Download Chapter 14

Lecture Presentation Software
to accompany
Investment Analysis and
Portfolio Management
Seventh Edition
by
Frank K. Reilly & Keith C. Brown
Chapter 14
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?
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?
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?
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?
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?
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?
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?
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?
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
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?
What Do We Learn
From Industry Analysis?
• Do firms within an industry show consistent
performance over time?
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?
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?
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
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
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
The Business Cycle and Industry
Sectors
• Economic Variables and Different Industries
–
–
–
–
Inflation
Interest Rates
International Economics
Consumer Sentiment
The Stock Market and
the Business Cycle
Exhibit 14.2
The Stock Market and
the Business Cycle
Exhibit 14.2
peak
trough
The Stock Market and
the Business Cycle
Basic
Industries
Excel
Consumer
Durables
Excel
Financial
Stocks Excel
trough
peak
Capital
Goods Excel
Exhibit 14.2
Consumer
Staples Excel
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
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
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
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
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
D1
Pi 
kg
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
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
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
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
Industry Valuation Using the Free
Cash Flow to Equity (FCFE)
Model
• The Constant Growth FCFE Model
FCFE1
V
kg
• The Two-Stage Growth FCFE Model
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
Industry Profit Margin Forecast
• Industry’s operating profit margin
(EBITDA / Sales)
– Depreciation expense
– interest expense
– tax rate
Industry Profit Margin Forecast
Industry’s operating profit margin
(EBITDA / Sales)
• Regression analysis
• Time series analysis
• Long-term consideration including competitive
structure
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
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
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)
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
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
•
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)
Other Relative Valuation Ratios
• Price-to-book value ratios (P/BV)
• Price-to-cash flow ratios (P/CF)
• Price-to-sales ratios (P/S)
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?
The Internet
Investments Online
www.lf.com
www.drugstorenews.com
www.studentcenter.com
www.nacds.org
www.nwda.org
End of Chapter 14
–Industry Analysis
Future topics
Chapter 15
Company Analysis and Stock Selection
• Value
• Growth
• Strategies