Finance Chapter 9 Different Industries Tend Perform Well Poorly Different Parts The Business Cycle Some

9 –

1

CHAPTER 9

THE TOP-DOWN APPROACH TO MARKET, INDUSTRY, AND COMPANY

ANALYSIS

9.1 Introduction to Market Analysis (Exhibits 9.1, 9.2, 9.3)

9.2 Aggregate Market Analysis (Macroanalysis)

▪ A strong relationship exists between the economy and the stock market, and stock prices

9.2.1 Leading, Coincident, and Lagging Indicators

1. Leading indicators

2. Coincident indicators

3. Lagging indicators

▪ Economic series that experience their peaks and troughs after those of the aggregate economy

9.2.2 Sentiment and Expectations Surveys

9.2.3 Interest Rates

▪ The final approach to tracking the economy is to follow interest rates

1. The real federal funds rate (Exhibit 9.12)

3. The risk premium between Treasury bonds and BBB bonds (Exhibit 9.14)

9.3 Microvaluation Analysis

9 –

2

9.3.1 FCFE to Value the Market

▪ Market valuation by using a constant growth model

1. Cash Flows (Exhibits 9.16, 9.17)

– Growth Rate of Sales per Share

2. The Discount Rate (Exhibit 9.18)

9.3.2 Multiplier Approach

1. P/E Multiple (Exhibit 9.19)

▪ In order to use a price–earnings multiple approach, an analyst needs to estimate two

–

9.3.3 Shiller P/E Ratio (Exhibit 9.20

9.3.4 Macrovaluation and Microvaluation of World Markets

▪ The basic valuation model and concepts apply globally.

▪ While the models and concepts are the same, the input values can and will vary dramatically

across countries, which means that values will differ and opportunities will differ.

9.4 Introduction to Industry Analysis: Why Industry Analysis Matters (Exhibit 9.21)

▪ The second step of top-down analysis is industry analysis.

9.5 Industry Analysis

9.5.1 The Business Cycle and Industry Sectors

▪ The business cycle refers to the period of time from which an economy’s output of goods and

services peaks, contracts (in a recession), recovers from the prior expansion to reach the prior

peak (recovery), and then grows further (expansion).

9.5.2 Structural Economic Changes Impact the Industry (Noncyclical Factors)

▪ As an analyst studies an industry, he has to search for major changes in the economy and how

it functions. Four categories of changes:

2. Lifestyles

4. Politics and Regulation

9.5.3 Industry Life Cycle

▪ Insight can be gained from viewing the industry over time and dividing its development into

stages (Exhibits 9.22, 9.23).

9.5.4 Industry Competition (Exhibits 9.24, 9.25)

▪ Michael Porter’s concept of competitive strategy is described as the search by a firm for a

favorable competitive position in an industry.

9.6 Estimating Industry Rates of Return

9.6.1 Estimating the Cost of Capital

9.6.2 Sales Growth Estimates

▪ Three approaches:

9.6.3 Other Considerations

▪ Difficult to apply regression and time-series analysis

9.7 Global Industry Analysis

▪ Global industry analysis is growing in importance, as documented by Cavaglia, Brightman,

9.8 Company Analysis

9.8.1 Growth Companies and Growth Stocks

▪ Growth companies are those that consistently experience above-average increases in sales

9.8.2 Defensive Companies and Stocks

▪ Defensive companies are those whose future earnings are likely to withstand an economic

9.8.3 Cyclical Companies and Stocks

▪ A cyclical company’s sales and earnings will be heavily influenced by aggregate business

9.8.4 Speculative Companies and Stocks

▪ Speculative companies are those whose assets involve great risk but those that also have a

9.8.5 Value versus Growth Investing

▪ Value investing involved identifying and investing in stocks that appear to be undervalued for

9.9 Connecting Industry Analysis to Company Analysis

9.9.1 Firm Competitive Strategies

▪ Defensive or offensive competitive strategies

1. Low-Cost Strategy

▪ Firm is determined to be the low-cost producer, and hence the cost leader in its industry.

3. Focusing a Strategy (Exhibit 9.27)

9.9.2 SWOT Analysis

▪ Strengths – give the firm a comparative advantage in the marketplace

9.10 Calculating Intrinsic Value

9.10.1 Some Additional Insights on Valuation—For Individual Companies

▪ Blindly using historic growth rates or margins is incorrect.

▪ When examining the sales of a company, always study how the sales mix is changing

▪ The growth rate of a company is going to be influenced by where the industry is in its life

9.10.2 Analyzing Growth Companies

▪ A growth company is a company that has the opportunity to reinvest significant amounts of

capital at rates of return that are higher than the firm’s cost of capital.

▪ Analyst must consider three issues:

– The amount of capital invested in growth investments

9 –

6

▪ Assumptions:

– Earnings and dividends are growing at a constant rate.

▪ Stock’s P/E ratio is a function of three factors:

– The firm’s expected rate of growth of earnings per share

▪ The growth duration model is based on two assumptions:

– Equal risk between the firms that you’re analyzing

– No significant differences in the payout ratios

2. Factors to Consider

9.11 Lessons from Some Legends

9.11.1 Some Lessons from Lynch

▪ Firm’s product should not be faddish.

9.11.2 Tenets of Warren Buffett

2. Management Tenets

4. Market Tenets

9.11.3 Tenets of Howard Marks

▪ Howard Marks is the co-chair of Oaktree Capital Management.

▪ He recently used many of the ideas from his memos to write the book The Most Important

Thing.

▪ Various important ideas from his book, including: