Macroeconomic and Industry Analysis

Macroeconomic and Industry Analysis
CHAPTER 17

Framework of Analysis Fundamental Analysis
Approach to Fundamental Analysis: Domestic and global economic analysis Industry analysis Company analysis Why use the top-down approach? Bahattin Buyuksahin, JHU Investment

Global Economic Considerations
Performance in countries and regions is highly variable Political risk Exchange rate risk Sales Profits Stock returns Bahattin Buyuksahin, JHU Investment

Table 17.1 Economic Performance in Selected Emerging Markets
Bahattin Buyuksahin, JHU Investment

Figure 17. 1 Change in Real Exchange Rate: U. S
Figure 17.1 Change in Real Exchange Rate: U.S. Dollar versus Major Currencies, 1999–2006 Bahattin Buyuksahin, JHU Investment

Key Economic Variables
Gross domestic product Unemployment rates Interest rates & inflation Budget deficit Consumer sentiment Bahattin Buyuksahin, JHU Investment

Figure 17.2 S&P 500 Index versus Earnings Per Share

Demand Shocks Demand shock - an event that affects demand for goods and services in the economy Bahattin Buyuksahin, JHU Investment

Supply Shocks Supply shock - an event that influences production capacity or production costs Bahattin Buyuksahin, JHU Investment

Federal Government Policy
Fiscal Policy: Demand-side management Tax rate cut Increases in government spending Bahattin Buyuksahin, JHU Investment

Federal Government Policy Continued
Monetary Policy - Demand-side management Manipulation of the money supply to influence economic activity Initial & feedback effects Tools of monetary policy Open market operations Discount rate Reserve requirements Bahattin Buyuksahin, JHU Investment

Federal Government Policy Continued
Fiscal Policy: Supply-side management Incentive or marginal taxes National policies on education, infrastructure, and research are important elements Bahattin Buyuksahin, JHU Investment

Business Cycles The transition points across cycles are called peaks and troughs A peak is the transition from the end of an expansion to the start of a contraction A trough occurs at the bottom of a recession just as the economy enters a recovery Bahattin Buyuksahin, JHU Investment

Figure 17.3 Cyclical Indicators

Leading Indicators Leading indicators tend to rise and fall in advance of the economy Examples: Avg. weekly hours of production workers Stock Prices Bahattin Buyuksahin, JHU Investment

Table 17.2 Indexes of Economic Indicators

Coincident Indicators
Coincident Indicators - indicators that tend to change directly with the economy Examples: Industrial production Manufacturing and trade sales Bahattin Buyuksahin, JHU Investment

Lagging Indicators Lagging Indicators - indicators that tend to follow the lag economic performance Examples: Ratio of trade inventories to sales Ratio of consumer installment credit outstanding to personal income Bahattin Buyuksahin, JHU Investment

Figure 17.4 Indexes of Leading, Coincident, and Lagging Indicators

Table 17.3 Economic Calendar

Industry Analysis Sensitivity to business cycles
Factors affecting sensitivity of earnings to business cycles: Sensitivity of sales of the firm’s product to the business cycles Operating leverage Financial leverage Industry life cycles Bahattin Buyuksahin, JHU Investment

Figure 17.5 Economic Calendar at Yahoo!

Table 17.4 Useful Economic Indicators

Figure 17.6 Return on Equity, 2007

Defining an Industry North American Industry Classification System, or NAICS codes Codes assigned to group firms for statistical analysis Bahattin Buyuksahin, JHU Investment

Figure 17.7 Industry Stock Price Performance as Measured by Rate of Return on Dow Jones Sector iShares, January-October 2007 Bahattin Buyuksahin, JHU Investment

Figure 17.8 ROE of Major Banks

Table 17.5 Examples of NAICS Industry Codes

Figure 17.9 Industry Cyclicality

Table 17.6 Operating Leverage of Firms A and B Throughout the Business Cycle

Figure 17.10 A Stylized Depiction of the Business Cycle

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 Bahattin Buyuksahin, JHU Investment

Figure 17.11 Sector Rotation

Industry Life Cycles Start-up Rapid & Increasing Consolidation Stable
Stage Sales Growth Start-up Rapid & Increasing Consolidation Stable Maturity Slowing Relative Decline Minimal or Negative Bahattin Buyuksahin, JHU Investment

Figure 17.12 The Industry Life Cycle

Industry Structure and Performance
Threat of entry Rivalry between existing competitors Pressure from substitute products Bargaining power of buyers Bargaining power of suppliers Bahattin Buyuksahin, JHU Investment

