1. Macroeconomic and Industry Analysis 1

2.  Fundamental Analysis  Approach to Fundamental Analysis ◦ Domestic and global economic analysis ◦ Industry analysis ◦ Company analysis  Why use the top-down approach

3.  Performance in countries and regions is highly variable  Political risk  Exchange rate risk

4. Table 17.1 Economic Performance in Selected Emerging Markets

5.  Considerable variation in performance across countries  expanding economies: more chance to succeed  contracting economies: less chance to succeed  Based on these performance, form expectation for your investment  economies growing  economies slowing down

7. Figure 17.1 Change in Real Exchange Rate: U.S. Dollar versus Major Currencies, 1999–2006 US investors: 2009: invest $1000 in Japan, exchange rate 1USD = 100 Yen, $1000 is worth 100,000 Yen In 2010: 1 USD = 110 Yen, 100,000 Yen = 909 USD Lose $91

8.  Gross domestic product ◦ Market value of goods and services produced over a period of time  Unemployment rates ◦ The ratio of number of people classified as unemployed to the total labor force  Interest rates & inflation ◦ inflation is the rate at which the general level of prices is rising. ◦ High inflation is associated with overheated economy ◦ Trade-off between inflation and unemployment  Budget Deficits ◦ Government spending > government revenue  Consumer sentiment ◦ consumers’ optimism and pessimism about the economy

10.  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

11.  Fiscal Policy - government spending and taxing actions ◦ Increase spending: increase demand ◦ tax increase: reduce demand ◦ Net impact:  budget deficit  budget surplus

12.  Monetary Policy - manipulation of the money supply to influence economic activity  Tools of monetary policy ◦ Open market operations ◦ Discount rate ◦ Reserve requirements  If government wants to tighten money supply, what should it do?

14.  Business Cycle ◦ Peak ◦ Trough  Industry relationship to business cycles ◦ Cyclical  above average sensitivity to states of economy ◦ Defensive  below sensitivity to states of economy

15.  At trough, right before recovery, one would expect cyclical industries to outperform others ◦ (economy increases (decreases) by 1%, the industry increases (decreases) by > 1%) ◦ Example: durable goods: auto, washing machine, financial industries ◦ Cyclical firms: betas > 1 or < 1, high or low betas?  Economy enters recession: ◦ cyclical or defensive ◦ example: food, public utilities, pharmaceutical ◦ Low or high betas? ◦ performance is stable, unaffected by market conditions

16. Figure 17.3 Cyclical Indicators

17.  Leading indicators tend to rise and fall in advance of the economy  Examples: ◦ Avg. weekly hours of production workers ◦ Stock Prices Leading Indicators

18. Table 17.2 Indexes of Economic Indicators

19.  Coincident Indicators - indicators that tend to change directly with the economy  Examples: ◦ Industrial production ◦ Manufacturing and trade sales Coincident Indicators

20.  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 ◦ unemployment Lagging Indicators

21. Figure 17.4 Indexes of Leading, Coincident, and Lagging Indicators

22. Table 17.3 Economic Calendar

23. Figure 17.5 Economic Calendar at Yahoo!

24. Table 17.4 Useful Economic Indicators

25. Figure 17.6 Return on Equity, 2007

26. Defining an Industry  North American Industry Classification System, or NAICS codes ◦ Codes assigned to group firms for statistical analysis

27. Figure 17.7 Industry Stock Price Performance as Measured by Rate of Return on Dow Jones Sector iShares, January-October 2007

28. Figure 17.8 ROE of Major Banks

29. Table 17.5 Examples of NAICS Industry Codes

30.  Sensitivity to business cycles  Sector Rotation  Industry life cycles

31.  Factors affecting sensitivity of earnings to business cycles ◦ Sensitivity of sales of the firm’s product to the business cycles ◦ Operating leverage ◦ Financial leverage

