Industry analysis

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					Industry Analysis
          Industry and Company
l   Wide dispersion in rates of return in different industries
l   Performance varies from year to year
l   Research shows that there is almost no association in individual
    industry performance year to year or over sequential rising or
    falling markets
l   Variables that affect industry performance change over time
l   There is wide dispersion in the performance of companies
    within an industry
l   This reinforces the need for company analysis in addition to
    industry analysis
    The Business Cycle and Industry Sectors
l   Economic trends affect industry performance (Inflation, Interest
    Rates, International Economics, Consumer Sentiment)
     l Change in interest rates affects firms with substantial
       amount of debt such as (utilities, banks, and airlines)
     l Change in interest rates affect demand for Consumer
       durables, Housing, Automobiles, Deferrable purchases
     l Higher oil prices may help oil producing and exploration
       firms but hurt utilities and airlines
     l Change in Inflation affects firms with natural resources (Oil,
       Precious metals)
l   Cyclical or Structural Changes
     l Cyclical changes in the economy arise from the ups and
       downs of the business cycle
     l Structure changes occur when the economy undergoes a
       major change in organization or how it functions
l   Rotation strategy is when one switches from one industry
    group to another over the course of a business cycle
     l Cyclical firms are more sensitive to changes in the level of
       economic activity while Non-cyclical firms are less sensitive…
       The Stock Market and
        the Business Cycle

               Consumer        peak        Staples Excel

               trough     Goods Excel
Stocks Excel
   Structural Economic Changes
    and Alternative Industries
l Social   Influences
  l Demographics
  l Lifestyles

l Technology
l Politics   and Regulations
  l Economic     reasoning
  l Fairness
  l Regulatory    changes affect numerous
 Evaluating the Industry Life
Five Stage Model
l Pioneering
l Rapidly accelerating
  industry growth
l Mature industry
l Stabilization and
  market maturity
l Deceleration of
  growth and decline
     Analysis of Industry Competition
           Competition and Expected Industry Returns
l   Porter’s concept of competitive strategy is described as the
    search by a firm for a favorable competitive position in an
l   To create a profitable competitive strategy, a firm must first
    examine the basic competitive structure of its industry
l   The potential profitability of a firm is heavily influenced by the
    profitability of its industry
l   Porter’s Competitive Forces
     l Rivalry among existing competitors
     l Threat of new entrants
     l Threat of substitute products
     l Bargaining power of buyers
     l Bargaining power of suppliers
     Estimating Industry Rates of
l   Present value using required rate of return for the
    equity in the industry
l   Two-step P/E ratio approach uses expected value at
    the end of investment horizon and compute the
    expected dividend return during the period
l   Valuation using the reduced form DDM
                 Pi = the price of industry i at time t
                 D1 = the expected dividend for industry i in period 1
                 equal to D0(1+g)
                 k = the required rate of return on the equity for industry i
                 g = the expected long-run growth rate of earnings and
                 dividend for industry i
 Estimating the Required Rate of
l Influenced by the risk-free rate
l Expected inflation rate
l Risk premium for the industry versus the
  l businessrisk, financial risk, liquidity risk,
    exchange rate risk, country political risk
l Orcompare systematic risk (beta) for the
 industry to the market beta of 1.0
 Estimating the Expected Growth
l Earningsand dividend growth are
 determined by the retention rate
 and the return on equity
 lEarnings retention rate of industry
  compared to the overall market
 lReturn on equity is a function of
   lthe net profit margin
   ltotal asset turnover
   la measure of financial leverage
Industry Valuation Using the Free
Cash Flow to Equity (FCFE) Model

  FCFE is defined as follows:
  Net income
  + Depreciation
  - Capital expenditures
  - D in working capital
  - Principal debt repayments
  + New debt issues
Industry Valuation Using the Free
Cash Flow to Equity (FCFE) Model

l The   Constant Growth FCFE Model

l The   Two-Stage Growth FCFE Model
The Earnings Multiple Technique
l   Estimating earnings per share
     l start with forecasting sales per share
       l Industriallife cycle
       l Input-output analysis
       l Industry-aggregate economy relationship
    l earnings forecasting and analysis of industry
       l competitive strategy
       l competitive environment
       l industry operating profit margin
       l industry earnings estimate
       l industry earnings multiplier
      Industry Profit Margin Forecast
l   Industry’s operating profit margin (EBITDA / Sales)
     l Depreciation expense (subtract depreciation from profit
       margin to determine industry’s net before int. and taxes)
     l Interest expense (Calculate the annual total asset turnover
       (TAT); Use your current sales estimate and an estimate of
       TAT to estimate total assets next year; Calculate the annual
       long-term (interest bearing) debt as a percent of total
       assets; Estimate long-term debt for the next year; Calculate
       the annual interest cost as a percent of long-term debt and
       analyze the trend; Estimate next year’s interest cost of debt
       for this industry based upon your prior estimate of market
       yields; Estimate interest expense based on the Interest Cost
       of Debt on Outstanding Long-Term Debt)
     l Tax rate (Regression analysis and plot; after estimating the
       tax rate, multiply the EBT per share by (1 - tax rate) to
       estimate earnings per share; derive an estimate of industry’s
       net profit margin as a check on your EPS estimate)
Estimating an Industry Earnings Multiplier
l   Macroanalysis
    l relationship between multiplier for the industry and the
    l variables that influence the multiplier:
        l required rate of return (k) [nominal risk-free rate plus a risk
        l expected growth rate of earnings and dividend
        l dividend payout ratio
l   Microanalysis
    l Estimate the variables that influence the industry earnings
       multiplier and compare them to the comparable values for
       the market P/E
    l Industry multiplier versus the market multiplier
    l Comparing dividend-payout ratios
    l Estimating the required rate of return (k)
    l Estimating the expected growth rate (g)
        g = Retention Rate (b) X Return on Equity (ROE) = (b) X (ROE)
Other Relative Valuation Ratios
l Price-to-book  value ratios (P/BV)
l Price-to-cash flow ratios (P/CF)
l Price-to-sales ratios (P/S)
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