McGraw-Hill/Irwin Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter Macroeconomic and Industry Analysis

17-2 Approach to Fundamental Analysis: Domestic and global economic analysis Industry analysis Company analysis Why use the top-down approach? Fundamental Analysis

17-3 Performance in countries and regions is highly variable. Political risk Exchange rate risk Sales Profits Stock returns Global Economic Considerations

17-4 Gross domestic product Unemployment rates Interest rates & inflation International measures Consumer sentiment Key Economic Variables

17-5 Fiscal Policy - government spending and taxing actions. Direct policy Slowly implemented Monetary Policy - manipulation of the money supply to influence economic activity. Initial & feedback effects Tools of monetary policy Open market operations Discount rate Reserve requirements Domestic Economic Policy

17-6 Demand shock - an event that affects demand for goods and services in the economy. Tax rate cut Increases in government spending Supply shock - an event that influences production capacity or production costs. Commodity price changes Educational level of economic participants Shocks

17-7 Business Cycle Peak Trough Industry relationship to business cycles Cyclical Defensive Business Cycles

17-8 Leading Indicators tend to rise and fall in advance of the economy. Avg. weekly hours of production workers Stock Prices Coincident Indicators tend to change directly with the economy. Industrial production Manufacturing and trade sales Lagging Indicators tend to follow the lag economic performance. Ratio of trade inventories to sales Ratio of consumer installment credit outstanding to personal income Cyclical Indicators

17-9 Sensitivity to business cycles Sensitivity of earnings to business cycles depends on: Sensitivity of sales of the firm’s product to the business cycles Operating leverage Financial leverage Industry life cycles StageSales Growth Start-upRapid & Increasing ConsolidationStable MaturitySlowing Relative DeclineMinimal or Negative Industry Analysis

17-10 Sector Rotation Portfolio is adjusted by selecting companies that should perform well for the stage of the business cycle Peaks – natural resource extraction firms Contraction – defensive industries such as pharmaceuticals and food Trough – capital goods industries Expansion – cyclical industries such as consumer durables

McGraw-Hill/Irwin Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 18 Equity Valuation Models

17-12 Basic Types of Models Balance Sheet Models Dividend Discount Models Price/Earning Ratios Estimating growth rates and opportunities Intrinsic Value Self assigned value or estimate derived from a variety of models Market Price Consensus value of all potential traders Trading Signal IV > MP Buy IV < MP Sell or Short Sell IV = MP Hold or Fairly Priced Models of Equity Valuation

17-13 V 0 = Value of Stock D t = Dividend k = required return Dividend Discount Models: General Model

17-14 Stocks with earnings & dividends expected to be constant (often preferred stock) E 1 = D 1 = $5.00 k =.15 V 0 = $5.00 /.15 = $33.33 No Growth Model

17-15 g = constant perpetual growth rate E 1 = $5.00b = 40% k = 15% (1-b) = 60%D 1 = $3.00 g = 8% V 0 = 3.00 / ( ) = $42.86 Constant Growth Model

17-16 g = growth rate in dividends ROE = Return on Equity for the firm b = plowback or retention percentage rate (1- dividend payout percentage rate) Estimating Dividend Growth Rates

17-17 P N = the expected sales price for the stock at time N N = the specified number of years the stock is expected to be held Specified Holding Period Model

17-18 PVGO = Present Value of Growth Opportunities E 1 = Earnings Per Share for period 1 Growth & No Growth Components of Value

17-19 ROE = 20% d = 60% b = 40% E 1 = $5.00 D 1 = $3.00 k = 15% g =.20 x.40 =.08 or 8% Partitioning Value: Example

17-20 V o = value with growth NGV o = no growth component value PVGO = Present Value of Growth Opportunities Partitioning Value: Example

17-21 P/E Ratios are a function of two factors Required Rates of Return (k) Expected growth in Dividends Uses Relative valuation Extensive Use in industry Price Earnings Ratios

