PART FOUR SECURITY ANALYSIS T ell your friends or relatives that you are study- analyze the financial statements that firms provide to ing investments and they will ask you, “What the public. You also need to have mastered corporate stocks should I buy?” This is the question finance, since security analysis at its core is the ability at the heart of security analysis. How do analysts to value a firm. In short, a good security analyst will be choose the stocks and other securities to hold in their a generalist, with a grasp of the widest range of finan- portfolios? cial issues.
This is where there is the biggest premium Security analysis requires a wide mix of skills. You on “putting it all together.” need to be a decent economist with a good grasp of The chapters in Part Four are an introduction to both macroeconomics and microeconomics, the for- security analysis. We will provide you with a “top-down” mer to help you form forecasts of the general direction approach to the subject, starting with an overview of of the market and the latter to help you assess the rela- international, macroeconomic, and industry issues, tive position of particular industries or firms. You need and only then progressing to the analysis of particu- a good sense of demographic and social trends to help lar firms.
These topics form the core of fundamental identify industries with bright prospects. You need to be analysis. After reading these chapters, you will have a a quick study of the ins and outs of particular indus- good sense of the various techniques used to analyze tries to choose the firms that will succeed within each stocks and the stock market. You need a good accounting background to CHAPTERS IN THIS PART 12 Macroeconomic and Industry Analysis 13 Equity Valuation 14 Financial Statement Analysis www.com/bkm bod05175_ch12_369-400.indd 369 8/17/07 5:33:04 PM CHAPTER 12 Macroeconomic and Industry Analysis AFTER STUDYING THIS CHAPTER YOU SHOULD BE ABLE TO: ➜ Predict the effect of monetary and fiscal policies on key macroeconomic vari- ables such as gross domestic product, interest rates, and the inflation rate.
➜ Use leading, coincident, and lagging economic indicators to describe and pre- dict the economy’s path through the business cycle. ➜ Predict which industries will be more or less sensitive to business cycle fluctuations. ➜ Analyze the effect of industry life cycles and structure on industry earnings prospects over time. T o determine a proper price for a firm’s stock, the security analyst must forecast the dividends and earnings that can be expected from fundamental analysis the firm.
This is the heart of fundamental analysis, that is, the analysis The analysis of of determinants of value such as earnings prospects. Ultimately, the business determinants of firm value, such as prospects success of the firm determines the dividends it can pay to shareholders and the for earnings and dividends. price it will command in the stock market. Because the prospects of the firm are tied to those of the broader economy, however, valuation analyses must consider the business environment in which the firm operates.
For some firms, macro- economic and industry circumstances might have a greater influence on profits than the firm’s relative performance within its industry. In other words, investors need to keep the big economic picture in mind. Therefore, in analyzing a firm’s prospects it often makes sense to start with the broad economic environment, examining the state of the aggregate economy and even the international economy. From there, one considers the implications of the outside environment on the industry in which the firm oper- ates.
Finally, the firm’s position within the industry is examined.indd 370 8/17/07 5:33:11 PM This chapter examines the broad-based aspects of fundamental analysis— macroeconomic and industry analysis. The following two chapters cover firm- specific analysis. We begin with a discussion of international factors relevant to firm performance and move on to an overview of the significance of the key variables usually used to summarize the state of the economy. We then discuss government macroeconomic policy and the determination of interest rates.
We conclude the analysis of the macroeconomic environment with a discussion of business cycles. Next, we move to industry analysis, treating issues concerning Related Web sites for this chapter the sensitivity of the firm to the business cycle, the typical life cycle of an industry, are available at and strategic issues that affect industry performance.1 THE GLOBAL ECONOMY A top-down analysis of a firm’s prospects must start with the global economy. The interna- tional economy might affect a firm’s export prospects, the price competition it faces from foreign competitors, or the profits it makes on investments abroad. Certainly, despite the fact that the economies of most countries are linked in a global macroeconomy, there is consider- able variation in economic performance across countries at any time.
Consider, for example, Table 12.1, which presents data on several major economies. The table documents striking variation in growth rates of economic output. For example, while the Chinese economy grew by 10.4% in 2006 (see last column), output in Japan grew by only 1. Similarly, there has been considerable variation in stock market returns in these countries in recent years, as docu- mented in the first two columns of the table.
These data illustrate that the national economic environment can be a crucial determinant of industry performance. It is far harder for businesses to succeed in a contracting economy than in an expanding one. This observation highlights the role of a big-picture macroeconomic analysis as a fundamental part of the investment process.1 Stock Market Return (%) Growth in GDP Economic performance, In Local Currency In U.2 Source: The Economist, January 4, 2007. © 2007 The Economist Newspaper Group, Inc.
Reprinted with permission. Further reproduction is prohibited.com 371 bod05175_ch12_369-400.indd 371 8/17/07 5:33:17 PM 372 Part FOUR Security Analysis In addition, the global environment presents political risks of far greater magnitude than are typically encountered in U. In the last decade, we have seen sev- eral instances where political developments had major impacts on economic prospects. For example, the biggest international economic story in late 1997 and 1998 was the turmoil in several Asian economies, notably Thailand, Indonesia, and South Korea.
