Macroeconomic and Industry Analysis

1
Chapter 17

• MacroeconomicandIndustry Analysis

2
Framework of Analysis

• Fundamental Analysis
• Approach to Fundamental Analysis
• Domestic and global economic analysis
• Industry analysis
• Company analysis
• Why use the top-down approach?

3
Global Economic Considerations

• Performance in countries and regions is highly
  variable
• Political risk
• Exchange rate risk
• Sales
• Profits
• Stock returns

4
Key Economic Variables

• Gross domestic product
• Unemployment rates
• Interest rates inflation
• International measures
• Consumer sentiment

5
Federal Government Policy

• Fiscal Policy - government spending and taxing
  actions
• Direct policy
• Slowly implemented

6
Federal Government Policy (contd)

• 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

7
Inflation and Equity Valuation

• Inflation has an impact on equity valuations
• Historical costs underestimate economic costs
• Empirical research shows that (high) inflation
  has an adverse effect on equity values
• Research shows that real rates of return are
  lower with high rates of inflation

8
Potential Causes of 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
• ?

9
What Stock Market Data Tells Us About Inflation

• The last 30 years represent a period of high
  inflation compared to the last 200 years
• If a government spends more than it collects in
  taxes, inflation will usually result
• Inflation is measured through a consumers price
  index (CPI)
• As inflation increases interest rates rise
  leading to a decrease in bond prices

10
What Stock Market Data Tells Us About Inflation

• Some argue inflation is good for the stock market
  because corporations increase the selling price
  of their product and their costs do not rise
• This is a fallacy because
• Consumers resist price increases
• Corporations enter long-term contracts to sell
  products at a fixed price
• GAAP do not contain inflation adjustments for
  depreciation
• Thus depreciation cash flows are inadequate for
  equipment renewal during periods of inflation

11
What Stock Market Data Tells Us About Inflation
Real returns were below average during high
inflation periods.
Average real returns are negative during
extra-ordinary inflation periods.
Stock market returns were average during moderate
inflation.
12
Demand Shocks

• Demand shock - an event that affects demand for
  goods and services in the economy
• Tax rate cut
• Increases in government spending

13
Supply Shocks

• Supply shock - an event that influences
  production capacity or production costs
• Commodity price changes
• Educational level of economic participants

14
Business Cycles

• Business Cycle
• Peak
• Trough
• Industry relationship to business cycles
• Cyclical
• Defensive

15
NBER Cyclical Indicators Leading

• Leading Indicators - tend to rise and fall in
  advance of the economy
• Examples
• Avg. weekly hours of production workers
• Stock Prices

16
NBER Cyclical Indicators Coincident

• Coincident Indicators - indicators that tend to
  change directly with the economy
• Examples
• Industrial production
• Manufacturing and trade sales

17
NBER Cyclical Indicators Lagging

• 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

18
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

19
Industry Analysis

• Industries are usually defined by a single
  product
• Thus, all companies within an industry usually
  profit or lose in tandem
• Therefore, it is worthwhile to examine an
  industrys prospects before bothering to examine
  specific firms within an industry

20
Product Life Cycle
21
Industry Life Cycles

• Stage Sales Growth
• Start-up Rapid Increasing
• Consolidation Stable
• Maturity Slowing
• Relative Decline Minimal or Negative

22
Product Life Cycle

• Industrys life cycle determined by type of
  product
• Example Musical groups vs. Coca-Cola
• Coca-Cola has been in product maturation stage
  for over 100 years
• Life cycle model is important to many security
  analysts
• Must determine stage the industry, product or
  firm is in

23
Financial Analysis of an Industry

• Many different sources compile industry data
  useful to investors
• Standard Poors Corporation
• Moodys Investors Services
• Trade associations
• Government
• Standard Poors provides stock price indexes on
  numerous U.S. industries and also offers balance
  sheets, income statements, and financial ratios
  for
• 87 Industrial
• 13 Technology
• 4 Transportation
• 2 Utility
• 10 Financial

24
Background

• Global market
• US Market is 40 - 45 of all markets
• Improved access technology
• New instruments
• Emphasis for our investigation
• Risk assessment
• Diversification

25
Issues

• What are the risks involved in investment in
  foreign securities?
• How do you measure benchmark returns on foreign
  investments?
• Are there benefits to diversification in foreign
  securities?

