Framework for Equity Analysis
Framework of Analysis
• Fundamental Analysis
• Approach to Fundamental Analysis:
– Domestic and global economic analysis
– Industry analysis
– Company analysis
• Why use the top-down approach?
Global Economic Considerations
• Performance in countries and regions is
highly variable
• Political risk
• Exchange rate risk
– Sales
– Profits
– Stock returns
Economic Performance in Selected
Emerging Markets
Change in Real Exchange Rate: U.S. Dollar
versus Major Currencies,
1999–2006
Key Economic Variables
• Gross domestic product
• Unemployment rates
• Interest rates & inflation
• Budget deficit
• Consumer sentiment
S&P 500 Index versus Earnings Per
Share
Demand Shocks
• Demand shock - an event that affects
demand for goods and services in the
economy
Supply Shocks
• Supply shock - an event that influences
production capacity or production costs
Federal Government Policy
• Fiscal Policy: Demand-side management
– Tax rate cut
– Increases in government spending
Federal Government Policy Continued
• Monetary Policy - Demand-side management
– Manipulation of the money supply to
influence economic activity
• Initial & feedback effects
• Tools of monetary policy
– Open market operations
– Discount rate
– Reserve requirements
Federal Government Policy Continued
• Fiscal Policy: Supply-side management
– Incentive or marginal taxes
• National policies on education, infrastructure,
and research are important elements
Business Cycles
• The transition points across cycles are called
peaks and troughs
– A peak is the transition from the end of an
expansion to the start of a contraction
– A trough occurs at the bottom of a
recession just as the economy enters a
recovery
Leading Indicators
• Leading indicators tend to rise and fall in
advance of the economy
• Examples:
– Avg. weekly hours of production workers
– Stock Prices
Indexes of Economic Indicators
Coincident Indicators
• Coincident Indicators - indicators that tend to
change directly with the economy
• Examples:
– Industrial production
– Manufacturing and trade sales
Lagging Indicators
• 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
Economic Calendar
Industry Analysis
• Sensitivity to business 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
• Industry life cycles
Economic Calendar at Yahoo!
Useful Economic Indicators
Return on Equity, 2007
Defining an Industry
• North American Industry Classification
System, or NAICS codes
– Codes assigned to group firms for statistical
analysis
Industry Stock Price Performance as Measured
by Rate of Return on Dow Jones Sector Shares,
January-October
ROE of Major Banks
Industry Cyclicality
Operating Leverage of Firms A and B Throughout
the Business Cycle
Sector Rotation
• 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
Figure 17.11 Sector Rotation
Industry Life Cycles
Stage Sales Growth
Start-up Rapid & Increasing
Consolidation Stable
Maturity Slowing
Relative Decline Minimal or Negative
The Industry Life Cycle
Industry Structure and Performance
• Threat of entry
• Rivalry between existing competitors
• Pressure from substitute products
• Bargaining power of buyers
• Bargaining power of suppliers
