Macroeconomic and Industry Analysis CHAPTER 17 FRAMEWORK OF

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Macroeconomic and Industry Analysis CHAPTER 17

Macroeconomic and Industry Analysis CHAPTER 17

FRAMEWORK OF ANALYSIS Fundamental Analysis Approach to Fundamental Analysis: Domestic and global economic 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? BAHATTIN BUYUKSAHIN, JHU INVESTMENT 2

GLOBAL ECONOMIC CONSIDERATIONS Performance in countries and regions is highly variable Political risk Exchange

GLOBAL ECONOMIC CONSIDERATIONS Performance in countries and regions is highly variable Political risk Exchange rate risk Sales Profits Stock returns BAHATTIN BUYUKSAHIN, JHU INVESTMENT 3

TABLE 17. 1 ECONOMIC PERFORMANCE IN SELECTED EMERGING MARKETS BAHATTIN BUYUKSAHIN, JHU INVESTMENT 4

TABLE 17. 1 ECONOMIC PERFORMANCE IN SELECTED EMERGING MARKETS BAHATTIN BUYUKSAHIN, JHU INVESTMENT 4

FIGURE 17. 1 CHANGE IN REAL EXCHANGE RATE: U. S. DOLLAR VERSUS MAJOR CURRENCIES,

FIGURE 17. 1 CHANGE IN REAL EXCHANGE RATE: U. S. DOLLAR VERSUS MAJOR CURRENCIES, 1999– 2006 BAHATTIN BUYUKSAHIN, JHU INVESTMENT 5

KEY ECONOMIC VARIABLES Gross domestic product Unemployment rates Interest rates & inflation Budget deficit

KEY ECONOMIC VARIABLES Gross domestic product Unemployment rates Interest rates & inflation Budget deficit Consumer sentiment BAHATTIN BUYUKSAHIN, JHU INVESTMENT 6

FIGURE 17. 2 S&P 500 INDEX VERSUS EARNINGS PER SHARE BAHATTIN BUYUKSAHIN, JHU INVESTMENT

FIGURE 17. 2 S&P 500 INDEX VERSUS EARNINGS PER SHARE BAHATTIN BUYUKSAHIN, JHU INVESTMENT 7

DEMAND SHOCKS Demand shock - an event that affects demand for goods and services

DEMAND SHOCKS Demand shock - an event that affects demand for goods and services in the economy BAHATTIN BUYUKSAHIN, JHU INVESTMENT 8

SUPPLY SHOCKS Supply shock - an event that influences production capacity or production costs

SUPPLY SHOCKS Supply shock - an event that influences production capacity or production costs BAHATTIN BUYUKSAHIN, JHU INVESTMENT 9

FEDERAL GOVERNMENT POLICY Fiscal Policy: Demand-side management Tax rate cut Increases in government spending

FEDERAL GOVERNMENT POLICY Fiscal Policy: Demand-side management Tax rate cut Increases in government spending BAHATTIN BUYUKSAHIN, JHU INVESTMENT 10

FEDERAL GOVERNMENT POLICY CONTINUED Monetary Policy - Demand-side management Manipulation of the money supply

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 BAHATTIN BUYUKSAHIN, JHU INVESTMENT 11

FEDERAL GOVERNMENT POLICY CONTINUED Fiscal Policy: Supply-side management Incentive or marginal taxes National policies

FEDERAL GOVERNMENT POLICY CONTINUED Fiscal Policy: Supply-side management Incentive or marginal taxes National policies on education, infrastructure, and research are important elements BAHATTIN BUYUKSAHIN, JHU INVESTMENT 12

BUSINESS CYCLES The transition points across cycles are called peaks and troughs A peak

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 BAHATTIN BUYUKSAHIN, JHU INVESTMENT 13

FIGURE 17. 3 CYCLICAL INDICATORS BAHATTIN BUYUKSAHIN, JHU INVESTMENT 14

FIGURE 17. 3 CYCLICAL INDICATORS BAHATTIN BUYUKSAHIN, JHU INVESTMENT 14

LEADING INDICATORS Leading indicators tend to rise and fall in advance of the economy