These episodes also highlighted the close interplay between politics and economics, as both currency and stock values swung with enormous volatility in response to developments concerning the prospects for aid for these countries from the International Monetary Fund. In August 1998, the shock waves following Russia’s devaluation of the ruble and default on some of its debt created havoc in world security markets, ultimately requiring a rescue of the giant hedge fund Long Term Capital Management to avoid further major disruptions. In the current envi- ronment, stock prices are highly sensitive to developments in Iraq and the security of energy supplies. Other political issues that are less sensational but still extremely important to economic growth and investment returns include issues of protectionism and trade policy, the free flow of capital, and the status of a nation’s workforce.
One obvious factor that affects the international competitiveness of a country’s industries exchange rate is the exchange rate between that country’s currency and other currencies. The exchange rate The rate at which is the rate at which domestic currency can be converted into foreign currency. For example, domestic currency can in early 2007, it took about 114 Japanese yen to purchase one U. We would say that be converted into foreign the exchange rate is ¥114 per dollar, or equivalently, $0.
As exchange rates fluctuate, the dollar value of goods priced in foreign currency similarly fluctuates. For example, in 1980, the dollar–yen exchange rate was about $0. Since the exchange rate in 2007 was $0. citizen would have needed almost twice as many dollars in 2007 to buy a product selling for ¥10,000 as would have been required in 1980.
If the Japanese producer were to maintain a fixed yen price for its product, the price expressed in U. dollars would have to double. This would make Japanese products more expensive to U. consumers, however, and result in lost sales.
Obviously, appreciation of the yen creates a problem for Japanese producers such as automakers that must compete with U.1 shows the change in the purchasing power of the U. dollar relative to the purchasing power of several major currencies in the period between 1999 and 2006. The ratio of purchasing powers is called the “real” or inflation-adjusted exchange rate. The change in the real exchange rate measures how much more or less expensive foreign goods have become to U.
citizens, accounting for both exchange rate fluctuations and infla- tion differentials across countries. A positive value in Figure 12.1 means that the dollar FIGURE 12.1 Change in real exchange rate: U.7% sus major currencies, 1999–2006 Euro ⫺13.indd 372 8/17/07 5:33:17 PM 12 Macroeconomic and Industry Analysis 373 2,500 FIGURE 12.2 S&P 500 Index versus earnings per share 2,000 Source: Authors’ calculations using data from The Economic Report of the President, 2007. 1,500 S&P 500 1,000 25 ⫻ EPS 18 ⫻ EPS 500 12 ⫻ EPS 0 1970 1973 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006 has gained purchasing power relative to another currency; a negative number indicates a depreciating dollar. Therefore, the figure shows that goods priced in terms of British pounds, euros, or Canadian dollars became more expensive to U.
consumers in the last four years but that goods priced in yen became cheaper. Conversely, goods priced in U. dollars became more expensive to Japanese consumers, but more affordable to Canadian consumers.2 THE DOMESTIC MACROECONOMY The macroeconomy is the environment in which all firms operate. The importance of the mac- roeconomy in determining investment performance is illustrated in Figure 12.2, which com- pares the level of the S&P 500 stock price index to estimates of earnings per share of the S&P 500 companies.
The graph shows that stock prices tend to rise along with earnings. While the exact ratio of stock price to earnings per share varies with factors such as interest rates, risk, inflation rates, and other variables, the graph does illustrate that, as a general rule, the ratio has tended to be in the range of 12 to 25. Given “normal” price-to-earnings ratios, we would expect the S&P 500 Index to fall within these boundaries. While the earnings-multiplier rule clearly is not perfect—note the dramatic increase in the P/E multiple in the 1990s—it also seems clear that the level of the broad market and aggregate earnings do trend together.
Thus, the first step in forecasting the performance of the broad market is to assess the status of the economy as a whole. The ability to forecast the macroeconomy can translate into spectacular investment perfor- mance. But it is not enough to forecast the macroeconomy well. One must forecast it better than one’s competitors to earn abnormal profits.
In this section, we will review some of the key economic statistics used to describe the state of the macroeconomy. Gross Domestic Product Gross domestic product, or GDP, is the measure of the economy’s total production of goods gross domestic and services. Rapidly growing GDP indicates an expanding economy with ample opportunity product (GDP) for a firm to increase sales. Another popular measure of the economy’s output is industrial The market value of goods production.
This statistic provides a measure of economic activity more narrowly focused on and services produced the manufacturing side of the economy. over a period of time.indd 373 8/17/07 5:33:19 PM 374 Part FOUR Security Analysis Employment unemployment rate The unemployment rate is the percentage of the total labor force (i., those who are either The ratio of the number working or actively seeking employment) yet to find work. The unemployment rate measures of people classified as the extent to which the economy is operating at full capacity.