32. Figure 17.9 Industry Cyclicality

33.  Operating leverage = fixed cost / variable cost  If operating leverage is high ◦ fixed cost dominates variable cost ◦ When economy changes, cost do not move enough to offset change in sale  economy goes down, sale decreases, variable cost also decreases, but is dominated by fixed cost, total cost is quite stable, therefore, earning goes down more than the economy  Sale increases, variable cost increases, but still dominated by fixed cost, total cost is quite stable, earning goes up more than economy  Earning is very sensitive to economy  If operating leverage is low: variable cost >> fixed cost ◦ sale goes down, total cost goes down ◦ sale goes up, total cost goes up ◦ earning is stable

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

35.  Use of borrowing  Similar to fixed cost  High financial leverage, earning is more sensitive to economy  Low financial leverage, earning is more stable

36. Figure 17.10 A Stylized Depiction of the Business Cycle

37. 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

39. Figure 17.11 Sector Rotation

40. StageSales Growth Start-upRapid & Increasing ConsolidationStable MaturitySlowing Relative DeclineMinimal or Negative

42.  Example: VCR  Start-up: new, so sale and earnings go up rapidly  Consolidation stage: ◦ product is established, more firms enter, growth rate is stable, and higher than economy  Maturity stage ◦ product reach full potential use by consumers ◦ market is very competitive ◦ pay more dividends ◦ less on reinvestment  Relative decline ◦ new better products come in, e.g., DVD ◦ Substitute for old products

43. 43 FINANCIAL STATEMENT ANALYSIS

44. Objectives: Use a firm’s income statement, balance sheet, and statement of cash flows to calculate standard financial ratios. Calculate the impact of taxes and leverage on a firm’s return on equity using ratio decomposition analysis. Measure a firm’s operating efficiency Identify likely sources of biases in accounting data.

45.  Balance Sheet ◦ Common Sized ◦ Trend or Indexed  Income Statement ◦ Common Sized ◦ Trend or Indexed  Statement of Cash Flows Financial Statements

46.  Firm’s revenues and expenses during a specific period  Typical format Sale - Operating expense COGS Depreciation Operating Income (EBIT) - Interest Earning before tax (EBT) - Tax Net Income (NI)

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

48.  A snapshot of firm’s assets and liability at a given point in time AssetLiabilities + Equity 1. Current Asset1. Current liabilities CashShort term debt Account receivableAccount payable InventoryNote payable 2. Fixed asset2. Long-term debt 3. Equity Common stock Retained earning Total assetsTotal liabilities + equity

49. Table 19.2 Consolidated Balance Sheet for Hewlett-Packard, 2006

50.  Net income: accounting profit  Cash flow: cash available on hand  Statement of cash flow: firm’s cash receipts and payments during a specific period

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

52. Accounting Versus Economic Earnings  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

53. 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

54. Table 19.4 Nodett’s Profitability over the Business Cycle

55. Table 19.5 Impact of Financial Leverage on ROE

56.  ROE=Net profit/Equity  g = ROE × b  To estimate g, need to estimate ROE  Past ROE might not be good estimator of future ROE  ROE is linked with ROA and affected by firm’s financial policies  Watch out financial leverage: ROA: Return on Assets=EBIT/Assets

57. ROE, ROA and Leverage

58. 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

59. An analyst applies the DuPont system of financial analysis to the following data for a company: Leverage ratio 2.2 Total asset turnover2.0 Net profit margin5.5% Dividend payout ratio31.8% What is the company’s return on equity?

60. Table 19.6 Ratio Decomposition Analysis for Nodett and Somdett

61. Table 19.7 Differences between Profit Margin and Asset Turnover across Industries

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

63. Table 19.9 Summary of Key Financial Ratios: Leverage, Asset Utilization, Liquidity, Profitability and Market Price

64. Figure 19.1 DuPont Decomposition for Hewlett-Packard

65. Table 19.10 Financial Ratios for Major Industry Groups

66.  Liquidity Ratios  Activity or Mgmt Efficiency Ratios  Leverage Ratios  Profitability Ratios  Market Price Ratios

68.  Current ratio = Current asset/ current liabilities 2005: current ratio = (60+30+90)/(36+87.3) = 1.46 200520062007 2007 industry average (IA) 1.461.170.972.0 ◦ Trend: decreasing ◦ poor standing relative to industry  Quick ratio = (current asset-inventory)/current liability 2005: quick ratio = (60+30)/(36+87.3) = 0.73 200520062007 2007 industry average (IA) 0.730.580.491.0 ◦ Trend: decreasing ◦ poor standing relative to industry