LEADING INDICATORS Leading indicators tend to rise and fall in advance of the economy Examples: Avg. weekly hours of production workers Stock Prices BAHATTIN BUYUKSAHIN, JHU INVESTMENT 15

TABLE 17. 2 INDEXES OF ECONOMIC INDICATORS BAHATTIN BUYUKSAHIN, JHU INVESTMENT 16

TABLE 17. 2 INDEXES OF ECONOMIC INDICATORS BAHATTIN BUYUKSAHIN, JHU INVESTMENT 16

COINCIDENT INDICATORS Coincident Indicators - indicators that tend to change directly with the economy

COINCIDENT INDICATORS Coincident Indicators - indicators that tend to change directly with the economy Examples: Industrial production Manufacturing and trade sales BAHATTIN BUYUKSAHIN, JHU INVESTMENT 17

LAGGING INDICATORS Lagging Indicators - indicators that tend to follow the lag economic performance

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 BAHATTIN BUYUKSAHIN, JHU INVESTMENT 18

FIGURE 17. 4 INDEXES OF LEADING, COINCIDENT, AND LAGGING INDICATORS BAHATTIN BUYUKSAHIN, JHU INVESTMENT

FIGURE 17. 4 INDEXES OF LEADING, COINCIDENT, AND LAGGING INDICATORS BAHATTIN BUYUKSAHIN, JHU INVESTMENT 19

TABLE 17. 3 ECONOMIC CALENDAR BAHATTIN BUYUKSAHIN, JHU INVESTMENT 20

TABLE 17. 3 ECONOMIC CALENDAR BAHATTIN BUYUKSAHIN, JHU INVESTMENT 20

INDUSTRY ANALYSIS Sensitivity to business cycles Factors affecting sensitivity of earnings to business cycles:

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 BAHATTIN BUYUKSAHIN, JHU INVESTMENT 21

FIGURE 17. 5 ECONOMIC CALENDAR AT YAHOO! BAHATTIN BUYUKSAHIN, JHU INVESTMENT 22

FIGURE 17. 5 ECONOMIC CALENDAR AT YAHOO! BAHATTIN BUYUKSAHIN, JHU INVESTMENT 22

TABLE 17. 4 USEFUL ECONOMIC INDICATORS BAHATTIN BUYUKSAHIN, JHU INVESTMENT 23

TABLE 17. 4 USEFUL ECONOMIC INDICATORS BAHATTIN BUYUKSAHIN, JHU INVESTMENT 23

FIGURE 17. 6 RETURN ON EQUITY, 2007 BAHATTIN BUYUKSAHIN, JHU INVESTMENT 24

FIGURE 17. 6 RETURN ON EQUITY, 2007 BAHATTIN BUYUKSAHIN, JHU INVESTMENT 24

DEFINING AN INDUSTRY North American Industry Classification System, or NAICS codes Codes assigned to

DEFINING AN INDUSTRY North American Industry Classification System, or NAICS codes Codes assigned to group firms for statistical analysis BAHATTIN BUYUKSAHIN, JHU INVESTMENT 25

FIGURE 17. 7 INDUSTRY STOCK PRICE PERFORMANCE AS MEASURED BY RATE OF RETURN ON

FIGURE 17. 7 INDUSTRY STOCK PRICE PERFORMANCE AS MEASURED BY RATE OF RETURN ON DOW JONES SECTOR ISHARES, JANUARY-OCTOBER 2007 BAHATTIN BUYUKSAHIN, JHU INVESTMENT 26