26
Diversification Benefits

• Evidence shows international diversification is
  beneficial
• Possible to expand the efficient frontier above
  domestic only frontier
• Possible to reduce the systematic risk level
  below the domestic only level

27
Efficient Frontier with International
Diversification
28
Systematic Risk Level with International
Diversification
29
Risks in International Investing

• Political Risks
• Expropriation of assets
• Restrictions on foreign exchange
• Political instability

30
Risks in International Investing

• Foreign Exchange Risk
• Variation in return related to changes in the
  relative value of the domestic and foreign
  currency
• Total return investment return return on
  foreign exchange
• Not possible to completely hedge a foreign
  investment

31
Returns with FX

• Return in US is a function of two factors
• 1. Return in the foreign market
• 2. Return on the foreign exchange

32
Returns with FX

• (1 rUS) (1 rFM) (1 rFX)
• rUS return on the foreign investment in US
  Dollars
• rFM return on the foreign market in local
  currency
• rFX return on the foreign exchange

33
Return Example Dollar Appreciates

• Initial Investment 100,000
• Initial Exchange 2.00/ Pound Sterling
• Final Exchange2.10/ Pound Sterling
• Return in British Security 10
• Return in US Dollars
• (1 rUS) (1.10) (1.05) (1.155)
• rUS 15.5

34
Return Example Dollar Depreciates

• Initial Investment 100,000
• Initial Exchange 2/ Pound Sterling
• Final Exchange 1.85/ Pound Sterling
• Return in British Security 10
• Return in US Dollars
• (1 rUS) (1.10) (.9250) (1.0175)
• rUS 1.75

35
International Risk

• Why invest internationally?
• World growth life cycle
• Importance of country risk
• Understanding diversification
• Should all countries be investment targets?

36
International RiskInternational Investment
Rationale

• Standard reasons
• Performance (but non-U.S. hasnt done well)
• Diversification (misunderstood)

37
International Risk International Investment
Rationale

• When U.S. down, other markets likely down
• Hence, correlation higher (less beneficial) when
  U.S. market is down
• Critical to distinguish long-run and short-run

38
International Risk/Harvey International
Investment Rationale
10 Worst Months - U.S. Equity Returns From
January 1985-
Return
Oct 87 Aug 98 Aug 90 Sept 86 Nov 87
Jan 90 Aug 97 Jul 86 Sept 90 Jun 91
39
International Risk International Investment
Rationale
1990 has 3 of 10 worst months
Return
Performance in full year of 1990
40
International RiskUnderstanding Growth

• Emerging economies-gt high growth prospects
• Emerging economies much like start-up companies
• Do not want to exclude these opportunities

41
International Risk Understanding Growth
Real GDP growth
42
International Risk Country Risk
Political risk. International Country Risk Guide
43
International Risk Country Risk
Financial risk. International Country Risk Guide
44
International Risk Country Risk
Ratings predict inflation
45
International Risk Country Risk
Ratings correlated with wealth
46
International Risk Country Risk
Fit is as good as it gets - lower rating (higher
risk) commands higher expected returns. Even in
among US firms, our best model gets about 30
explanatory power.
47
International Risk Country Risk

September
48
International Risk Understanding Diversification

• Diversification much misunderstood
• Diversification really means protection when the
  U.S. economy is bad
• But that is not how it is measured
• Correlation tells us average movement of these
  markets in both good and bad times

49
International Risk Understanding Diversification
Correlations of World Returns and Developed
Markets
50
International Risk Understanding Diversification
Correlations of World Equity Returns and Emerging
Markets
51
International Risk Should All Countries Be
Investment Targets?

• Should you invest in all countries?
• No
• Given the risk of some countries, it is unlikely
  they can meet their target returns
• May be excessively costly to transact
• Human rights issue of investing in certain
  countries
• May give up some return performance in the
  long-run by following this strategy and add
  tracking error

52
International Risk Should All Countries Be
Investment Targets?

• Selection criteria
• Economic
• Tactical criteria

53
International Risk/Harvey Should All Countries
Be Investment Targets?

• Selection criteria
• Political
• Catastrophe risk
• Rule of law, for example, insider trading
  regulations (foreign portfolio investors at
  distinct disadvantage)
• Human rights factors

54
International Risk/Harvey Should All Countries
Be Investment Targets?

• Selection criteria
• Financial
• Liberalization of capital markets
• Credibility of liberalizations
• Reliability of institutions

55
International Risk Should All Countries Be
Investment Targets?
CalPERS Limited Exposure Countries
ITInsider Trading
Source Bhattacharya Daouk (1999)
56
International Risk Should All Countries Be
Investment Targets?
CalPERS Prohibited Countries
ITInsider Trading
Source Bhattacharya Daouk (1999)
57
International Risk Conclusions

• Reward and risk in finance maps into growth and
  business cycle volatility
• Portfolio and direct investment contingent on
  risk profile
• Finance and economics not the whole story - the
  strength of institutions/infrastructure critical
  to long-term prospects

58
Chapter 18

• Equity ValuationModels

59
Common Stock

• Stockholders are owners of the firm.
• Stockholders are residual claimants.
• Stockholders have the right to
• vote at company meetings
• dividends and other distributions
• sell their shares
• Stockholders benefit in two ways
• dividends
• capital gains
• Stock is issued by public corporations to finance
  investments.
• Stock is initially issued in the primary market
  (IPOs and secondary offerings).
• Stock is traded in the secondary market on
  organized exchanges.