69.  Inventory turnover = COGS (excluding depreciation) / average inventory ◦ How fast firm can sell inventory ◦ 2005: inventory turnover = (55-15)/{(75+90)/2)}= 0.485 ◦ 200520062007IA 0.4850.4850.4850.5 ◦ Slower in selling inventory  total asset turnover = sale/average total asset ◦ 2005: TA turnover = 100/((300+360)/2) = 0.30 ◦ 200520062007IA 0.300.300.300.4

70.  Average collection period (days receivable) = average AR/sales per day ◦ average time between date of sale and date payment received ◦ 2005: {(25+30)/2}/(100/365) = 100.4 ◦ 200520062007IA 100.4100.4100.460  fixed asset turnover = sale/average of fixed asset ◦ 2005: 100/{(150+180)/2}=0.600 ◦ 200520062007IA 0.6060.6060.6060.7

71.  Total asset turnover of G.I. < industry average (0.3<0.4) ◦ fixed asset turnover < Industry average (0.60 < 0.7): inefficient in using fixed asset ◦ days receivable > industry average (100.4 > 60): receive cash longer than average, poor receivable procedure ◦ Inventory turnover < industry average (0.485<0.5): turn inventory into sale slower than average, poor inventory management

72.  Interest coverage (times interest earned) = EBIT/Interest expense  Leverage ratio: Assets/Equity = 1 + Debt/Equity  Debt ratio = debt/equity

73.  ROA = EBIT/(average total assets)  ROE = NI/(average total equity)  Return on sale (profit margin) = EBIT/Sales

74.  Market-to-book =price per share/ book value per share ◦ Lower market-to-book stocks: safer stocks  Price-to-earning (P/E) = market price per share / EPS ◦ Low P/E, more bargain

75. Table 19.9 Summary of Key Financial Ratios: Leverage, Asset Utilization, Liquidity, Profitability and Market Price

76.  In her 2007 annual report to shareholders of Growth Industries, Inc., the president wrote “2007 was another successful year for GI: sale, assets, and operating income all continue to grow at 20%” Is she right? ◦ ROE has been declining steadily and below the I.A. ◦ Low and falling market-to-book and P/E: investors are less optimistic about firm’s future. ◦ ROA has not been declining implying ROE’s decrease is due to financial leverage ◦ Borrow more and more short-term debt to finance new investment and the interest on these short-term debt is very high  2007: coupon rate 8% on long-term debt, long-term interest expense = 8%*75 mil = 6 mil. Total interest paid = 34.391 mil, short-term interest expense = 28.391 (about 20% of total short-term debt). ROA on 2007 = 9.09% ◦ Firm’s cash flows decreases over time from 12.7 mil in 2005 to 6.725 mil in 2007 ◦ But firm’s investment in capital asset has been nearly doubles from 2005-2007. ROA < interest rate but firms keeps investing on capital assets ◦ That explains why ROE keeps going down, hence P/E and P/B ratios ◦ Currently low P/E, P/B ratios might represent a bargain here

78. Table 19.12 Key Financial Ratios of Growth Industries, Inc

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

80.  GAAP (Generally Accepted Accounting Principles) is not unique ◦ Inventory valuation: LIFO vs FIFO ◦ Depreciation: Straight line vs Accelerated  Quality of earnings affected by: ◦ Allowance of bad debt; nonrecurring items; stock option; revenue recognition; off-balance-sheet assets and liabilities  GAAP vs IAS (International Accounting Standards)

81.  Allowance for bad debts: ◦ When companies sell goods using credit, need to have allowance for bad debts. This is the estimate. Different companies have different estimates  Non-recurring items: ◦ Unusual income, does not happen regularly.  Reserves management: ◦ Different companies have different estimates of reserve for future investment  Stock options ◦ Companies use stock options as bonus therefore it should be reported as expenses and need to price the options  Revenue recognition  Off-balance sheet assets and liabilities

82. Figure 19.2 Adjusted Versus Reported Price-Earnings Ratios