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Macroeconomic
and Industry Analysis
Chapter 17-19
McGraw-Hill/Irwin
Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
Fundamental Analysis
Approach to Fundamental Analysis:
Domestic and global economic analysis
Industry analysis
Company analysis
Why use the top-down approach?
17-2
Global Economic Considerations
Performance in countries and regions is
highly variable.
Political risk
Exchange rate risk
Sales
Profits
Stock returns
17-3
Key Economic Variables
Gross domestic product
Unemployment rates
Interest rates & inflation
International measures
Consumer sentiment
17-4
Domestic Economic Policy
Fiscal Policy - government spending and
taxing actions.
Direct policy
Slowly implemented
Monetary Policy - manipulation of the money
supply to influence economic activity.
Initial & feedback effects
Tools of monetary policy
Open market operations
Discount rate
Reserve requirements
17-5
Shocks
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
17-6
Business Cycles
Business Cycle
Peak
Trough
Industry relationship to business cycles
Cyclical
Defensive
17-7
Cyclical Indicators
Leading Indicators
tend to rise and fall in advance of the economy.
Avg. weekly hours of production workers
Stock Prices
Coincident Indicators
tend to change directly with the economy.
Industrial production
Manufacturing and trade sales
Lagging Indicators
tend to follow the lag economic performance.
Ratio of trade inventories to sales
Ratio of consumer installment credit outstanding to
personal income
17-8
Industry Analysis
Sensitivity to business cycles
Sensitivity of earnings to business cycles
depends on:
Sensitivity of sales of the firm’s product to the
business cycles
Operating leverage
Financial leverage
Industry life cycles
Stage
Sales Growth
Start-up
Consolidation
Maturity
Relative Decline
Rapid & Increasing
Stable
Slowing
Minimal or Negative
17-9
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
17-10
Equity Valuation Models
Chapter 18
McGraw-Hill/Irwin
Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
Models of Equity Valuation
Basic Types of Models
Balance Sheet Models
Dividend Discount Models
Price/Earning Ratios
Estimating growth rates and opportunities
Intrinsic Value
Self assigned value or estimate derived from a variety of models
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
17-12
Dividend Discount Models: General Model

Dt
Vo  
t
t  1 (1  k )
V0 = Value of Stock
Dt = Dividend
k = required return
17-13
No Growth Model
D
Vo 
k
Stocks with earnings & dividends expected to be
constant (often preferred stock)
E1 = D1 = $5.00
k = .15
V0 = $5.00 / .15 = $33.33
17-14
Constant Growth Model
Do (1  g )
Vo 
kg
g = constant perpetual growth rate
E1 = $5.00 b = 40%
k = 15%
(1-b) = 60% D1 = $3.00 g = 8%
V0 = 3.00 / (.15 - .08) = $42.86
17-15
Estimating Dividend Growth Rates
g  ROE  b
g = growth rate in dividends
ROE = Return on Equity for the firm
b = plowback or retention percentage rate
(1- dividend payout percentage rate)
17-16
Specified Holding Period Model
P
D
D
D

... 
V 
(1 k ) (1 k )
(1 k )
1
0
N
2
1
2
N
N
PN = the expected sales price for the stock at
time N
N = the specified number of years the stock is
expected to be held
17-17
Growth & No Growth Components of Value
E1
Vo 
 PVGO
k
Do (1  g )
E1
PVGO 

(k  g)
k
PVGO = Present Value of Growth
Opportunities
E1 = Earnings Per Share for period 1
17-18
Partitioning Value: Example
ROE = 20% d = 60% b = 40%
E1 = $5.00 D1 = $3.00 k = 15%
g = .20 x .40 = .08 or 8%
17-19
Partitioning Value: Example
3
Vo 
 $42.86
(.15.08)
5
NGVo 
 $33.33
.15
PVGO  $42.86  $33.33  $9.52
Vo = value with growth
NGVo = no growth component value
PVGO = Present Value of Growth Opportunities
17-20
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
17-21
P/E Ratio: No Expected Growth
E1
P0 
k
P0
1

