Transcript Document

Macroeconomic and
Industry Analysis
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Fundamental Analysis
Approach to Fundamental Analysis
◦ Domestic and global economic analysis
◦ Industry analysis
◦ Company analysis
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Why use the top-down approach
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Performance in countries and regions is highly variable
Political risk
Exchange rate risk
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Considerable variation in performance across countries
expanding economies: more chance to succeed
contracting economies: less chance to succeed
Based on these performance, form expectation for your
investment
 economies growing
 economies slowing down
US investors:
2009: invest $1000
in Japan, exchange
rate 1USD = 100
Yen, $1000 is
worth 100,000 Yen
In 2010: 1 USD =
110 Yen, 100,000
Yen = 909 USD
Lose $91
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Gross domestic product
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Unemployment rates
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Interest rates & inflation
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Budget Deficits
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Consumer sentiment
◦ Market value of goods and services produced over a period
of time
◦ The ratio of number of people classified as unemployed to
the total labor force
◦ inflation is the rate at which the general level of prices is
rising.
◦ High inflation is associated with overheated economy
◦ Trade-off between inflation and unemployment
◦ Government spending > government revenue
◦ consumers’ optimism and pessimism about the economy
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Demand shock - an event that affects demand for goods and
services in the economy
◦ Tax rate cut
◦ Increases in government spending
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Supply shock - an event that influences production capacity or
production costs
◦ Commodity price changes
◦ Educational level of economic participants
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Fiscal Policy - government spending and taxing
actions
◦ Increase spending: increase demand
◦ tax increase: reduce demand
◦ Net impact:
 budget deficit
 budget surplus
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Monetary Policy - manipulation of the
money supply to influence economic
activity
Tools of monetary policy
◦ Open market operations
◦ Discount rate
◦ Reserve requirements
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If government wants to tighten money
supply, what should it do?
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Business Cycle
◦ Peak
◦ Trough
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Industry relationship to business cycles
◦ Cyclical
 above average sensitivity to states of economy
◦ Defensive
 below sensitivity to states of economy
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At trough, right before recovery, one would expect cyclical
industries to outperform others
◦ (economy increases (decreases) by 1%, the industry increases
(decreases) by > 1%)
◦ Example: durable goods: auto, washing machine, financial industries
◦ Cyclical firms: betas > 1 or < 1, high or low betas?
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Economy enters recession:
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cyclical or defensive
example: food, public utilities, pharmaceutical
Low or high betas?
performance is stable, unaffected by market conditions
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Leading indicators tend to rise and fall
in advance of the economy
Examples:
◦ Avg. weekly hours of production
workers
◦ Stock Prices
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Coincident Indicators - indicators that
tend to change directly with the economy
Examples:
◦ Industrial production
◦ Manufacturing and trade sales
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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
◦ unemployment
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North American Industry Classification
System, or NAICS codes
◦ Codes assigned to group firms for statistical
analysis
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Sensitivity to business cycles
Sector Rotation
Industry life cycles
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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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Operating leverage = fixed cost / variable cost
If operating leverage is high
◦ fixed cost dominates variable cost
◦ When economy changes, cost do not move enough to offset change in
sale
 economy goes down, sale decreases, variable cost also decreases, but is
dominated by fixed cost, total cost is quite stable, therefore, earning goes
down more than the economy
 Sale increases, variable cost increases, but still dominated by fixed cost, total
cost is quite stable, earning goes up more than economy
 Earning is very sensitive to economy
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If operating leverage is low: variable cost >> fixed cost
◦ sale goes down, total cost goes down
◦ sale goes up, total cost goes up
◦ earning is stable
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Use of borrowing
Similar to fixed cost
High financial leverage, earning is more sensitive to economy
Low financial leverage, earning is more stable
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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
Stage
Start-up
Consolidation
Maturity
Relative Decline
Sales Growth
Rapid & Increasing
Stable
Slowing
Minimal or Negative
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Example: VCR
Start-up: new, so sale and earnings go up rapidly
Consolidation stage:
◦ product is established, more firms enter, growth rate is stable, and higher
than economy
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Maturity stage
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product reach full potential use by consumers
market is very competitive
pay more dividends
less on reinvestment
Relative decline
◦ new better products come in, e.g., DVD
◦ Substitute for old products
FINANCIAL STATEMENT
ANALYSIS
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Objectives:
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Use a firm’s income statement, balance sheet, and
statement of cash flows to calculate standard financial
ratios.
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Calculate the impact of taxes and leverage on a firm’s
return on equity using ratio decomposition analysis.
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Measure a firm’s operating efficiency
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Identify likely sources of biases in accounting data.