Equity Valuation Models
CHAPTER 18

Models of Equity Valuation
Balance Sheet Models Book Value Dividend Discount Models Price/Earning Ratios Bahattin Buyuksahin, JHU Investment

Table 18.1 Financial Highlights for Microsoft Corporation, October 25, 2007

Limitations of Book Value
Book value is an application of arbitrary accounting rules Can book value represent a floor value? Better approaches Liquidation value Replacement cost Bahattin Buyuksahin, JHU Investment

Expected Holding Period Return
The return on a stock investment comprises cash dividends and capital gains or losses Assuming a one-year holding period Bahattin Buyuksahin, JHU Investment

Required Return CAPM gave us required return:
If the stock is priced correctly Required return should equal expected return Bahattin Buyuksahin, JHU Investment

Intrinsic Value and Market Price
Self assigned Value Variety of models are used for estimation 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 Bahattin Buyuksahin, JHU Investment

Specified Holding Period
PH = the expected sales price for the stock at time H H = the specified number of years the stock is expected to be held Bahattin Buyuksahin, JHU Investment

Dividend Discount Models: General Model
V0 = Value of Stock Dt = Dividend k = required return Bahattin Buyuksahin, JHU Investment

No Growth Model Stocks that have earnings and dividends that are expected to remain constant Preferred Stock Bahattin Buyuksahin, JHU Investment

No Growth Model: Example
E1 = D1 = $5.00 k = .15 V0 = $5.00 /.15 = $33.33 Bahattin Buyuksahin, JHU Investment

Constant Growth Model g = constant perpetual growth rate

Constant Growth Model: Example
E1 = $5.00 b = 40% k = 15% (1-b) = 60% D1 = $3.00 g = 8% V0 = 3.00 / ( ) = $42.86 Bahattin Buyuksahin, JHU Investment

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

Figure 18.1 Dividend Growth for Two Earnings Reinvestment Policies

Present Value of Growth Opportunities
If the stock price equals its IV, growth rate is sustained, the stock should sell at: If all earnings paid out as dividends, price should be lower (assuming growth opportunities exist) Bahattin Buyuksahin, JHU Investment

Present Value of Growth Opportunities Continued
Price = No-growth value per share + PVGO (present value of growth opportunities) Bahattin Buyuksahin, JHU Investment

Partitioning Value: Example
ROE = 20% d = 60% b = 40% E1 = $5.00 D1 = $3.00 k = 15% g = .20 x .40 = .08 or 8% Bahattin Buyuksahin, JHU Investment

Partitioning Value: Example Continued
Vo = value with growth NGVo = no growth component value PVGO = Present Value of Growth Opportunities Bahattin Buyuksahin, JHU Investment

Life Cycles and Multistage Growth Models
g1 = first growth rate g2 = second growth rate T = number of periods of growth at g1 Bahattin Buyuksahin, JHU Investment

Multistage Growth Rate Model: Example
D0 = $ g1 = 20% g2 = 5% k = 15% T = 3 D1 = 2.40 D2 = D3 = D4 = 3.63 V0 = D1/(1.15) + D2/(1.15)2 + D3/(1.15)3 + D4 / ( ) ( (1.15)3 V0 = = $30.40 Bahattin Buyuksahin, JHU Investment

Table 18.2 Financial Ratios in Two Industries

Figure 18.2 Value Line Investment Survey Report on Honda Motor Co.

Price Earnings Ratios 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 Bahattin Buyuksahin, JHU Investment

P/E Ratio: No Expected Growth
E1 - expected earnings for next year E1 is equal to D1 under no growth k - required rate of return Bahattin Buyuksahin, JHU Investment

P/E Ratio: Constant Growth
b = retention ratio ROE = Return on Equity Bahattin Buyuksahin, JHU Investment

Numerical Example: No Growth
E0 = $ g = 0 k = 12.5% P0 = D/k = $2.50/.125 = $20.00 PE = 1/k = 1/.125 = 8 Bahattin Buyuksahin, JHU Investment

Numerical Example: Growth
b = 60% ROE = 15% (1-b) = 40% E1 = $2.50 (1 + (.6)(.15)) = $2.73 D1 = $2.73 (1-.6) = $1.09 k = 12.5% g = 9% P0 = 1.09/( ) = $31.14 PE = 31.14/2.73 = 11.4 PE = ( ) / ( ) = 11.4 Bahattin Buyuksahin, JHU Investment

Table 18.3 Effect of ROE and Plowback on Growth and the P/E Ratio

P/E Ratios and Stock Risk
Holding all else equal Riskier stocks will have lower P/E multiples Higher values of k; therefore, the P/E multiple will be lower Bahattin Buyuksahin, JHU Investment

