CHAPTER 9
THE TOP-DOWN APPROACH TO MARKET, INDUSTRY, AND
COMPANY ANALYSIS
Answers to Questions
1. There are three problems with simply tracking the GDP data that has been released in
order to make investment decisions:
2. Analysts want to know the level of the federal funds rate and whether it is intended to
stimulate the economy or restrict the economy. If a low federal funds rate results in lower
3. An inverted yield curve occurs when the long-term yields are lower than short-term
yields. The yield curve has inverted prior to every recession since 1970, and evidence
4. The four factors impact operating margins for the overall market are:
(2) Unit labor costs
5. When calculating the cost of equity a required risk premium should be used, the
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6. The four categories of structural (noncyclical) economic changes that an analyst should
review are:
(3) Technology
7. The five forces driving industry competition are:
(2) Bargaining Power of Buyers
(4) Bargaining Power of Suppliers
8. Growth companies are those that consistently grow sales and earnings at a rate that is
faster than the overall economy. A growth stock is a stock with a higher expected rate of
return than other stocks in the market with similar risk characteristics.
9. The firm that pursues the low-cost strategy is determined to become the low-cost
producer and, hence, the cost leader in its industry. Cost advantages vary by industry and
may include economies of scale, proprietary technology, or preferential access to raw
materials. In order to benefit from cost leadership, the firm must command prices near the
10. The growth duration model is based on two assumptions:
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CHAPTER 9
Answers to Problems
1. Student Exercise
2.
2(a).1. The National Bureau of Economic Research has conducted extensive analysis of leading,
coincident, and lagging indicators of general economic activity. Business Conditions
Digest classifies economic indicators by their participation in the stage of the economic
2(a).2. Leading indicators have historically been a good tool for anticipating the economy.
Investment managers should be aware of this information and, where possible,
investment decisions may reflect projected trends. However, these indicators are by no
means infallible. They often generate false signals. A downturn in leading indicators may
2(b). Interest rate forecasts are usually important in investment management for the following
reasons:
Interest rates help determine the relative competitiveness of stocks versus bonds;
2(c). Three economic time series, indicators, or data items that may be of key relevance to an
auto analyst would be disposable personal income, consumer interest rate series, and
consumer confidence survey results. An increase in disposable personal income may
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1. Currently, the dividend-payout ratio (D/E) for the aggregate market is 60 percent, the
required return (k) is 11 percent, and the expected growth rate for dividends (g) is 5 percent.
a. Compute the current earnings multiplier.
b. You expect the D/E payout ratio to decline to 50 percent, but you assume there will be no
other changes. What will be the P/E?
3. .55
2. As an analyst for Charlotte and Chelle Capital, you are forecasting the market P/E ratio using
the dividend discount model. Because the economy has been expanding for 9 years, you
expect the dividend-payout ratio will be at its low of 40 percent and that long-term
government bond rates will rise to 7 percent. Because investors are becoming less risk
averse, the equity risk premium will decline to 3 percent. As a result, investors will require a
10 percent return, and the return on equity will be 12 percent.
a. What is the expected growth rate?
b. What is your expectation of the market P/E ratio?
c. What will be the value for the market index if the expectation is for earnings per share of
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4.
4(b). .40
3. You are given the following estimated per share data related to the S&P Industrials Index for
the year 2013:
Sales $1,450.00
Depreciation 58.00
Interest expense 28.00
You are also informed that the estimated operating profit (EBIT) margin is 12 percent and the
tax rate is 32 percent.
a. Compute the estimated EPS for 2013.
b. Assume that a member of the research committee for your firm feels that it is important
to consider a range of operating profit margin (OPM) estimates. Therefore, you are asked
to derive both optimistic and pessimistic EPS estimates using 11 and 13 percent for the
OPM and holding everything else constant.
5.
5(a). $1,950 x .12 = $234.00 (operating profit margin)
5(b). Optimistic:
$1,950 x .13 = $253.50 (operating profit margin)
Pessimistic:
6.
6(a). Growth Rates: Required return:
Optimistic = (1 – 0.45) x 0.15 = .0825 Optimistic = 0.08 + 0.03 = 0.11
6(b). Optimistic = (1,084.91/2050) –1 = -.471 or -47.1%
7.
7(a).
FCFE
$80
Growth
years 4-6
= 8%
Growth years
7+ = 7%
Year
FCFE
PV of cash
flows
k= 9%
1
$87.20
$80.00
2
$95.05
$80.00
3
$103.60
$80.00
4
$111.89
$79.27
5
$120.84
$78.54
6
$130.51
$4,241.10
7
$139.64
$4,638.90
Price = Sum of
discounted
cash flows
If the current value of the Index were 2,050, one would overweight the U.S. equity
market in the portfolio.
7(b). A one percent increase in the rate of inflation would have two possible effects: One, the
required return would increase from 9% to 10%, decreasing the value; and two, the
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9. 24 1 + .14 + .02
ln = T ln
10(a). Assuming dividend yield is zero, we have by the growth duration formula:
ln (x) = 10 ln (1.18/1.08)
10(b). ln (x) = 5 ln (1.18/1.08)
11(a). Company A
11(b).
30 1 + .18 + .00
11(c). After computing the implied growth durations, the analyst must decide whether the
12.
12(a). The dividend discount model is
D1
P =
k – g
12(b). Many professional investors shy away from the dividend discount framework analysis due
to its many inherent complexities.
1) The model cannot be used where companies pay very small or no dividends and
2) The model presumes one can accurately forecast long-term growth of earnings
4) The correct k or the discount rate is difficult to estimate for a specific company as an
5) The model is not definable when g > k as with growth companies, so it is not
applicable to a large number of companies.
12(c). Three alternative methods of valuation would include:
2) Price/Asset value ratios (including market and book asset values)
13.
Fed Model:
15. Student Exercise
16. Student Exercise