FIGURE 17. 8 ROE OF MAJOR BANKS BAHATTIN BUYUKSAHIN, JHU INVESTMENT 27

FIGURE 17. 8 ROE OF MAJOR BANKS BAHATTIN BUYUKSAHIN, JHU INVESTMENT 27

TABLE 17. 5 EXAMPLES OF NAICS INDUSTRY CODES BAHATTIN BUYUKSAHIN, JHU INVESTMENT 28

TABLE 17. 5 EXAMPLES OF NAICS INDUSTRY CODES BAHATTIN BUYUKSAHIN, JHU INVESTMENT 28

FIGURE 17. 9 INDUSTRY CYCLICALITY BAHATTIN BUYUKSAHIN, JHU INVESTMENT 29

FIGURE 17. 9 INDUSTRY CYCLICALITY BAHATTIN BUYUKSAHIN, JHU INVESTMENT 29

TABLE 17. 6 OPERATING LEVERAGE OF FIRMS A AND B THROUGHOUT THE BUSINESS CYCLE

TABLE 17. 6 OPERATING LEVERAGE OF FIRMS A AND B THROUGHOUT THE BUSINESS CYCLE BAHATTIN BUYUKSAHIN, JHU INVESTMENT 30

FIGURE 17. 10 A STYLIZED DEPICTION OF THE BUSINESS CYCLE BAHATTIN BUYUKSAHIN, JHU INVESTMENT

FIGURE 17. 10 A STYLIZED DEPICTION OF THE BUSINESS CYCLE BAHATTIN BUYUKSAHIN, JHU INVESTMENT 31

SECTOR ROTATION Portfolio is adjusted by selecting companies that should perform well for the

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 BAHATTIN BUYUKSAHIN, JHU INVESTMENT 32

FIGURE 17. 11 SECTOR ROTATION BAHATTIN BUYUKSAHIN, JHU INVESTMENT 33

FIGURE 17. 11 SECTOR ROTATION BAHATTIN BUYUKSAHIN, JHU INVESTMENT 33

INDUSTRY LIFE CYCLES Stage Sales Growth Start-up Consolidation Maturity Relative Decline BAHATTIN BUYUKSAHIN, JHU

INDUSTRY LIFE CYCLES Stage Sales Growth Start-up Consolidation Maturity Relative Decline BAHATTIN BUYUKSAHIN, JHU INVESTMENT Rapid & Increasing Stable Slowing Minimal or Negative 34

FIGURE 17. 12 THE INDUSTRY LIFE CYCLE BAHATTIN BUYUKSAHIN, JHU INVESTMENT 35

FIGURE 17. 12 THE INDUSTRY LIFE CYCLE BAHATTIN BUYUKSAHIN, JHU INVESTMENT 35

INDUSTRY STRUCTURE AND PERFORMANCE Threat of entry Rivalry between existing competitors Pressure from substitute

INDUSTRY STRUCTURE AND PERFORMANCE Threat of entry Rivalry between existing competitors Pressure from substitute products Bargaining power of buyers Bargaining power of suppliers BAHATTIN BUYUKSAHIN, JHU INVESTMENT 36

Equity Valuation Models CHAPTER 18

Equity Valuation Models CHAPTER 18

MODELS OF EQUITY VALUATION Balance Sheet Models Book Value Dividend Discount Models Price/Earning Ratios

MODELS OF EQUITY VALUATION Balance Sheet Models Book Value Dividend Discount Models Price/Earning Ratios BAHATTIN BUYUKSAHIN, JHU INVESTMENT 38

TABLE 18. 1 FINANCIAL HIGHLIGHTS FOR MICROSOFT CORPORATION, OCTOBER 25, 2007 BAHATTIN BUYUKSAHIN, JHU

TABLE 18. 1 FINANCIAL HIGHLIGHTS FOR MICROSOFT CORPORATION, OCTOBER 25, 2007 BAHATTIN BUYUKSAHIN, JHU INVESTMENT 39

LIMITATIONS OF BOOK VALUE Book value is an application of arbitrary accounting rules Can

LIMITATIONS OF BOOK VALUE Book value is an application of arbitrary accounting rules Can book value represent a floor value? Better approaches Liquidation value Replacement cost BAHATTIN BUYUKSAHIN, JHU INVESTMENT 40

EXPECTED HOLDING PERIOD RETURN The return on a stock investment comprises cash dividends and

EXPECTED HOLDING PERIOD RETURN The return on a stock investment comprises cash dividends and capital gains or losses Assuming a one-year holding period BAHATTIN BUYUKSAHIN, JHU INVESTMENT 41

REQUIRED RETURN CAPM gave us required return: If the stock is priced correctly Required

REQUIRED RETURN CAPM gave us required return: If the stock is priced correctly Required return should equal expected return BAHATTIN BUYUKSAHIN, JHU INVESTMENT 42

INTRINSIC VALUE AND MARKET PRICE Intrinsic Value Self assigned Value Variety of models are