E1
k
E1 - expected earnings for next year
E1 is equal to D1 under no growth
k - required rate of return
17-22
P/E Ratio with Constant Growth
D1
E1(1  b)
P0 

k  g k  (b  ROE )
P0
1 b

E1 k  (b  ROE )
b = retention ratio
ROE = Return on Equity
17-23
Numerical Example: No Growth
E0 = $2.50
g=0
k = 12.5%
P0 = D/k = $2.50/.125 = $20.00
PE = 1/k = 1/.125 = 8
17-24
Numerical Example with 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/(.125-.09) = $31.14
PE = 31.14/2.73 = 11.4
PE = (1 - .60) / (.125 - .09) = 11.4
17-25
Pitfalls in P/E Analysis
Use of accounting earnings
Historical costs
May not reflect economic earnings
Reported earnings fluctuate around the
business cycle.
17-26
Other Valuation Ratios
Price-to-Book
Price-to-Cash Flow
Price-to-Sales
17-27
Inflation and Equity Valuation
Inflation has an impact on equity
valuations.
Historical costs underestimate
economic costs.
Empirical research shows that inflation
has an adverse effect on equity values.
Research shows that real rates of return
are lower with high rates of inflation.
17-28
Lower Equity Values with Inflation
Shocks cause expectation of lower
earnings by market participants.
Returns are viewed as being riskier with
higher rates of inflation.
Real dividends are lower because of
taxes.
17-29
Financial Statement Analysis
Chapter 19
McGraw-Hill/Irwin
Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
Overview
Purpose
Tools Used
Statements
Ratio Analysis
Limitations
17-31
Financial Statements
Balance Sheet
Common Sized
Trend or Indexed
Income Statement
Common Sized
Trend or Indexed
Statement of Cash Flows
17-32
Ratio Analysis
Purpose of Ratio Analysis
Uses
Trend analysis
Comparative analysis
Combination
Use by External Analysts
Important information for investment community
Important for credit markets
17-33
Type of Financial Ratios
Liquidity Ratios
Activity or Mgmt Efficiency Ratios
Leverage Ratios
Profitability Ratios
Market Price Ratios
17-34
Liquidity Ratios
Current Ratio
Current Assets
Current Liabilities
Quick Ratio
Current Assets - Inventory
Current Liabilities
17-35
Activity or Management Efficiency Ratios
Inventory Turnover
Sales or Cost of Goods Sold
Inventory
Total Asset Turnover
Sales
Total Assets
17-36
Activity or Management Efficiency Ratios
Average Collection Period
Accounts Receivable
Sales Per Day
Days to Sell Inventory
Inventory
Sales Per Day
17-37
Leverage Ratios
Times Interest Earned
Earnings Before Int. & Taxes
Interest Expense
Fixed Charge Coverage Ratios
Lease Payments
Principal Repayments
Preferred Dividends
17-38
Leverage Ratios
Debt to Assets
Long Term Debt
Assets
Debt to Equity
Long Term Debt
Shareholders Equity
17-39
Profitability Ratios
Net Profit Margin %
Net Income
Sales
Return on Assets
Net Income
Total Assets
17-40
Profitability Ratios
Return on Equity
Net Income
Common Equity
Operating Margin After Depr.
Operating Profit
Sales
17-41
Market Price Ratios
Price to Earnings
Market Price of Stock
Earnings
Market-to-Book-Value
Market Price of Stock
Book Value Per Share
17-42
Decomposition of ROE
ROE =
Net Profit
x
Pretax Profit
Burden
x
EBIT
(1)
Tax
Pretax Profit
x
x
(2)
Interest
Burden
x
EBIT
Sales
(3)
x
x
Sales
Assets
x
Assets
Equity
(4) x (5)
x Margin x Turnover x Leverage
17-43
Economic Value Added
Difference between return on assets
(ROA) and the opportunity cost of
capital (k)
EVA = above difference time the
invested capital
EVA can be positive or negative for
firms that have positive earnings
17-44
Comparability Problems
Accounting Differences
Inventory Valuation
Depreciation
Inflation
International Accounting Conventions
Reserves –more or less flexibility allowed in
use of reserves.
Depreciation –separate tax and reporting
presentations may be allowed.
Intangibles – treatment varies widely.
17-45