such cost advantage and differentiation will be sustainable only
if there are significant barriers to imitation by competitors.
11. See Competing for the Future by Gary Hammel and C. K. Prahalad (Boston: Harvard Busi-
ness School Press, 1994) for a more detailed discussion of the concept of core competencies and
their critical role in corporate strategy.
12. Cynthia Montgomery, āCorporate Diversification,ā Journal of Economic Perspectives,
2-21 Part 2 Business Analysis and Valuation Tools
13. The following works are seminal to the transaction cost economics: āThe Nature of the
Firmā by Ronald Coase, Economica 4, 1937: 386ā“405; āMarkets and Hierarchies: Analysis and
Antitrust Implicationsā by Oliver Williamson (New York: The Free Press, 1975); āToward an
Economic Theory of the Multi-product Firmā by David Teece, Journal of Economic Behavior and
Organization 3, 1982: 39ā“63.
14. For a more complete discussion of these issues, see āBuilding Institutional Infrastructure
in Emerging Marketsā by Krishna Palepu and Tarun Khanna, Brown Journal of World Affairs,
Winter/Spring 1998, and āWhy Focused Strategies May Be Wrong for Emerging Markets,ā by
Tarun Khanna and Krishna Palepu, Harvard Business Review, July/August, 1997.
15. For an empirical study which illustrates this point, see āIs Group Affiliation Profitable in
Emerging Markets? An Analysis of Diversified Indian Business Groups,ā by Tarun Khanna and
Krishna Palepu, Journal of Finance, forthcoming.
16. See āTobinā™s q, diversification, and firm performanceā by Larry Lang and Rene Stulz,
Journal of Political Economy 102: 1248ā“1280, and āDiversificationā™s Effect on Firm Valueā by
Phillip Berger and Eli Ofek, Journal of Financial Economics 37: 39ā“65.
17. See āWhich Takeovers are Profitable: Strategic or Financial?ā by Paul Healy, Krishna
Palepu, and Richard Ruback, Sloan Management Review, 1996.
18. See āEffects of Recontracting on Shareholder Wealth: The Case of Voluntary Spinoffsā by
Katherine Schipper and Abbie Smith, Journal of Financial Economics 12: 437ā“467; āAsset Sales,
Firm Performance, and the Agency Costs of Managerial Discretionā by L. Lang, A. Poulsen, and
R. Stulz, Journal of Financial Economics 37: 3ā“37.
19. āeBay vs. Amazon.com,ā Business Week, May 31, 1999.
20. āAmazon.Bombā by Jacqueline Doherty, Barronā™s, May 31, 1999.
America Online, Inc.
W hen it comes to technology companies, the stock marketā™s current
mania, itā™s hard to top America Online, Inc. Technology stocks are hot, up about
50 percent on average this year, but AOL is positively scalding, up about 135 per-
Business Analysis and
cent. In fact, AOLā™s stock has soared more than 2,000 percent from its initial public
offering, in 1992. The Vienna-based company has 35 times the customers and 20
times the revenue it had ļ¬ve years ago. Itā™s the nationā™s biggest on-line company
and is building a recognized brand.
But look closely and you see that AOL is as much about accounting technology
as it is about computer technology. So make sure you understand the numbers be-
fore rushing out to buy AOL, which is valued at about $4 billion.
The above report written by Allan Sloan appeared on October 24, 1995, in News-
2 weekā™s business section.1
Founded in Vienna, VA, America Online, Inc. (AOL) was a leader in the development of
a new mass medium that encompassed online services, the Internet, multimedia, and oth-
er interactive technologies. Through its America Online service the company offered
members a broad range of features including real-time talk, electronic mail, electronic
magazines and newspapers, online classes and shopping, and Internet access. In addition
to its online service, AOLā™s business had expanded during 1995 to include access soft-
ware for the Internet, production and distribution of original content, interactive market-
ing and transactions capabilities, and networks to support the transmission of data.
AOL generated revenues principally from consumers through membership fees, as
well as from content providers and merchandisers through advertising, commissions on
merchandise sales and other transactions, and from other businesses through the sale of
network and production services. Through continued investment in the growth of its ex-
isting online service, the pursuit of related business opportunities, its ability to provide
This case was prepared by Professors Krishna Palepu and Amy Hutton as the basis for class discussion rather than to
illustrate either effective or ineffective handling of an administrative situation. Copyright ļ£© 1997 by the President and
Fellows of Harvard College. Harvard Business School case 9-196-13.
1. āLook Beyond the High-Tech Accounting To Measure America Onlineā™s Market Risk,ā Allan Sloan, Newsweek, Octo-
ber 24, 1995.
2-23 Part 2 Business Analysis and Valuation Tools
a full range of interactive services, and its technological ļ¬‚exibility, the company posi-
tioned itself to lead the development of the evolving mass medium for interactive
Stephen Case and James Kimsey founded America Onlineā™s predecessor, Quantum
Computer Services, in 1985. Quantum offered its Q-Link service for Commodore com-
puters. In 1989, the service was extended to Apple computers. The company changed its
name to America Online in 1991 and went public in 1992. That same year, AOL licensed
its on-line technology to Apple for use in eWorld and NewtonMail services for which
AOL continues to receive a usage-based royalty. In 1993, the company expanded its
market with a Windows version of its software and began developing a version for palm-
top computer. In 1994, AOLā™s subscription base surpassed those of CompuServe and