Slide 1

CHAPTER 17 Macroeconomic and Industry Analysis

Slide 2

Fundamental Analysis Approach to Fundamental Analysis: Domestic and global economic analysis Industry analysis Company analysis Why use the top-down approach? FRAMEWORK OF ANALYSIS BAHATTIN BUYUKSAHIN, JHU INVESTMENT 2

Slide 3

Performance in countries and regions is highly variable Political risk Exchange rate risk Sales Profits Stock returns GLOBAL ECONOMIC CONSIDERATIONS BAHATTIN BUYUKSAHIN, JHU INVESTMENT 3

Slide 4

TABLE 17.1 ECONOMIC PERFORMANCE IN SELECTED EMERGING MARKETS BAHATTIN BUYUKSAHIN, JHU INVESTMENT 4

Slide 5

FIGURE 17.1 CHANGE IN REAL EXCHANGE RATE: U.S. DOLLAR VERSUS MAJOR CURRENCIES, 19992006 BAHATTIN BUYUKSAHIN, JHU INVESTMENT 5

Slide 6

Gross domestic product Unemployment rates Interest rates & inflation Budget deficit Consumer sentiment KEY ECONOMIC VARIABLES BAHATTIN BUYUKSAHIN, JHU INVESTMENT 6

Slide 7

FIGURE 17.2 S&P 500 INDEX VERSUS EARNINGS PER SHARE BAHATTIN BUYUKSAHIN, JHU INVESTMENT 7

Slide 8

Demand shock - an event that affects demand for goods and services in the economy DEMAND SHOCKS BAHATTIN BUYUKSAHIN, JHU INVESTMENT 8

Slide 9

Supply shock - an event that influences production capacity or production costs SUPPLY SHOCKS BAHATTIN BUYUKSAHIN, JHU INVESTMENT 9

Slide 10

FEDERAL GOVERNMENT POLICY Fiscal Policy: Demand-side management Tax rate cut Increases in government spending BAHATTIN BUYUKSAHIN, JHU INVESTMENT 10

Slide 11

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 11

Slide 12

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 12

Slide 13

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 13

Slide 14

FIGURE 17.3 CYCLICAL INDICATORS BAHATTIN BUYUKSAHIN, JHU INVESTMENT 14

Slide 15

Leading indicators tend to rise and fall in advance of the economy Examples: Avg. weekly hours of production workers Stock Prices LEADING INDICATORS BAHATTIN BUYUKSAHIN, JHU INVESTMENT 15

Slide 16

TABLE 17.2 INDEXES OF ECONOMIC INDICATORS BAHATTIN BUYUKSAHIN, JHU INVESTMENT 16

Slide 17

Coincident Indicators - indicators that tend to change directly with the economy Examples: Industrial production Manufacturing and trade sales COINCIDENT INDICATORS BAHATTIN BUYUKSAHIN, JHU INVESTMENT 17

Slide 18

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 LAGGING INDICATORS BAHATTIN BUYUKSAHIN, JHU INVESTMENT 18

Slide 19

FIGURE 17.4 INDEXES OF LEADING, COINCIDENT, AND LAGGING INDICATORS BAHATTIN BUYUKSAHIN, JHU INVESTMENT 19

Slide 20

TABLE 17.3 ECONOMIC CALENDAR BAHATTIN BUYUKSAHIN, JHU INVESTMENT 20

Slide 21

INDUSTRY ANALYSIS Sensitivity to business cycles Factors affecting sensitivity of earnings to business cycles: Sensitivity of sales of the firms product to the business cycles Operating leverage Financial leverage Industry life cycles BAHATTIN BUYUKSAHIN, JHU INVESTMENT 21

Slide 22

FIGURE 17.5 ECONOMIC CALENDAR AT YAHOO! BAHATTIN BUYUKSAHIN, JHU INVESTMENT 22

Slide 23

TABLE 17.4 USEFUL ECONOMIC INDICATORS BAHATTIN BUYUKSAHIN, JHU INVESTMENT 23

Slide 24

FIGURE 17.6 RETURN ON EQUITY, 2007 BAHATTIN BUYUKSAHIN, JHU INVESTMENT 24

Slide 25

DEFINING AN INDUSTRY North American Industry Classification System, or NAICS codes Codes assigned to group firms for statistical analysis BAHATTIN BUYUKSAHIN, JHU INVESTMENT 25

