Macroeconomic and Industry Analysis
From the various sources
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Framework of Analysis
Fundamental Analysis
Approach to Fundamental Analysis– Domestic and global economic analysis– Industry analysis– Company analysis
Top-down approach (“Three-Step” Valuation Approach
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Three-Step Valuation Approach
1. General economic influences– First examine the influence of the general economy on all firms
and the security markets– Decide how to allocate investment funds among countries, and
within countries to bonds, stocks, and cash (Go to slide #8)
2. Industry influences– Determine which industries will prosper and which industries will
suffer on a global basis and within countries (Go to slide # 36 and 37)
– analyze the prospects for various global industries with the best outlooks in this economic environment
3. Company analysis– turn to the analysis of individual firms in the preferred industries
and to the common stock of these firms.– Determine which companies in the selected industries will prosper
and which stocks are undervalued
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Does the Three-Step Process Work?
Studies indicate that most changes in an individual firm’s earnings can be attributed to changes in aggregate corporate earnings and changes in the firm’s industryStudies have found a relationship between aggregate stock prices and various economic series such as employment, income, or productionMost of the changes in rates of return for individual stock could be explained by changes in the rates of return for the aggregate stock market and the stock’s industry
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1 THE GLOBAL ECONOMY
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Global Economic Considerations
Performance in countries and regions is highly variable
Political risk
Exchange rate risk– Sales– Profits– Stock returns
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Economic Performance 2006
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2 THE DOMESTIC MACROECONOMY
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Key Economic Variables
Gross domestic product
Employment
Inflation
Interest rates
Budget Deficits
Consumer sentiment
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S&P 500 vs. EPS Estimate
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3 INTEREST RATES
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Factors Determining the Level of Interest Rates
Supply of funds from savers
Demand for funds from businesses
Government’s net supply and/or demand for funds
Expected rate of inflation
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Determination of the Equilibrium Real Rate of Interest
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4 DEMAND AND SUPPLY SHOCKS
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Demand Shocks
Demand– An event that affects the demand for goods
and services in the economyReduction in tax rates
Increases in the money supply
Increases in government spending
Increases in foreign export demand
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Supply Shocks
Supply– An event that influences production capacity
and production costsChanges in the price of imported oil
Commodity price changes
Floods, Droughts
Changes in the wage rates
Educational level of economic participants
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5 FEDERAL GOVERNMENT POLICY
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Fiscal Policy
Government spending and taxing actions– Direct policy– Slowly implemented
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Monetary Policy
Manipulation of the money supply to influence economic activity– Initial & feedback effects
Tools of monetary policy– Open market operations (federal funds rate)– Discount rate– Reserve requirements
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Supply-Side Policies
Supply-siders focus on incentives and marginal tax rates
Lowering tax rates will – elicit more investment – Improve incentives to work
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6 BUSINESS CYCLES
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The Business Cycle
Recurring patterns of recession and recovery—business cycles– Peak– Trough
Industry relationship to business cycles– Cyclical – Defensive
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Leading Indicators - tend to rise and fall in advance of the economyExamples– Avg. weekly hours of production workers– Stock Prices – Initial claims for unemployment– Manufacturer’s new orders– Stock market indexes
Economic Indicators
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Economic Activity and Security Markets
Stock Market as a Leading Indicator– Stock prices reflect expectations of
earnings, dividends, and interest rates– Stock market reacts to various leading
indicator series– Stock prices consistently turn before the
economy does
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Coincident Indicators - indicators that tend to change directly with the economy
Examples– Industrial production– Manufacturing and trade sales
Economic Indicators (cont)
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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
Economic Indicators (cont)
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Indexes of Economic Indicators
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Cyclical Indicators
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Indexes of Leading, Coincident, and Lagging Indicators
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Economic Calendar
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Useful Economic Indicators
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Economic Calendar at Yahoo!
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7 INDUSTRY ANALYSIS
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Industry Analysis
Performance can vary widely across industries
ROE can range from 10.6% for electronic equipment to 29.2% for the cigarette industry
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Return on Equity
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Industry Stock Price Performance, 2006
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Defining an Industry
Where to draw the line between one industry and another– Money-center banks: Variation by
SizeFocusregion
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ROE of Major Banks, 2007
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North American Industry Classification System or NAICS Codes
Codes assigned to group firms for statistical analysis
Industry classifications are never perfect
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Examples of NAICS Industry Codes
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Sensitivity to Business Cycle
Factors affecting sensitivity of earnings to business cycles– Sensitivity of sales of the firm’s product to the
business cycles– Operating leverage– Financial leverage
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Industry Cyclicality
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A Stylized Depiction of the Business Cycle
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Sector Rotation
Selecting Industries in line with the stage of the business cycle Peak – natural resource firms Contraction – defensive firms Trough – equipment, transportation and
construction firms Expanding – cyclical industries
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Industry Life Cycles
Stage Sales GrowthStart-up Rapid & Increasing
Consolidation Stable
Maturity Slowing
Relative Decline Minimal or Negative
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The Industry Life Cycle
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Industry Structure and Performance
Threat of Entry
Rivalry between existing competitors
Pressure from substitute products
Bargaining power of buyers
Bargaining power of suppliers
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An Example of Industry Analysis
Go to TxState Library Web Site
Go to Database
Under Database, find “Standard & Poor’s Net Advantage”
Click on “Industries.”
Choose the industry you want to find S&P industry analysis for recent quarter or year.