INTRINSIC VALUE AND MARKET PRICE Intrinsic Value Self assigned Value Variety of models are used for estimation Market Price Consensus value of all potential traders Trading Signal IV > MP Buy IV < MP Sell or Short Sell IV = MP Hold or Fairly Priced BAHATTIN BUYUKSAHIN, JHU INVESTMENT 43

SPECIFIED HOLDING PERIOD PH = the expected sales price for the stock at time

SPECIFIED HOLDING PERIOD PH = the expected sales price for the stock at time H H = the specified number of years the stock is expected to be held BAHATTIN BUYUKSAHIN, JHU INVESTMENT 44

DIVIDEND DISCOUNT MODELS: GENERAL MODEL V 0 = Value of Stock Dt = Dividend

DIVIDEND DISCOUNT MODELS: GENERAL MODEL V 0 = Value of Stock Dt = Dividend k = required return BAHATTIN BUYUKSAHIN, JHU INVESTMENT 45

NO GROWTH MODEL Stocks that have earnings and dividends that are expected to remain

NO GROWTH MODEL Stocks that have earnings and dividends that are expected to remain constant Preferred Stock BAHATTIN BUYUKSAHIN, JHU INVESTMENT 46

NO GROWTH MODEL: EXAMPLE E 1 = D 1 = $5. 00 k =.

NO GROWTH MODEL: EXAMPLE E 1 = D 1 = $5. 00 k =. 15 V 0 = $5. 00 /. 15 = $33. 33 BAHATTIN BUYUKSAHIN, JHU INVESTMENT 47

CONSTANT GROWTH MODEL g = constant perpetual growth rate BAHATTIN BUYUKSAHIN, JHU INVESTMENT 48

CONSTANT GROWTH MODEL g = constant perpetual growth rate BAHATTIN BUYUKSAHIN, JHU INVESTMENT 48

CONSTANT GROWTH MODEL: EXAMPLE E 1 = $5. 00 b = 40% k =

CONSTANT GROWTH MODEL: EXAMPLE E 1 = $5. 00 b = 40% k = 15% (1 -b) = 60% D 1 = $3. 00 g = 8% V 0 = 3. 00 / (. 15 -. 08) = $42. 86 BAHATTIN BUYUKSAHIN, JHU INVESTMENT 49

ESTIMATING DIVIDEND GROWTH RATES g = growth rate in dividends ROE = Return on

ESTIMATING DIVIDEND GROWTH RATES g = growth rate in dividends ROE = Return on Equity for the firm b = plowback or retention percentage rate (1 - dividend payout percentage rate) BAHATTIN BUYUKSAHIN, JHU INVESTMENT 50

FIGURE 18. 1 DIVIDEND GROWTH FOR TWO EARNINGS REINVESTMENT POLICIES BAHATTIN BUYUKSAHIN, JHU INVESTMENT

FIGURE 18. 1 DIVIDEND GROWTH FOR TWO EARNINGS REINVESTMENT POLICIES BAHATTIN BUYUKSAHIN, JHU INVESTMENT 51

PRESENT VALUE OF GROWTH OPPORTUNITIES If the stock price equals its IV, growth rate

PRESENT VALUE OF GROWTH OPPORTUNITIES If the stock price equals its IV, growth rate is sustained, the stock should sell at: If all earnings paid out as dividends, price should be lower (assuming growth opportunities exist) BAHATTIN BUYUKSAHIN, JHU INVESTMENT 52

PRESENT VALUE OF GROWTH OPPORTUNITIES CONTINUED Price = No-growth value per share + PVGO

PRESENT VALUE OF GROWTH OPPORTUNITIES CONTINUED Price = No-growth value per share + PVGO (present value of growth opportunities) BAHATTIN BUYUKSAHIN, JHU INVESTMENT 53

PARTITIONING VALUE: EXAMPLE ROE = 20% d = 60% b = 40% E 1

PARTITIONING VALUE: EXAMPLE ROE = 20% d = 60% b = 40% E 1 = $5. 00 D 1 = $3. 00 k = 15% g =. 20 x. 40 =. 08 or 8% BAHATTIN BUYUKSAHIN, JHU INVESTMENT 54