Slide 26

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 26

Slide 27

FIGURE 17.8 ROE OF MAJOR BANKS BAHATTIN BUYUKSAHIN, JHU INVESTMENT 27

Slide 28

TABLE 17.5 EXAMPLES OF NAICS INDUSTRY CODES BAHATTIN BUYUKSAHIN, JHU INVESTMENT 28

Slide 29

FIGURE 17.9 INDUSTRY CYCLICALITY BAHATTIN BUYUKSAHIN, JHU INVESTMENT 29

Slide 30

TABLE 17.6 OPERATING LEVERAGE OF FIRMS A AND B THROUGHOUT THE BUSINESS CYCLE BAHATTIN BUYUKSAHIN, JHU INVESTMENT 30

Slide 31

FIGURE 17.10 A STYLIZED DEPICTION OF THE BUSINESS CYCLE BAHATTIN BUYUKSAHIN, JHU INVESTMENT 31

Slide 32

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 32

Slide 33

FIGURE 17.11 SECTOR ROTATION BAHATTIN BUYUKSAHIN, JHU INVESTMENT 33

Slide 34

StageSales Growth Start-upRapid & Increasing ConsolidationStable MaturitySlowing Relative DeclineMinimal or Negative INDUSTRY LIFE CYCLES BAHATTIN BUYUKSAHIN, JHU INVESTMENT 34

Slide 35

FIGURE 17.12 THE INDUSTRY LIFE CYCLE BAHATTIN BUYUKSAHIN, JHU INVESTMENT 35

Slide 36

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 36

Slide 37

CHAPTER 18 Equity Valuation Models

Slide 38

Balance Sheet Models Book Value Dividend Discount Models Price/Earning Ratios MODELS OF EQUITY VALUATION BAHATTIN BUYUKSAHIN, JHU INVESTMENT 38

Slide 39

TABLE 18.1 FINANCIAL HIGHLIGHTS FOR MICROSOFT CORPORATION, OCTOBER 25, 2007 BAHATTIN BUYUKSAHIN, JHU INVESTMENT 39

Slide 40

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 40

Slide 41

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 41

Slide 42

REQUIRED RETURN CAPM gave us required return: If the stock is priced correctly Required return should equal expected return BAHATTIN BUYUKSAHIN, JHU INVESTMENT 42

Slide 43

Intrinsic Value 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 INTRINSIC VALUE AND MARKET PRICE BAHATTIN BUYUKSAHIN, JHU INVESTMENT 43

Slide 44

P H = the expected sales price for the stock at time H H = the specified number of years the stock is expected to be held SPECIFIED HOLDING PERIOD BAHATTIN BUYUKSAHIN, JHU INVESTMENT 44

Slide 45

V 0 = Value of Stock D t = Dividend k = required return DIVIDEND DISCOUNT MODELS: GENERAL MODEL BAHATTIN BUYUKSAHIN, JHU INVESTMENT 45

Slide 46

Stocks that have earnings and dividends that are expected to remain constant Preferred Stock NO GROWTH MODEL BAHATTIN BUYUKSAHIN, JHU INVESTMENT 46

Slide 47

E 1 = D 1 = $5.00 k =.15 V 0 = $5.00 /.15 = $33.33 NO GROWTH MODEL: EXAMPLE BAHATTIN BUYUKSAHIN, JHU INVESTMENT 47

Slide 48

g = constant perpetual growth rate CONSTANT GROWTH MODEL BAHATTIN BUYUKSAHIN, JHU INVESTMENT 48

Slide 49

E 1 = $5.00b = 40% k = 15% (1-b) = 60%D 1 = $3.00 g = 8% V 0 = 3.00 / (.15 -.08) = $42.86 CONSTANT GROWTH MODEL: EXAMPLE BAHATTIN BUYUKSAHIN, JHU INVESTMENT 49

Slide 50

g = growth rate in dividends ROE = Return on Equity for the firm b = plowback or retention percentage rate (1- dividend payout percentage rate) ESTIMATING DIVIDEND GROWTH RATES BAHATTIN BUYUKSAHIN, JHU INVESTMENT 50

Slide 51

FIGURE 18.1 DIVIDEND GROWTH FOR TWO EARNINGS REINVESTMENT POLICIES BAHATTIN BUYUKSAHIN, JHU INVESTMENT 51

Slide 52

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 52

Slide 53

PRESENT VALUE OF GROWTH OPPORTUNITIES CONTINUED Price = No-growth value per share + PVGO (present value of growth opportunities) BAHATTIN BUYUKSAHIN, JHU INVESTMENT 53

Slide 54

ROE = 20% d = 60% b = 40% E 1 = $5.00 D 1 = $3.00 k = 15% g =.20 x.40 =.08 or 8% PARTITIONING VALUE: EXAMPLE BAHATTIN BUYUKSAHIN, JHU INVESTMENT 54

Slide 55

V o = value with growth NGV o = no growth component value PVGO = Present Value of Growth Opportunities Partitioning Value: Example Continued BAHATTIN BUYUKSAHIN, JHU INVESTMENT 55

