Macroeconomic and Industry Analysis

1

Fundamental Analysis Approach to Fundamental Analysis

◦ Domestic and global economic analysis◦ Industry analysis◦ Company analysis

Why use the top-down approach

Performance in countries and regions is highly variable Political risk Exchange rate risk

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 YenIn 2010: 1 USD = 110 Yen, 100,000 Yen = 909 USDLose $91

Gross domestic product◦ Market value of goods and services produced over a

period of time Unemployment rates

◦ The ratio of number of people classified as unemployed to the total labor force

Interest rates & inflation◦ 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

Budget Deficits◦ Government spending > government revenue

Consumer sentiment◦ consumers’ optimism and pessimism about the economy

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

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

Fiscal Policy - government spending and taxing actions◦ Increase spending: increase demand◦ tax increase: reduce demand◦ Net impact:

budget deficit budget surplus

Monetary Policy - manipulation of the money supply to influence economic activity

Tools of monetary policy◦ Open market operations◦ Discount rate◦ Reserve requirements

If government wants to tighten money supply, what should it do?

Business Cycle◦ Peak◦ Trough

Industry relationship to business cycles◦ Cyclical

above average sensitivity to states of economy◦ Defensive

below sensitivity to states of economy

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?

Economy enters recession:◦ cyclical or defensive◦ example: food, public utilities, pharmaceutical◦ Low or high betas?◦ performance is stable, unaffected by market conditions

Leading indicators tend to rise and fall in advance of the economy

Examples:◦Avg. weekly hours of production workers

◦Stock Prices

Coincident Indicators - indicators that tend to change directly with the economy

Examples:◦Industrial production◦Manufacturing and trade sales

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

North American Industry Classification System, or NAICS codes◦ Codes assigned to group firms for statistical

analysis

Sensitivity to business cycles Sector Rotation Industry life cycles

Factors affecting sensitivity of earnings to business cycles◦ Sensitivity of sales of the firm’s product to the

business cycles◦ Operating leverage◦ Financial leverage

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 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

Use of borrowing Similar to fixed cost High financial leverage, earning is more sensitive to economy Low financial leverage, earning is more stable

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 Sales GrowthStart-up Rapid & IncreasingConsolidation StableMaturity SlowingRelative Decline Minimal or Negative

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

Maturity stage◦ 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

43

FINANCIAL STATEMENT ANALYSIS

Objectives:

• Use a firm’s income statement, balance sheet, and statement of cash flows to calculate standard financial ratios.

• Calculate the impact of taxes and leverage on a firm’s return on equity using ratio decomposition analysis.

• Measure a firm’s operating efficiency

• Identify likely sources of biases in accounting data.

Balance Sheet◦Common Sized◦Trend or Indexed

Income Statement◦Common Sized◦Trend or Indexed

Statement of Cash Flows

Firm’s revenues and expenses during a specific period Typical formatSale

- Operating expense COGSDepreciation

Operating Income (EBIT)- InterestEarning before tax (EBT)- TaxNet Income (NI)

A snapshot of firm’s assets and liability at a given point in time

Asset Liabilities + Equity

1. Current Asset 1. Current liabilities

Cash Short term debt

Account receivable Account payable

Inventory Note payable

2. Fixed asset 2. Long-term debt

3. Equity

Common stock

Retained earning

Total assets Total liabilities + equity

Net income: accounting profit Cash flow: cash available on hand Statement of cash flow: firm’s cash receipts and payments

during a specific period

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

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

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:

ROA: Return on Assets=EBIT/Assets

Equity

DebtteInterestRaROAROATaxRateROE )()1(

Net profit EBIT - Interest - Taxes (1 - Tax rate)(EBIT- Interest)ROE

Equity Equity Equity

(ROA x Assets) - (Interest rate x Debt)(1 - Tax rate)

Equity

Equity + Debt(1 - Tax rate) ROA x Inter

Equity

Debt

est rate x Equity

Debt(1 - Tax rate) ROA + (ROA - Interest rate)

Equity

DebtROE = (1 - Tax rate) ROA + (ROA - Interest rate)

Equity

ROE = Net Profit

Pretax Profit

x

Pretax Profit

EBITx

EBIT

Sales

Sales

Assetsx x

Assets

Equity

(1) x (2) x (3) x (4) x (5)

x Margin x Turnover x Leverage Tax

Burden

Interest

Burden

x

An analyst applies the DuPont system of financial analysis to the following data for a company:Leverage ratio 2.2Total asset turnover 2.0Net profit margin 5.5%Dividend payout ratio 31.8%

What is the company’s return on equity?

Liquidity Ratios Activity or Mgmt Efficiency Ratios Leverage Ratios Profitability Ratios Market Price Ratios

Current ratio = Current asset/ current liabilities

2005: current ratio = (60+30+90)/(36+87.3) = 1.462005 2006 2007 2007 industry average (IA)1.46 1.17 0.97 2.0◦ Trend: decreasing◦ poor standing relative to industry

Quick ratio = (current asset-inventory)/current liability

2005: quick ratio = (60+30)/(36+87.3) = 0.732005 2006 2007 2007 industry average (IA)0.73 0.58 0.49 1.0◦ Trend: decreasing◦ poor standing relative to industry

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

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 60 fixed asset turnover = sale/average of fixed asset

◦ 2005: 100/{(150+180)/2}=0.600◦ 2005 2006 2007 IA

0.606 0.606 0.606 0.7

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

Interest coverage (times interest earned) = EBIT/Interest expense

Leverage ratio: Assets/Equity = 1 + Debt/Equity

Debt ratio = debt/equity

ROA = EBIT/(average total assets) ROE = NI/(average total equity) Return on sale (profit margin) = EBIT/Sales

Market-to-book = price per share/ book value per share◦ Lower market-to-book stocks: safer stocks

Price-to-earning (P/E) = market price per share / EPS◦ Low P/E, more bargain

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

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)

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 Non-recurring items:

◦ Unusual income, does not happen regularly. Reserves management:

◦ Different companies have different estimates of reserve for future investment Stock options

◦ Companies use stock options as bonus therefore it should be reported as expenses and need to price the options

Revenue recognition Off-balance sheet assets and liabilities