1. Lecture Presentation Software to accompany Investment Analysis and Portfolio Management Seventh Edition by Frank K. Reilly & Keith C. Brown
Chapter 14

2. Chapter 14 Industry Analysis
Questions to be answered:
Is there a difference between the returns for alternative industries during specific time periods? What is the implication of these results?
Is there consistency in the returns for individual industries over time? What do these results imply regarding industry analysis?

3. Chapter 14 Industry Analysis
Is the performance for firms within an industry consistent? What is the implication of these results for industry and company analysis?
Is there a difference in risk among industries? What are the implications of these results for industry analysis?

4. Chapter 14 Industry Analysis
What happens to risk for individual industries over time? What does this imply for industry analysis?
What are two variables that need to be estimated whether you use cash flow models or relative valuation ratios?

5. Chapter 14 Industry Analysis
Given the present value of cash flow valuation techniques, how does an analyst determine the value of an industry using the DDM and assuming constant growth or two stage growth?
How does an analyst determine the value of an industry using the free cash flow to equity (FCFE) model with constant growth or two stage growth?

6. Chapter 14 Industry Analysis
What are the steps involved in estimating earnings per share for an industry?
What are the stages in the industrial life cycle and how does the life cycle stage affect the sales estimate for an industry?
What are the five basic competitive forces that determine the intensity of competition in an industry and thus, its rate of return on capital?

7. Chapter 14 Industry Analysis
How does the estimating procedure for the operating profit differ for the aggregate market versus an industry?
What are the two alternative procedures for estimating an industry earnings multiplier?

8. Chapter 14 Industry Analysis
What is involved in a macroanalysis of the industry earnings multiplier?
What are the steps in the microanalysis of an industry earnings multiplier?
After you estimate an industry earnings multiplier, how do you determine if the industry’s multiplier is relatively high or low?

9. Chapter 14 Industry Analysis
How do industries differ in terms of what dictates their return on assets?
What are some of the unique factors that must be considered in global industry analysis?

10. Why Do Industry Analysis?
Help find profitable investment opportunities
Part of the three-step, top-down plan for valuing individual companies and selecting stocks for a portfolio

11. What Do We Learn From Industry Analysis?
Is there a difference between the returns for alternative industries during specific time periods?
Will an industry that performs well in one period continue to perform well in the future? That is, can we use past relationships between the market and an individual industry to predict future trends for the industry?

12. What Do We Learn From Industry Analysis?
Do firms within an industry show consistent performance over time?

13. What Do We Learn From Industry Analysis?
Do firms within an industry show consistent performance over time?
Is there a difference in the risk for alternative industries?

14. What Do We Learn From Industry Analysis?
Do firms within an industry show consistent performance over time?
Is there a difference in the risk for alternative industries?
Does the risk for individual industries vary or does it remain relatively constant over time?

15. Industry Performance
Wide dispersion in rates of return in different industries
Performance varies from year to year
Company performance varies within industries
Risks vary widely by industry but are fairly stable over time

16. The Business Cycle and Industry Sectors
Economic trends can and do affect industry performance
By identifying and monitoring key assumptions and variables, we can monitor the economy and gauge the implications of new information on our economic outlook and industry analysis

17. The Business Cycle and Industry Sectors
Cyclical or Structural Changes
Cyclical changes in the economy arise from the ups and downs of the business cycle
Structure changes occur when the economy undergoes a major change in organization or how it functions
Rotation strategy is when one switches from one industry group to another over the course of a business cycle

18. The Business Cycle and Industry Sectors
Economic Variables and Different Industries
Inflation
Interest Rates
International Economics
Consumer Sentiment

19. The Stock Market and the Business Cycle
Exhibit 14.2
ECONOMIC
CYCLE

20. The Stock Market and the Business Cycle
Exhibit 14.2
peak
ECONOMIC
CYCLE
trough

21. The Stock Market and the Business Cycle
Exhibit 14.2
Basic Industries Excel
Consumer Staples Excel
Consumer Durables Excel
peak
ECONOMIC
CYCLE
Capital Goods Excel
trough
Financial Stocks Excel

22. Structural Economic Changes and Alternative Industries
Social Influences
Demographics
Lifestyles
Technology
Politics and regulations
Economic reasoning
Fairness
Regulatory changes affect numerous industries
Regulations affect international commerce

23. Evaluating the Industry Life Cycle
Five Stage Model
Pioneering development
Rapidly accelerating industry growth
Mature industry growth
Stabilization and market maturity
Deceleration of growth and decline

24. Analysis of Industry Competition
Competition and Expected Industry Returns
Porter’s concept of competitive strategy is described as the search by a firm for a favorable competitive position in an industry
To create a profitable competitive strategy, a firm must first examine the basic competitive structure of its industry
The potential profitability of a firm is heavily influenced by the profitability of its industry