Slide 56

LIFE CYCLES AND MULTISTAGE GROWTH MODELS g 1 = first growth rate g 2 = second growth rate T = number of periods of growth at g 1 BAHATTIN BUYUKSAHIN, JHU INVESTMENT 56

Slide 57

MULTISTAGE GROWTH RATE MODEL: EXAMPLE D 0 = $2.00 g 1 = 20% g 2 = 5% k = 15% T = 3 D 1 = 2.40 D 2 = 2.88 D 3 = 3.46 D 4 = 3.63 V 0 = D 1 /(1.15) + D 2 /(1.15) 2 + D 3 /(1.15) 3 + D 4 / (.15 -.05) ( (1.15) 3 V 0 = 2.09 + 2.18 + 2.27 + 23.86 = $30.40 BAHATTIN BUYUKSAHIN, JHU INVESTMENT 57

Slide 58

TABLE 18.2 FINANCIAL RATIOS IN TWO INDUSTRIES BAHATTIN BUYUKSAHIN, JHU INVESTMENT 58

Slide 59

FIGURE 18.2 VALUE LINE INVESTMENT SURVEY REPORT ON HONDA MOTOR CO. BAHATTIN BUYUKSAHIN, JHU INVESTMENT 59

Slide 60

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 PRICE EARNINGS RATIOS BAHATTIN BUYUKSAHIN, JHU INVESTMENT 60

Slide 61

E 1 - expected earnings for next year E 1 is equal to D 1 under no growth k - required rate of return P/E RATIO: NO EXPECTED GROWTH BAHATTIN BUYUKSAHIN, JHU INVESTMENT 61

Slide 62

b = retention ratio ROE = Return on Equity P/E RATIO: CONSTANT GROWTH BAHATTIN BUYUKSAHIN, JHU INVESTMENT 62

Slide 63

E 0 = $2.50 g = 0 k = 12.5% P 0 = D/k = $2.50/.125 = $20.00 PE = 1/k = 1/.125 = 8 NUMERICAL EXAMPLE: NO GROWTH BAHATTIN BUYUKSAHIN, JHU INVESTMENT 63

Slide 64

b = 60% ROE = 15% (1-b) = 40% E 1 = $2.50 (1 + (.6)(.15)) = $2.73 D 1 = $2.73 (1-.6) = $1.09 k = 12.5% g = 9% P 0 = 1.09/(.125-.09) = $31.14 PE = 31.14/2.73 = 11.4 PE = (1 -.60) / (.125 -.09) = 11.4 NUMERICAL EXAMPLE: GROWTH BAHATTIN BUYUKSAHIN, JHU INVESTMENT 64

Slide 65

TABLE 18.3 EFFECT OF ROE AND PLOWBACK ON GROWTH AND THE P/E RATIO BAHATTIN BUYUKSAHIN, JHU INVESTMENT 65

Slide 66

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 66

Slide 67

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 67

Slide 68

FIGURE 18.3 P/E RATIOS OF THE S&P 500 INDEX AND INFLATION BAHATTIN BUYUKSAHIN, JHU INVESTMENT 68

Slide 69

FIGURE 18.4 EARNINGS GROWTH FOR TWO COMPANIES BAHATTIN BUYUKSAHIN, JHU INVESTMENT 69

Slide 70

FIGURE 18.5 PRICE-EARNINGS RATIOS BAHATTIN BUYUKSAHIN, JHU INVESTMENT 70

Slide 71

FIGURE 18.6 P/E RATIOS FOR DIFFERENT INDUSTRIES, 2007 BAHATTIN BUYUKSAHIN, JHU INVESTMENT 71

Slide 72

OTHER COMPARATIVE VALUE APPROACHES Price-to-book ratio Price-to-cash-flow ratio Price-to-sales ratio BAHATTIN BUYUKSAHIN, JHU INVESTMENT 72

Slide 73

FIGURE 18.7 MARKET VALUATION STATISTICS BAHATTIN BUYUKSAHIN, JHU INVESTMENT 73

Slide 74

FREE CASH FLOW APPROACH Discount the free cash flow for the firm Discount rate is the firms cost of capital Components of free cash flow After tax EBIT Depreciation Capital expenditures Increase in net working capital BAHATTIN BUYUKSAHIN, JHU INVESTMENT 74

Slide 75

COMPARING THE VALUATION MODELS In practice Values from these models may differ Analysts are always forced to make simplifying assumptions BAHATTIN BUYUKSAHIN, JHU INVESTMENT 75

Slide 76

THE AGGREGATE STOCK MARKET Explaining Past Behavior Forecasting the Stock Market BAHATTIN BUYUKSAHIN, JHU INVESTMENT 76

