Investments: Analysis and Behavior

Chapter 9 - Business Environment

Learning Objectives

Know the major forces driving economic growth Define the economic environment Identify industries /sectors Learn the impact of regulation Analyze the level of corporate governance in a firm

Current Events Article

Title: Consumer Sentiment Dips to Lowest Since November

Author: Caroline ValetkevitchSource: ReutersLink:

http://www.reuters.com/article/idUSTRE69S2LA20101029?loomia_ow=t0:s0:a49:g43:r3:c0.200000:b38946892:z0

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Fundamental Analysis

Top-down approach– Economy aspects

• Industry aspects Firm specific

» Accounting - Recording, reporting and analysis of financial transactions of a business

» Valuation: value (bargains) vs. growth (without regard for money) firms

Dimensions of the Economy As the economy goes, so goes the businesses and

their stock(s)… Macroeconomic Environment

– Aggregate Economic Activity • Gross Domestic Product ($14,730.2 Billion)

The total value of all goods and services produced by all people within the boundaries of a country during a one-year period

• Interest rates (0.25 percent)• Consumer spending and consumer income

• Employment (9.2% unemployment rate)

Microeconomic Environment – Industry, Firm, Plant, or Product Level

• Industry specific regulation• Material prices

Forces Driving the Economy

1) Demographics– Baby boom

generation• Born 1946

through 1964

Figure 9.1 U.S. 2007 Population Distribution

0

5,000

10,000

15,000

20,000

25,000

< 5 5 to 9 10 to 14 15 to 19 20 to 24 25 to 29 30 to 34 35 to 39 40 to 44 45 to 49 50 to 54 55 to 59 60 to 64 65 to 69 70 to 74 75 to 79 80 to 84 > 84

Age (in years)

Po

pu

lati

on

in

Ag

e G

rou

p (

in t

ho

us

an

ds

)

Baby Boom Generation

Significant impact on society:

• spending

• saving

• working/retirement

• housing

Figure 9.2 A Changing Age Distribution

0%

2%

4%

6%

8%

10%

12%

< 5 5 to 9 10 to 14 15 to 19 20 to 24 25 to 29 30 to 34 35 to 39 40 to 44 45 to 49 50 to 54 55 to 59 60 to 64 65 to 69 70 to 74 >75

Age Group (in years)

Pe

rce

nt

of

Po

pu

lati

on

1950

2030

2) Productivity– The ability to produce more products and services with the

same number of people.

– When productivity growth is robust, the standard of living increases.

– Gains are often made from advances in technology• Computers, Internet, etc. Figure 9.3 Actual and Trend in Labor Productivity

50

70

90

110

130

150

19

60

19

65

19

70

19

75

19

80

19

85

19

90

19

95

20

00

20

05

Source: US Bureau of Labor Statistics

Trend = 2.51% per year

Actual

Trend = 1.28% per year

Trend = 2.23% per yearIndex, 1992 = 100

3) International Trade– Imports

– Exports

Balance of trade• The total value of a nation’s exports minus the total value of its imports over some period of time

Trade deficit• A negative (unfavorable) balance of trade—imports exceed exports in value

Balance of payments• The total flow of money into a country minus the total flow of money out of that country over a period of time

U.S. International Trade in Goods

Source: U.S. Department of Commerce, International Trade Administration, U.S. Bureau of Economic Analysis, http://bea.gov/international/bp_web/simple.cfm?anon=78260&table_id=1&area_id=3, accessed September 18, 2008.

Value of U.S. Merchandise Exports and Imports

Source: U.S. Department of Commerce, International Trade Administration, http://www.census.gov/foreign-trade/statistics/highlights/top/top0712.html, accessed September 22, 2008.

Business Cycles Pattern of economic recession and expansion

– Periods of economic expansion are followed by periods of contractions

Recession is a sustained period of generally declining economic activity (GDP)– Higher unemployment

– Restricted credit

– Reduced output

Depression– Devastating recession

Economic Indicators

Inflation rate– An economic statistic that tracks the increase in prices of goods and

services over a period of time; usually calculated on a monthly or annual basis

National income– The total income earned by various segments of the population, including

employees, self-employed individuals, corporations, and other type of income

New housing starts– The total number of new homes started during a specific time period.

Unemployment rate– The percentage of a nation’s labor force unemployed at any time

Competitive Environment Industry’s market structure

– Number and size of competitors

– Conditions of entry and exit

– Monopoly

– Oligopoly

Competitive advantage– Better

– Cheaper

– Faster

http://www.forbes.com/lists/2009/18/global-09_The-Global-2000_Sales.html

Michael Porter’s Five Forces

Rivalry among existing competitors Threat of new entrants Pressure from substitute products Bargaining power of customers Bargaining power of suppliers

Legal EnvironmentRegulation

– All sectors of the US economy are regulated to some degree.

• OSHA, EPA, etc.

– Some industries have high regulation

• Banks, utilities, etc.

– Costs of regulation are very high

Antitrust Policy

Monopoly– A market (or industry) with only one seller

Government promotes competition– Reviews mergers for impact on competition

Corporate Governance

Principal-agent problem– Separation of ownership and control

• Stockholders own the firm with little control

• Managers control the firm with little ownership

Why should the managers (agents) care about stockholders? Corporate governance is the monitoring devices and incentives

in place to protect stockholders.

Executive Compensation

Aligning managerial incentives– Salary

• Fixed amount

– Bonus• Additional pay for meeting various accounting targets

– Incentive pay• Options, stock, restricted stock

– Benefits and Perks

http://money.cnn.com/2009/08/14/news/companies/highest_paid_ceos

Monitoring Executives

Board of Directors Active shareholders

– Institutional investors

Auditors Analysts Investment banks Credit rating agencies SEC

Ownership Structure

Corporate ownership– Stock

• The shares of ownership of a corporation

– Stockholder• A person who owns a corporation’s stock

– Closed corporation• A corporation whose stock is owned by relatively few people and is not sold to the

general public

– Open corporation• A corporation whose stock is bought and sold on security exchanges and can be

purchased by any individual

Inside equity– Shares held by top management.

Does high inside equity mean managers:– Are aligned with shareholders?– Are entrenched?

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Hierarchy of Corporate Structure

Stockholders exercise a great deal of influence through their right to elect the board of directors