finance chapter 12 (suited)

7/25/2019 Finance Chapter 12 (Suited)

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Macroeconomicand Industr

y

Analysis

Chapter 12

Copyright 2010 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

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12.1 The Global Economy

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Framework of Analysis

Fundamental Analysis

Analysis of the determinants of firm value,

specifically attempting to forecast the

earnings and dividends of a firm.

Top down approach:

Analyze economy

Analyze industry

Analyze firm

12-4


Approach to Fundamental Analysis

Domestic and global economic analysis

Performance in countries and regions is highly

variable

Politics affects the economy


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12-5



Foreign exchange rates affect U.S. firms

and their competitors

How are the following affected by a change inthe value of the dollar?

Ski resort in Aspen Colorado

Profits of Rocky Mountain Log homes, an exporter oflog homes around the world

Yen profit on sale of Toyota cars in U.S.

12-6

Exchange Rate Risk

Exchange rate risk can affect:

Sales

Profits

Stock returns

12-7



Industry analysis

Critical to understand the competitiveness of

the industry

Company analysis

Detailed strategic and financial analysis of the

firm

Why use the top-down approach?

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Table 12.1 Economic Performance,

2008


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Figure 12.1 Change in Real Exchange

Rate: Dollar Versus Major Currencies.

1999-2008

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12.2 The Domestic

Macroeconomy

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Gross domestic product

The market value of gods and services

produced domestically in a given time period

Unemployment rate

The ratio of number of people classified as

unemployed to the total labor force

Inflation

The rate of change in the general price level

as measured by some price index:

Consumer Price Index

Producer Price Index

GDP Deflator

Key Economic Variables

12-12


Interest rates

Major impact on security prices (stocks and

bonds) and the level of economic growth

Budget Deficits

The budget deficit is the amount by whichgovernment spending exceeds government

revenues

Budget deficits can crowd out private

investment, private investment generates

more growth than public sector investment.

Alternative to crowding out is overreliance on

foreign borrowing.


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12-13


Consumer sentiment

concerning the economy and job prospects.

Source: Federal Reserve Bank of St. Louis, National

Economic Trends, May 2009 12-14

Figure 12.2 S&P 500

Versus EPS Estimate

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12.3 Interest Rates

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Factors Determining the Level of

Interest Rates

1. Supply of funds from savers

2. Demand for funds from businesses

3.

funds

Fiscal policyMonetary policy

4. Expected rate of inflation

Interest rates contain a premium for expectedinflation

The Federal Reserve typically raises interest

rates proactively when inflation is expected

to increase


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12-17

Figure 12.3 Determination of the

Equilibrium Real Rate of Interest

How would an increase in the government budget

deficit affect the equilibrium interest rate?

If the Federal Reserve wishes to stimulate

growth how would they choose to affect the

money supply? Would it work? 12-18

12.4 Demand and Supply

Shocks

12-19

Demand Shocks

Demand Shock

An event that affects the demand for

goods and services, some examples

include:

Change in tax rates

Change in the money supply

Change in government spending

Change in foreign export demand

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Supply ShocksSupply Shocks

An event that influences production capacity

and input costs, including labor costs,examples include

Changes in the price or availability of imported oil

FreezesFloods

Droughts

Changes in wage rates

Negative supply shocks tend to result in

demand > supply, which is inflationary.

Negative supply shocks also may result inreduced output, leading to slower economic

growth.


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Tie to investmentsChoose industries that will be helped by

your expected economic scenario and

avoid those that will be hurt.

For example, choose consumer cyclicals if

the economy is projected to do well, but not ifthe economy will weaken,

May choose consumer staples and

necessities such as utilities if the economy is

not expected to do well.