Pitfalls in P/E Analysis
Use of accounting earnings Earnings Management Choices on GAAP Inflation Reported earnings fluctuate around the business cycle Bahattin Buyuksahin, JHU Investment

Figure 18.3 P/E Ratios of the S&P 500 Index and Inflation

Figure 18.4 Earnings Growth for Two Companies

Figure 18.5 Price-Earnings Ratios

Figure 18.6 P/E Ratios for Different Industries, 2007

Other Comparative Value Approaches
Price-to-book ratio Price-to-cash-flow ratio Price-to-sales ratio Bahattin Buyuksahin, JHU Investment

Figure 18.7 Market Valuation Statistics

Free Cash Flow Approach
Discount the free cash flow for the firm Discount rate is the firm’s cost of capital Components of free cash flow After tax EBIT Depreciation Capital expenditures Increase in net working capital Bahattin Buyuksahin, JHU Investment

Comparing the Valuation Models
In practice Values from these models may differ Analysts are always forced to make simplifying assumptions Bahattin Buyuksahin, JHU Investment

The Aggregate Stock Market
Explaining Past Behavior Forecasting the Stock Market Bahattin Buyuksahin, JHU Investment

Figure 18.8 Earnings Yield of S&P 500 versus 10-Year Treasury-Bond Yield

Table 18.4 S&P 500 Price Forecasts Under Various Scenarios

Financial Statement Analysis
CHAPTER 19

Overview Purpose Tools Used Statement analysis Ratio analysis
Limitations Bahattin Buyuksahin, JHU Investment

Financial Statements Balance Sheet Common Sized Trend or Indexed
Income Statement Statement of Cash Flows Bahattin Buyuksahin, JHU Investment

Table 19.1 Consolidated Statement of Income for Hewlett-Packard, 2006

Table 19.2 Consolidated Balance Sheet for Hewlett-Packard, 2006

Table 19.3 Statement of Cash Flows for Hewlett-Packard, 2006

Accounting Versus Economic Earnings
Sustainable cash flow that can be paid to stockholders without impairing productive capacity of the firm Accounting earnings Affected by conventions regarding the valuation of assets Bahattin Buyuksahin, JHU Investment

Profitability Measures
ROE: measures the profitability for contributors of equity capital ROA: measures the profitability for all contributors of capital Leverage has a significant effect on profitability measures Bahattin Buyuksahin, JHU Investment

Table 19.4 Nodett’s Profitability over the Business Cycle

Table 19.5 Impact of Financial Leverage on ROE

ROE, ROA and Leverage Bahattin Buyuksahin, JHU Investment

Decomposition of ROE (1) x (2) x (3) x (4) x (5) ROE = x Net Profit
Pretax Profit x EBIT Sales Assets Equity (1) x (2) x (3) x (4) x (5) x Margin x Turnover x Leverage Tax Burden Interest x Bahattin Buyuksahin, JHU Investment

Table 19.6 Ratio Decomposition Analysis for Nodett and Somdett

Table 19.7 Differences between Profit Margin and Asset Turnover across Industries

Table 19.8 Growth Industries Financial Statements, 2004 – 2007 ($ thousands)

Table 19.9 Summary of Key Financial Ratios: Leverage, Asset Utilization, Liquidity, Profitability and Market Price Bahattin Buyuksahin, JHU Investment

Figure 19.1 DuPont Decomposition for Hewlett-Packard

Table 19.10 Financial Ratios for Major Industry Groups

Economic Value Added Difference between return on assets (ROA) and the opportunity cost of capital (k) EVA is also called residual income EVA can be positive or negative for firms that have positive earnings Bahattin Buyuksahin, JHU Investment

Table 19.11 Economic Value Added, 2007

Table 19.12 Key Financial Ratios of Growth Industries, Inc

Table 19.13 Growth Industries Statement of Cash Flows ($ thousands)

Comparability Problems
Accounting Differences Inventory Valuation Depreciation Inflation and Interest Expense Fair Value Accounting Quality of Earnings International Accounting Conventions Bahattin Buyuksahin, JHU Investment

International Accounting Differences
Reserves – many other countries allow more flexibility in use of reserves Depreciation – US allows separate tax and reporting presentations Intangibles – treatment varies widely Bahattin Buyuksahin, JHU Investment

Figure 19.2 Adjusted Versus Reported Price-Earnings Ratios

The Graham Technique Careful analysis of a firm’s financial statements could turn up bargain stocks Purchase common stocks at less then their working-capital value Give no weight to plant or other fixed assets Deduct all liabilities in full from assets Bahattin Buyuksahin, JHU Investment

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