17-22 E 1 - expected earnings for next year E 1 is equal to D 1 under no growth k - required rate of return P/E Ratio: No Expected Growth

17-23 b = retention ratio ROE = Return on Equity P/E Ratio with Constant Growth

17-24 E 0 = $2.50 g = 0 k = 12.5% P 0 = D/k = $2.50/.125 = $20.00 PE = 1/k = 1/.125 = 8 Numerical Example: No Growth

17-25 b = 60% ROE = 15% (1-b) = 40% E 1 = $2.50 (1 + (.6)(.15)) = $2.73 D 1 = $2.73 (1-.6) = $1.09 k = 12.5% g = 9% P 0 = 1.09/( ) = $31.14 PE = 31.14/2.73 = 11.4 PE = (1 -.60) / ( ) = 11.4 Numerical Example with Growth

17-26 Pitfalls in P/E Analysis Use of accounting earnings Historical costs May not reflect economic earnings Reported earnings fluctuate around the business cycle.

17-27 Other Valuation Ratios Price-to-Book Price-to-Cash Flow Price-to-Sales

17-28 Inflation and Equity Valuation Inflation has an impact on equity valuations. Historical costs underestimate economic costs. Empirical research shows that inflation has an adverse effect on equity values. Research shows that real rates of return are lower with high rates of inflation.

17-29 Lower Equity Values with Inflation Shocks cause expectation of lower earnings by market participants. Returns are viewed as being riskier with higher rates of inflation. Real dividends are lower because of taxes.

McGraw-Hill/Irwin Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 19 Financial Statement Analysis

17-31 Purpose Tools Used Statements Ratio Analysis Limitations Overview

17-32 Balance Sheet Common Sized Trend or Indexed Income Statement Common Sized Trend or Indexed Statement of Cash Flows Financial Statements

17-33 Purpose of Ratio Analysis Uses Trend analysis Comparative analysis Combination Use by External Analysts Important information for investment community Important for credit markets Ratio Analysis

17-34 Liquidity Ratios Activity or Mgmt Efficiency Ratios Leverage Ratios Profitability Ratios Market Price Ratios Type of Financial Ratios

17-35 Current Ratio Current Assets Current Liabilities Quick Ratio Current Assets - Inventory Current Liabilities Liquidity Ratios

17-36 Inventory Turnover Sales or Cost of Goods Sold Inventory Total Asset Turnover Sales Total Assets Activity or Management Efficiency Ratios

17-37 Average Collection Period Accounts Receivable Sales Per Day Days to Sell Inventory Inventory Sales Per Day Activity or Management Efficiency Ratios

17-38 Times Interest Earned Earnings Before Int. & Taxes Interest Expense Fixed Charge Coverage Ratios Lease Payments Principal Repayments Preferred Dividends Leverage Ratios

17-39 Debt to Assets Long Term Debt Assets Debt to Equity Long Term Debt Shareholders Equity Leverage Ratios

17-40 Net Profit Margin % Net Income Sales Return on Assets Net Income Total Assets Profitability Ratios

17-41 Return on Equity Net Income Common Equity Operating Margin After Depr. Operating Profit Sales Profitability Ratios

17-42 Price to Earnings Market Price of Stock Earnings Market-to-Book-Value Market Price of Stock Book Value Per Share Market Price Ratios

17-43 ROE = Net Profit Pretax Profit x EBIT x Sales Assets xx Equity (1) x (2) x (3) x (4) x (5) x Margin x Turnover x Leverage Tax Burden Interest Burden Decomposition of ROE x

17-44 Economic Value Added Difference between return on assets (ROA) and the opportunity cost of capital (k) EVA = above difference time the invested capital EVA can be positive or negative for firms that have positive earnings

17-45 Accounting Differences Inventory Valuation Depreciation Inflation International Accounting Conventions Reserves –more or less flexibility allowed in use of reserves. Depreciation –separate tax and reporting presentations may be allowed. Intangibles – treatment varies widely. Comparability Problems