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Balance Sheet
◦ Common Sized
◦ Trend or Indexed
Income Statement
◦ Common Sized
◦ Trend or Indexed
Statement of Cash Flows
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Firm’s revenues and expenses during a specific period
Typical format
Sale
- Operating expense
COGS
Depreciation
Operating Income (EBIT)
- Interest
Earning before tax (EBT)
- Tax
Net Income (NI)
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A snapshot of firm’s assets and liability at a given point in time
Asset
1. Current Asset
Cash
Account receivable
Inventory
2. Fixed asset
Liabilities + Equity
1. Current liabilities
Short term debt
Account payable
Note payable
2. Long-term debt
3. Equity
Common stock
Retained earning
Total assets
Total liabilities + equity
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Net income: accounting profit
Cash flow: cash available on hand
Statement of cash flow: firm’s cash receipts and payments
during a specific period
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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
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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
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ROE=Net profit/Equity
g = ROE × b
To estimate g, need to estimate ROE
Past ROE might not be good estimator of future ROE
ROE is linked with ROA and affected by firm’s financial
policies
Watch out financial leverage:
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Debt 
ROE  (1  TaxRate)  ROA  ( ROA  InterestRate)
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Equity
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ROA: Return on Assets=EBIT/Assets
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Debt 
ROE = (1 - Tax rate) ROA + (ROA - Interest rate)
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Equity
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ROE 
Net profit EBIT - Interest - Taxes (1 - Tax rate)(EBIT- Interest)
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Equity
Equity
Equity
 (ROA x Assets) - (Interest rate x Debt) 
 (1 - Tax rate) 
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Equity
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Equity + Debt
Debt 
 (1 - Tax rate)  ROA x
 Interest rate x
Equity
Equity 
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Debt 
 (1 - Tax rate)  ROA + (ROA - Interest rate)
Equity 
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ROE =
Net Profit
x
Pretax Profit
Burden
x
EBIT
(1)
Tax
Pretax Profit
x
x
(2)
Interest
Burden
x
EBIT
Sales
(3)
x
x
Sales
Assets
(4)
x
Assets
Equity
x (5)
x Margin x Turnover x Leverage
An analyst applies the DuPont system of financial analysis to
the following data for a company:
Leverage ratio
2.2
Total asset turnover
2.0
Net profit margin
5.5%
Dividend payout ratio
31.8%
What is the company’s return on equity?
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Liquidity Ratios
Activity or Mgmt Efficiency Ratios
Leverage Ratios
Profitability Ratios
Market Price Ratios
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Current ratio = Current asset/ current liabilities
2005: current ratio = (60+30+90)/(36+87.3) = 1.46
2005
2006
2007
1.46
1.17
0.97
◦ Trend: decreasing
◦ poor standing relative to industry
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2007 industry average (IA)
2.0
Quick ratio = (current asset-inventory)/current liability
2005: quick ratio = (60+30)/(36+87.3) = 0.73
2005
2006
2007
0.73
0.58
0.49
◦ Trend: decreasing
◦ poor standing relative to industry
2007 industry average (IA)
1.0
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Inventory turnover = COGS (excluding depreciation) / average inventory
◦ How fast firm can sell inventory
◦ 2005: inventory turnover = (55-15)/{(75+90)/2)}= 0.485
◦ 2005
2006
2007
IA
0.485
0.485
0.485
0.5
◦ Slower in selling inventory
total asset turnover = sale/average total asset
◦ 2005: TA turnover = 100/((300+360)/2) = 0.30
◦ 2005
2006
2007
IA
0.30
0.30
0.30
0.4
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Average collection period (days receivable)
= average AR/sales per day
◦ average time between date of sale and date payment received
◦ 2005: {(25+30)/2}/(100/365) = 100.4
◦ 2005
2006
2007
IA
100.4
100.4
100.4
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fixed asset turnover = sale/average of fixed asset
◦ 2005:
◦ 2005
0.606
100/{(150+180)/2}=0.600
2006
2007
IA
0.606
0.606
0.7
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Total asset turnover of G.I. < industry average (0.3<0.4)
◦ fixed asset turnover < Industry average (0.60 < 0.7): inefficient in using
fixed asset
◦ days receivable > industry average (100.4 > 60): receive cash longer
than average, poor receivable procedure
◦ Inventory turnover < industry average (0.485<0.5): turn inventory into
sale slower than average, poor inventory management
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Interest coverage (times interest earned) = EBIT/Interest
expense
Leverage ratio:
Assets/Equity = 1 + Debt/Equity
Debt ratio = debt/equity
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ROA = EBIT/(average total assets)
ROE = NI/(average total equity)
Return on sale (profit margin) = EBIT/Sales
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Market-to-book = price per share/ book value per share
◦ Lower market-to-book stocks: safer stocks
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Price-to-earning (P/E) = market price per share / EPS
◦ Low P/E, more bargain
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In her 2007 annual report to shareholders of Growth Industries, Inc.,
the president wrote “2007 was another successful year for GI: sale,
assets, and operating income all continue to grow at 20%” Is she
right?
◦ ROE has been declining steadily and below the I.A.
◦ Low and falling market-to-book and P/E: investors are less optimistic about
firm’s future.
◦ ROA has not been declining implying ROE’s decrease is due to financial
leverage
◦ Borrow more and more short-term debt to finance new investment and the
interest on these short-term debt is very high
 2007: coupon rate 8% on long-term debt, long-term interest expense = 8%*75 mil = 6 mil. Total
interest paid = 34.391 mil, short-term interest expense = 28.391 (about 20% of total short-term
debt). ROA on 2007 = 9.09%
◦ Firm’s cash flows decreases over time from 12.7 mil in 2005 to 6.725 mil in 2007
◦ But firm’s investment in capital asset has been nearly doubles from 2005-2007. ROA <
interest rate but firms keeps investing on capital assets
◦ That explains why ROE keeps going down, hence P/E and P/B ratios
◦ Currently low P/E, P/B ratios might represent a bargain here
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GAAP (Generally Accepted Accounting Principles) is
not unique
◦ Inventory valuation: LIFO vs FIFO
◦ Depreciation: Straight line vs Accelerated
Quality of earnings affected by:
◦ Allowance of bad debt; nonrecurring items; stock
option; revenue recognition; off-balance-sheet assets
and liabilities
GAAP vs IAS (International Accounting Standards)
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Allowance for bad debts:
◦ When companies sell goods using credit, need to have allowance for bad
debts. This is the estimate. Different companies have different estimates
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Non-recurring items:
◦ Unusual income, does not happen regularly.
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Reserves management:
◦ Different companies have different estimates of reserve for future investment
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Stock options
◦ Companies use stock options as bonus therefore it should be reported as
expenses and need to price the options
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Revenue recognition
Off-balance sheet assets and liabilities