25. Competitive Structure of an Industry
Porter’s Competitive Forces
Rivalry among existing competitors
Threat of new entrants
Threat of substitute products
Bargaining power of buyers
Bargaining power of suppliers

26. Estimating Industry Rates of Return
Present value using required rate of return for the equity in the industry
Two-step P/E ratio approach uses expected value at the end of investment horizon and compute the expected dividend return during the period
Valuation using the reduced form DDM
Pi = the price of industry i at time t
D1 = the expected dividend for industry i in period 1 equal to D0(1+g)
k = the required rate of return on the equity for industry i
g = the expected long-run growth rate of earnings and dividend for industry i

27. Estimating the Required Rate of Return
Influenced by the risk-free rate
Expected inflation rate
Risk premium for the industry versus the market
business risk (BR)
financial risk (FR)
liquidity risk (LR)
exchange rate risk (ERR)
country political risk (CR)
Or compare systematic risk (beta) for the industry to the market beta of 1.0

28. Estimating the Expected Growth Rate
Earnings and dividend growth are determined by the retention rate and the return on equity
Earnings retention rate of industry compared to the overall market
Return on equity is a function of
the net profit margin
total asset turnover
a measure of financial leverage

29. Industry Valuation Using the Free Cash Flow to Equity (FCFE) Model
FCFE is defined as follows:
Net income
+ Depreciation
- Capital expenditures
- D in working capital
- Principal debt repayments
+ New debt issues

30. Industry Valuation Using the Free Cash Flow to Equity (FCFE) Model
The Constant Growth FCFE Model
The Two-Stage Growth FCFE Model

31. The Earnings Multiple Technique
Estimating earnings per share
start with forecasting sales per share
Industrial life cycle
Input-output analysis
Industry-aggregate economy relationship
earnings forecasting and analysis of industry competition
competitive strategy
competitive environment
industry operating profit margin
industry earnings estimate
industry earnings multiplier

32. Industry Profit Margin Forecast
Industry’s operating profit margin
(EBITDA / Sales)
Depreciation expense
interest expense
tax rate

33. Industry Profit Margin Forecast
Industry’s operating profit margin
(EBITDA / Sales)
Regression analysis
Time series analysis
Long-term consideration including competitive structure

34. Industry Profit Margin Forecast
Depreciation expense
Generally increasing time series
Specific estimate technique using the depreciation expense/PPE ratio
Subtract depreciation from operating profit margin to determine industry’s net before interest and taxes

35. Industry Profit Margin Forecast
Interest expense is a function of financial leverage and interest rates
1. Calculate the annual total asset turnover (TATO)
2. Use your current sales estimate and an estimate of TATO to estimate total assets next year
3. Calculate the annual long-term (interest bearing) debt as a percent of total assets,
4. Estimate long-term debt for the next year

36. Industry Profit Margin Forecast
Interest expense (cont.)
5. Calculate the annual interest cost as a percent of long-term debt and analyze the trend
6. Estimate next year’s interest cost of debt for this industry based upon your prior estimate of market yields
7. Estimate interest expense based on the following estimates: (Interest Cost of Debt) (Outstanding Long-Term Debt)

37. Industry Profit Margin Forecast
Tax rate
Regression analysis
Time series plot
After estimating the tax rate, multiply the EBT per share value by (1 - tax rate) to estimate earnings per share
Derive an estimate of industry’s net profit margin as a check on your EPS estimate

38. Estimating an Industry Earnings Multiplier
Macroanalysis
relationship between multiplier for the industry and the market
variables that influence the multiplier:
required rate of return (k)
function of the nominal risk-free rate plus a risk premium
expected growth rate of earnings and dividend
dividend payout ratio

39. Estimating an Industry Earnings Multiplier
Microanalysis
Estimate the variables that influence the industry earnings multiplier and compare them to the comparable values for the market P/E
Industry multiplier versus the market multiplier
Comparing dividend-payout ratios
Estimating the required rate of return (k)
Estimating the expected growth rate (g)
g = Retention Rate (b) X Return on Equity (ROE)
= (b) X (ROE)

40. Other Relative Valuation Ratios
Price-to-book value ratios (P/BV)
Price-to-cash flow ratios (P/CF)
Price-to-sales ratios (P/S)

41. Global Industry Analysis
The macroeconomic environment in the major producing and consuming countries for this industry
An overall analysis of the significant companies in the industry and the products they produce
What are the accounting differences by country and how do these differences impact the relative valuation ratios?
What is the effect of currency exchange rate trends for the major countries?

42. The Internet Investments Online

43. End of Chapter 14
Industry Analysis

44. Future topics Chapter 15 Company Analysis and Stock Selection Value
Growth
Strategies