Investments: Analysis and Behavior Chapter 9 - Business Environment

Learning Objectives  Know the major forces driving economic growth  Define the economic environment  Identify industries /sectors  Learn the impact of regulation  Analyze the level of corporate governance in a firm

Current Events Article  Title: Consumer Sentiment Dips to Lowest Since November  Author: Caroline Valetkevitch  Source: Reuters  Link: S2LA ?loomia_ow=t0:s0:a49:g43: r3:c :b :z0 3

Fundamental Analysis  Top-down approach –Economy aspects Industry aspects  Firm specific »Accounting - Recording, reporting and analysis of financial transactions of a business »Valuation: value (bargains) vs. growth (without regard for money) firms

Dimensions of the Economy  As the economy goes, so goes the businesses and their stock(s)…  Macroeconomic Environment –Aggregate Economic Activity Gross Domestic Product ($14,730.2 Billion)  The total value of all goods and services produced by all people within the boundaries of a country during a one-year period Interest rates (0.25 percent) Consumer spending and consumer income Employment (9.2% unemployment rate)  Microeconomic Environment –Industry, Firm, Plant, or Product Level Industry specific regulation Material prices

Forces Driving the Economy 1) Demographics –Baby boom generation Born 1946 through 1964 Significant impact on society: spending saving working/retirement housing

2) Productivity –The ability to produce more products and services with the same number of people. –When productivity growth is robust, the standard of living increases. –Gains are often made from advances in technology Computers, Internet, etc.

3) International Trade –Imports –Exports  Balance of trade The total value of a nation’s exports minus the total value of its imports over some period of time  Trade deficit A negative (unfavorable) balance of trade—imports exceed exports in value  Balance of payments The total flow of money into a country minus the total flow of money out of that country over a period of time

U.S. International Trade in Goods Source: U.S. Department of Commerce, International Trade Administration, U.S. Bureau of Economic Analysis, accessed September 18, 2008.

Value of U.S. Merchandise Exports and Imports Source: U.S. Department of Commerce, International Trade Administration, highlights/top/top0712.html, accessed September 22, 2008.

Business Cycles  Pattern of economic recession and expansion –Periods of economic expansion are followed by periods of contractions  Recession is a sustained period of generally declining economic activity (GDP) –Higher unemployment –Restricted credit –Reduced output  Depression –Devastating recession

Economic Indicators  Inflation rate –An economic statistic that tracks the increase in prices of goods and services over a period of time; usually calculated on a monthly or annual basis  National income –The total income earned by various segments of the population, including employees, self-employed individuals, corporations, and other type of income  New housing starts –The total number of new homes started during a specific time period.  Unemployment rate –The percentage of a nation’s labor force unemployed at any time

Competitive Environment  Industry’s market structure –Number and size of competitors –Conditions of entry and exit –Monopoly –Oligopoly  Competitive advantage –Better –Cheaper –Faster

Michael Porter’s Five Forces  Rivalry among existing competitors  Threat of new entrants  Pressure from substitute products  Bargaining power of customers  Bargaining power of suppliers

Legal Environment  Regulation –All sectors of the US economy are regulated to some degree. OSHA, EPA, etc. –Some industries have high regulation Banks, utilities, etc. –Costs of regulation are very high

Antitrust Policy  Monopoly –A market (or industry) with only one seller  Government promotes competition –Reviews mergers for impact on competition

Corporate Governance  Principal-agent problem –Separation of ownership and control Stockholders own the firm with little control Managers control the firm with little ownership  Why should the managers (agents) care about stockholders?  Corporate governance is the monitoring devices and incentives in place to protect stockholders.

Executive Compensation  Aligning managerial incentives –Salary Fixed amount –Bonus Additional pay for meeting various accounting targets –Incentive pay Options, stock, restricted stock –Benefits and Perks

Monitoring Executives  Board of Directors  Active shareholders –Institutional investors  Auditors  Analysts  Investment banks  Credit rating agencies  SEC

Ownership Structure  Corporate ownership –Stock The shares of ownership of a corporation –Stockholder A person who owns a corporation’s stock –Closed corporation A corporation whose stock is owned by relatively few people and is not sold to the general public –Open corporation A corporation whose stock is bought and sold on security exchanges and can be purchased by any individual  Inside equity –Shares held by top management.  Does high inside equity mean managers: –Are aligned with shareholders? –Are entrenched?

4 | 21 Hierarchy of Corporate Structure  Stockholders exercise a great deal of influence through their right to elect the board of directors