60
Fundamental Stock Analysis Models of Equity
Valuation

• Basic Types of Models
• Balance Sheet Models
• Dividend Discount Models
• Price/Earning Ratios
• Estimating Growth Rates and Opportunities

61
Intrinsic Value and Market Price

• Intrinsic Value
• Self assigned Value
• Variety of models are used for estimation
• Market Price
• Consensus value of all potential traders
• Trading Signal
• IV gt MP Buy
• IV lt MP Sell or Short Sell
• IV MP Hold or Fairly Priced

62
Dividend Discount ModelsGeneral Model

• V0 Value of Stock
• Dt Dividend
• k required return

63
No Growth Model

• Stocks that have earnings and dividends that are
  expected to remain constant
• Preferred Stock

64
No Growth Model Example

• E1 D1 5.00
• k .15
• V0 5.00 / .15 33.33

65
The Constant Growth Formula

• Assumption Dividends grow at a constant rate g
  for ever
• Then
• Issues
• constant growth
• g lt re.
• Is this a real or a nominal calculation?

66
Constant Growth Model

• g constant perpetual growth rate
• Limitations of the model
• Applied only to companies that pay dividends
• Applied only to companies whose dividends are
  expected to grow at a constant rate forever
• g lt re.
• Is this a real or a nominal calculation?

67
At what rate and for how long can a firms
dividends grow?

• A firms dividends cannot grow at a rate higher
  than the nominal rate of growth of the economy
  forever
• In applying the model, the constant growth rate
  must be constrained to be less than or equal to
  the economys nominal growth rate
• Recall Nominal growth rate real growth rate
  inflation rate

68

• In the case of the US economy, the nominal growth
  rate in the 1990s was 5
• Slovenia, Croatia?
• Use a maximum rate of 5-6 in your calculations
• What if we forecast a companys dividends to grow
  at a rate higher than 5-6 for, lets say, the
  next five years?

69
In this case, the companys stock value is the
sum of two components

• PV of expected dividends (based on our forecasts)
  during the high dividend growth period
• PV of Terminal price
• Terminal price present value of all future
  dividends beyond the high dividend growth period

70
How do we derive the terminal price?

• Suppose we have a forecast of a firms dividends
  for the next 6 years (the high dividend growth
  period) and that the forecasted dividend per
  share for the sixth year is 3
• We may then assume that after the sixth year the
  firms dividends will be growing at a constant
  growth rate of 3 per year
• Our assumption about this rate could be based on
• The companys average dividend growth rate over
  the past few years
• Information about the companys future dividend
  policy
• OR USE EXIT MULTIPLES

71
Constant Growth Model Example

• E1 5.00 b 40 k 15
• (1-b) 60 D1 3.00 g 8
• V0 3.00 / (.15 - .08) 42.86

72
Estimating Dividend Growth Rates

• g growth rate in dividends
• ROE Return on Equity for the firm
• b plowback or retention percentage rate
• (1- dividend payout percentage rate)

73
Specified Holding Period Model

• PN the expected sales price for the stock at
  time N
• N the specified number of years the stock is
  expected to be held

74
Partitioning Value Growth and No Growth
Components

• PVGO Present Value of Growth Opportunities
• E1 Earnings Per Share for period 1

75
Partitioning Value Example

• ROE 20 d 60 b 40
• E1 5.00 D1 3.00 k 15
• g .20 x .40 .08 or 8

76
Partitioning Value Example
Vo value with growth NGVo no growth component
value PVGO Present Value of Growth Opportunities
77
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

78
P/E Ratio No Expected Growth

• E1 - expected earnings for next year
• E1 is equal to D1 under no growth
• k - required rate of return

79
P/E Ratio with Constant Growth

• b retention ratio
• ROE Return on Equity

80
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

81
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

82
Pitfalls in P/E Analysis

• Use of accounting earnings
• Historical costs
• May not reflect economic earnings
• Reported earnings fluctuate around the business
  cycle

83
Price/Book Value Ratio

• Book value per share
• (Total Assets Total Liabilities )? of
  outstanding common stock shares
• Determined by economic events and accounting
  conventions
• Compared to market value
• Determined by markets assessment of earning
  power
• Some argue that if market price of stock lt
  (significantly gt) book value, stock is
  underpriced (over-priced)
• Can be measured by using Price/Book Value ratio

