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• Macroeconomics Analysis
• Industry Analysis
• Equity Valuation Model
(Dividend Discount Model- DDM)
• Financial Statement Analysis
Macroeconomics Analysis
• Global Economy Analysis
– affects export, price competition and profits
– exchange rate: purchasing power and earnings
• Domestic Economy
– The ability to forecast the macroeconomy can translate
into great investment performance
– outperform other analysts to earn extra profits
Many variables can affect economy
–Gross Domestic Product (GDP):
measures the economy’s total output of goods and services
– Employment rate:
measures the extent that the economy is operating at full capacity
– Inflation
measures the general level of prices increase Phillip’s curve
– Interest Rate
high interest rate reduces PV of cashflows, thus stock values
– Budget Deficit
large deficit means more borrowing, which
implies higher interest rate.
– Sentiment
Business Cycles
• business cycles: pattern of recession and recovery
• peak: the end of expansion and start of recession
• trough: the bottom of the recession
• stock returns are decreasing when at peak and
increasing at trough
• cyclical industries: do well in expansionary periods but
poorly in recession, e.g., durable goods such as automobile
and wash machines
• defensive industries: little sensitive to business cycles,
such food
Industry Analysis
• Select a good industry to invest. It is difficult for
a firm to do well in a troubled industry
• Standard Industry Classification (SIC) code
• Value line Investment Survey - reports 1700 firms in
90 industries
• Two factors that determine the sensitivity of a
firm’s earnings to business conditions:
business risk,
financial risk
Business risk
• Sales sensitivity to business condition
some industries are robust (food) while others are not
(movie)
• operating leverage: the division between fixed and variable
costs.
– firms with greater amounts of variable cost relative to the fixed
cost are subject less to business fluctuations, thus profits are
more stable
Financial Risk
• the degree in using financial leverage (the amount of
interest payment)
• leverage firm is more sensitive to business cycles
Industry cycles
= D1/(1+k) + D2/(1+k)2
...+ Dn/(1+k)n
• constant growth assumption
V0 = D1/(1+k) + D1(1+g)/(1+k)2
+D1(1+g)2/(1+k)3 + ...
= D1/(k-g)
or k = expected return
= D1/P0 + g
Multistage Growth Model
• Growth profile may not be constant such as:
Expected Growth
g1
g2
n Time
V=D0(1+g1)/(1+k)+...+D0(1+g1)n/(1+k)n
+ D0(1+g1)n(1+g2)/(1+k)n+1+ ... and so on
Illustration of two-stage Growth
Model
• A stock pays $1 dividend now and its g1=30% for
6 yrs. Thereafter, its g2=6%, its k=15%
• yr 1: $1(1+0.3) =1.13
yr 2: 1(1+0.3)2=1.69
yr 3: 1(1+0.3)3=2.20
yr 4: 1(1+0.3)4 =2.86
.
yr 7: 1(1+0.3)6(1+6%) =5.12
yr 8: 1(1+0.3)6(1+6%)2 =5.42
.
Market Value (equity)
Market value is the present value of its future dividends
At time 1:
FV(Dividends) = 34.00(1.15) - 1.3= 37.8
At time 2:
FV(dividends) = 37.80(1.15) - 1.69=41.78
P/E
average
Time
Pitfalls in P/E Analysis
TB IB GPM TAT EM
Pretax profit =EBIT - Interest
TB = Tax burden
IB = interest burden