Slide 77

FIGURE 18.8 EARNINGS YIELD OF S&P 500 VERSUS 10-YEAR TREASURY- BOND YIELD BAHATTIN BUYUKSAHIN, JHU INVESTMENT 77

Slide 78

TABLE 18.4 S&P 500 PRICE FORECASTS UNDER VARIOUS SCENARIOS BAHATTIN BUYUKSAHIN, JHU INVESTMENT 78

Slide 79

CHAPTER 19 Financial Statement Analysis

Slide 80

Purpose Tools Used Statement analysis Ratio analysis Limitations OVERVIEW BAHATTIN BUYUKSAHIN, JHU INVESTMENT 80

Slide 81

Balance Sheet Common Sized Trend or Indexed Income Statement Common Sized Trend or Indexed Statement of Cash Flows FINANCIAL STATEMENTS BAHATTIN BUYUKSAHIN, JHU INVESTMENT 81

Slide 82

TABLE 19.1 CONSOLIDATED STATEMENT OF INCOME FOR HEWLETT-PACKARD, 2006 BAHATTIN BUYUKSAHIN, JHU INVESTMENT 82

Slide 83

TABLE 19.2 CONSOLIDATED BALANCE SHEET FOR HEWLETT-PACKARD, 2006 BAHATTIN BUYUKSAHIN, JHU INVESTMENT 83

Slide 84

TABLE 19.3 STATEMENT OF CASH FLOWS FOR HEWLETT-PACKARD, 2006 BAHATTIN BUYUKSAHIN, JHU INVESTMENT 84

Slide 85

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 BAHATTIN BUYUKSAHIN, JHU INVESTMENT 85

Slide 86

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 86

Slide 87

TABLE 19.4 NODETTS PROFITABILITY OVER THE BUSINESS CYCLE BAHATTIN BUYUKSAHIN, JHU INVESTMENT 87

Slide 88

TABLE 19.5 IMPACT OF FINANCIAL LEVERAGE ON ROE BAHATTIN BUYUKSAHIN, JHU INVESTMENT 88

Slide 89

ROE, ROA AND LEVERAGE BAHATTIN BUYUKSAHIN, JHU INVESTMENT 89

Slide 90

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 BAHATTIN BUYUKSAHIN, JHU INVESTMENT 90

Slide 91

TABLE 19.6 RATIO DECOMPOSITION ANALYSIS FOR NODETT AND SOMDETT BAHATTIN BUYUKSAHIN, JHU INVESTMENT 91

Slide 92

TABLE 19.7 DIFFERENCES BETWEEN PROFIT MARGIN AND ASSET TURNOVER ACROSS INDUSTRIES BAHATTIN BUYUKSAHIN, JHU INVESTMENT 92

Slide 93

TABLE 19.8 GROWTH INDUSTRIES FINANCIAL STATEMENTS, 2004 2007 ($ THOUSANDS) BAHATTIN BUYUKSAHIN, JHU INVESTMENT 93

Slide 94

TABLE 19.9 SUMMARY OF KEY FINANCIAL RATIOS: LEVERAGE, ASSET UTILIZATION, LIQUIDITY, PROFITABILITY AND MARKET PRICE BAHATTIN BUYUKSAHIN, JHU INVESTMENT 94

Slide 95

FIGURE 19.1 DUPONT DECOMPOSITION FOR HEWLETT-PACKARD BAHATTIN BUYUKSAHIN, JHU INVESTMENT 95

Slide 96

TABLE 19.10 FINANCIAL RATIOS FOR MAJOR INDUSTRY GROUPS BAHATTIN BUYUKSAHIN, JHU INVESTMENT 96

Slide 97

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 97

Slide 98

TABLE 19.11 ECONOMIC VALUE ADDED, 2007 BAHATTIN BUYUKSAHIN, JHU INVESTMENT 98

Slide 99

TABLE 19.12 KEY FINANCIAL RATIOS OF GROWTH INDUSTRIES, INC BAHATTIN BUYUKSAHIN, JHU INVESTMENT 99

Slide 100

TABLE 19.13 GROWTH INDUSTRIES STATEMENT OF CASH FLOWS ($ THOUSANDS) BAHATTIN BUYUKSAHIN, JHU INVESTMENT 100

Slide 101

Accounting Differences Inventory Valuation Depreciation Inflation and Interest Expense Fair Value Accounting Quality of Earnings International Accounting Conventions COMPARABILITY PROBLEMS BAHATTIN BUYUKSAHIN, JHU INVESTMENT 101

Slide 102

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 102

Slide 103

FIGURE 19.2 ADJUSTED VERSUS REPORTED PRICE-EARNINGS RATIOS BAHATTIN BUYUKSAHIN, JHU INVESTMENT 103

Slide 104

THE GRAHAM TECHNIQUE Careful analysis of a firms 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 104