84
Price/Book Value Ratio

• Price/Book Value (PBV) ratio
• Market price per share ? Book value per share
• In 1990 Fama and French, Pontiff and Schall, etc.
  suggested that PBV ratio has explanatory power
  over stock prices and returns
• Fama and French grouped assets into portfolios
• Kim argues that using individual assets rather
  than portfolios offers several advantages
• Additional work has cast doubt on use of PBV ratio

85
Analysis of PBV Ratio

• The basic DDM is

• But given that Div1 can be calculated as
• Payout ratio x EPS0 x (1g)
• The DDM can be rewritten as

86
Analysis of PBV Ratio

• Since EPS0 ROE x Book value per share, this can
  be rewritten as

• The PBV ratio can be obtained by dividing both
  sides by BV0

• If everything else remains the same, the higher
  ROE, the higher PBV

87
Over- and Under-Priced Stocks

• This explains why firms with high (low) ROEs have
  stock prices in excess of (below) book values
• Consider the following

• If a firm has high PBV ratio coupled with low ROE
• May be overpriced
• Remembermarket places more emphasis on expected
  earnings than historical earnings (EPS0)

88
Tobins Q Ratio

• Tobin offers a ratio similar to the PBV ratio
• Tobins Q Market value of firms assets ?
  Replacement value of firms assets in place
• Useful in a highly inflationary environment
• Useful when technological advances have decreased
  cost of replacing existing assets

89
Price-Cash Flow Ratio

• Cash flows can also be used in this approach, and
  are often considered less susceptible to
  manipulation by management.
• The steps are similar to using the P/E ratio
• V CF1x(P/CF)

90
Price-Sales Ratio

• Finally, sales can be used in relation to stock
  price.
• Some drawbacks, in that sales do not necessarily
  produce profit and positive cash flows
• Advantage is that sales are also less susceptible
  to manipulation
• The steps are similar to using the P/E ratio
• V S1x(P/S)

91
Valuing Common Stock as a Call Option

• If a firms total liabilities gt total assets,
  creditors receive assets as partial payment
• Stockholders get nothing
• Can be equated to a call option model
• Creditors own the company and sell a call option
  on firms assets to stockholders
• Exercise price equals par value of firms debt
• If stockholders exercise option, they call in
  total assets but must pay all companys
  liabilities to keep assets
• If assets lt liabilities, option expires worthless
• Shareholders forfeit all claim on bankrupt firm
  to creditors

92
Conflicts of Interest

• Conflicts of interest exist between stockholders
  and bondholders
• Protective provisions of bond indenture
• Generally state that bonds coupon interest
  payments will be made on scheduled dates
• If scheduled payment is missed, bondholders can
  force firm into bankruptcy
• Bondholders are essentially exercising an option
  to call in assets before principal payment is due
• Bondholders gain control over corporation
• Offers evidence that shareholders have an
  American call option (not a European one)

93
Springdale Corporation Hypothetical Valuation
Case

• Springdale issues 30 million of mortgage bonds
  to finance plant and equipment purchases
• Offers 50 million in assets as collateral
• All debt have same maturity date
• No cash dividends can be paid until all debts are
  repaid

If Assets gt than Debt, shareholders will benefit
from paying D dollars to bondholders. If assets
lt D, share-holders will let option expire
worthless.
94
Springdale Corporation Hypothetical Valuation
Case

• Option theory suggests the following equation for
  calculating stock price when debt comes due
• Intrinsic value of stock
• Max 0, Assets Debt ? of outstanding common
  shares
• The value of the firms mortgage bonds is
• Min Debt, Assets

95
Springdale Corporation Hypothetical Valuation
Case

• If Springdales assets remain valued at 50
  million, changes in the value of the firms
  equity will be offset by equal and opposite
  changes in debt values
• Because A L E or
• Total Assets Aggregate debt owed to creditors
  Total equity of corporation
• Also, options have time value

96
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97
Option Pricing Theory

• Option theory can also be used to gain insight on
• Pure speculations
• Firms near bankruptcy
• Firms currently being reorganized
• Leveraged buy-outs
• Management buy-outs
• Merged firms
• Emerging new firms
• Patents
• New technologies

98
Example Valuing a Patent

• Your corporation is offered a patent by a
  computer science professor on computer software
• Patent owner has right to develop and distribute
  product monopolistically
• What is this patent worth?
• Patent is call option on underlying software
  product
• Exercise price represents total initial
  investment
• Cost of patent, product development, marketing
  and legal costs
• Life of patent is 20 years (U.S. Patent Office)
• Probability distribution of expected cash flows
  from project will have big impact on value of
  option

99
Example Valuing a Patent