To earn abnormal returns you must

have better information (unlikely) or

better analysis than the competition. 12-22

12.5 Federal Government

Policy

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Fiscal Policy

Government spending and taxing actions

to stabilize or spur growth in the economy

Most direct policy method in terms of its

effect on the economy (Keynesian policy)

Often implemented too slowly due to politicalprocess

Leaky budget analogy

Poor means to fine tune an economy, can be

inflationary

May be necessary when monetary policy is

ineffective such as in the Financial Crisis of

200812-24

Monetary Policy

Manipulation of the money supply to

influence economic activity by

influencing the demand for goods and

services to be produced and consumed

Initial & long run effects

Potentially long lags

Changes incentives to purchase and

invest, but may not lead to desired effect

on demand


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12-25

Tools of monetary policy

Open market operations (federal funds

rate)

Discount rate

Reserve requirements

Monetary Policy

12-26

Supply-Side Policies

Supply-siders focus on incentives and

marginal tax rates

Lowering tax rates tends to

encourage more investmentImprove incentives to work

generate faster economic growth

Can we rely solely on supply side

policies in a severe recession such as

the Financial Crisis of 2008?

12-27

Supply-Side Policies

Income inequality may also rise

Those with better ideas, education,

opportunities, work ethic, providence,

etc. will do better, others may not.If the majority are better off, but some

much more so than others does this

indicate that we should not use supply

side policies?

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12.6 Business Cycles


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The Business Cycle

Recurring patterns of recession and

recovery

Peak

Trough

Industry relationship to business cycles

Cyclical industries

Industries with above average sensitivity to the

state of the economy

Defensive

Industries with below average sensitivity to the

state of the economy12-30

Economic Indicators

Leading Indicators - tend to rise and fallin advance of the economy

12-31

Economic Indicators (cont)

Coincident Indicators - indicators that

tend to change at the same time as the

economy

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Economic Indicators (cont)

Lagging Indicators - indicators thattend to follow or lag economicperformance


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Cyclical Indicators

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Other Indicators

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Figure 12.6 Economic Calendar at

Yahoo!

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12.7 Industry Analysis


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Industry Analysis

Performance can vary widely across

industries

It is difficult to find a good stock in a poor

industry

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Figure 12.8 Industry Stock Price

Performance, 2008

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Defining an Industry

It can be difficult to define an industry

North American Industry ClassificationSystem (NAICS) attempts to define

industry groups with a four or five digitcode:

The first two digits broadly define the industrygroup: NAIC code 23 = construction

The last two or three digits define the industrymore narrowly

12-40

Example of NAICS Industry

Codes


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Figure 12.9 ROE of Application

Software Firms, 2008

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Sensitivity to Business Cycle

Factors affecting sensitivity of earnings tobusiness cycles

business cycles

Fixed costs and leverageFixed costs are costs that do not vary with the levelof production.

Fixed costs contribute to higher profitability whensales are high, but will result in lower profitabilitywhen sales are lower.

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Sensitivity to Business Cycle

Operating leverageProportion of fixed operating costs as a percent oftotal costs

Greater operating leverage results in greaterswings in profits over the business cycle

Airlines, automobiles

Financial leverageProportion of fixed financing costs as a percent oftotal costs

Greater financial leverage results in greater swingsin profits over the business cycle

Airlines, banks, investment banks

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Figure 12.10 Industry Cyclicality


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Figure 12.11 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

ContractionTrough

Expanding

natural resource firms

defensive firms

equipment, transportation and

construction firms

cyclical industries

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Figure 12.12 Sector Rotation

Illustrated

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Industry Life Cycles

Stage Sales Growth

Start-up

Consolidation

MaturityRelative Decline

Rapid & Increasing

Stable

Slowing

Minimal or Negative


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12-49

Figure 12.13 The Industry Life

Cycle

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Industry Structure and

Performance (Porter Model)

Determinants of Industry Competition and

Profitability

Threat of Entry

New entrants reduce profitability

Barriers to entry preserve profitability

Large scale required to be profitable (autos)

Secure distribution channels

Brand loyalty, unique differentiated product

Proprietary production technology

Intellectual property protections

Learning curve effects

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Determinants of Industry Competition and

Profitability

Rivalry between existing competitors

Equal competitors reduce profitabilitySlow industry growth,

High fixed costs,

Scale economies,

Pressure to

cut prices

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Determinants of Industry Competition and Profitability

Pressure from substitute products

Substitutes limit profitability (propane, natural gas)

Bargaining power of buyers

A buyer that purchases a large percent of an

profitability (auto parts suppliers)

Bargaining power of suppliers

A supplier that controls a key input can limit the

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