Partitioning Value: Example Continued Vo = value with growth NGVo = no growth component

Partitioning Value: Example Continued Vo = value with growth NGVo = no growth component value PVGO = Present Value of Growth Opportunities BAHATTIN BUYUKSAHIN, JHU INVESTMENT 55

LIFE CYCLES AND MULTISTAGE GROWTH MODELS g 1 = first growth rate g 2

LIFE CYCLES AND MULTISTAGE GROWTH MODELS g 1 = first growth rate g 2 = second growth rate T = number of periods of growth at g 1 BAHATTIN BUYUKSAHIN, JHU INVESTMENT 56

MULTISTAGE GROWTH RATE MODEL: EXAMPLE D 0 = $2. 00 g 1 = 20%

MULTISTAGE GROWTH RATE MODEL: EXAMPLE D 0 = $2. 00 g 1 = 20% g 2 = 5% k = 15% D 2 = 2. 88 T=3 D 1 = 2. 40 D 3 = 3. 46 D 4 = 3. 63 V 0 = D 1/(1. 15) + D 2/(1. 15)2 + D 3/(1. 15)3 + D 4 / (. 15 -. 05) ( (1. 15)3 V 0 = 2. 09 + 2. 18 + 2. 27 + 23. 86 = $30. 40 BAHATTIN BUYUKSAHIN, JHU INVESTMENT 57

TABLE 18. 2 FINANCIAL RATIOS IN TWO INDUSTRIES BAHATTIN BUYUKSAHIN, JHU INVESTMENT 58

TABLE 18. 2 FINANCIAL RATIOS IN TWO INDUSTRIES BAHATTIN BUYUKSAHIN, JHU INVESTMENT 58

FIGURE 18. 2 VALUE LINE INVESTMENT SURVEY REPORT ON HONDA MOTOR CO. BAHATTIN BUYUKSAHIN,

FIGURE 18. 2 VALUE LINE INVESTMENT SURVEY REPORT ON HONDA MOTOR CO. BAHATTIN BUYUKSAHIN, JHU INVESTMENT 59

PRICE EARNINGS RATIOS P/E Ratios are a function of two factors Required Rates of

PRICE EARNINGS RATIOS P/E Ratios are a function of two factors Required Rates of Return (k) Expected growth in Dividends Uses Relative valuation Extensive Use in industry BAHATTIN BUYUKSAHIN, JHU INVESTMENT 60

P/E RATIO: NO EXPECTED GROWTH E 1 - expected earnings for next year E

P/E RATIO: NO EXPECTED GROWTH E 1 - expected earnings for next year E 1 is equal to D 1 under no growth k - required rate of return BAHATTIN BUYUKSAHIN, JHU INVESTMENT 61

P/E RATIO: CONSTANT GROWTH b = retention ratio ROE = Return on Equity BAHATTIN

P/E RATIO: CONSTANT GROWTH b = retention ratio ROE = Return on Equity BAHATTIN BUYUKSAHIN, JHU INVESTMENT 62

NUMERICAL EXAMPLE: NO GROWTH E 0 = $2. 50 g=0 k = 12. 5%

NUMERICAL EXAMPLE: NO GROWTH E 0 = $2. 50 g=0 k = 12. 5% P 0 = D/k = $2. 50/. 125 = $20. 00 PE = 1/k = 1/. 125 = 8 BAHATTIN BUYUKSAHIN, JHU INVESTMENT 63

NUMERICAL EXAMPLE: GROWTH b = 60% ROE = 15% (1 -b) = 40% E

NUMERICAL EXAMPLE: GROWTH b = 60% ROE = 15% (1 -b) = 40% E 1 = $2. 50 (1 + (. 6)(. 15)) = $2. 73 D 1 = $2. 73 (1 -. 6) = $1. 09 k = 12. 5% g = 9% P 0 = 1. 09/(. 125 -. 09) = $31. 14 PE = 31. 14/2. 73 = 11. 4 PE = (1 -. 60) / (. 125 -. 09) = 11. 4 BAHATTIN BUYUKSAHIN, JHU INVESTMENT 64

TABLE 18. 3 EFFECT OF ROE AND PLOWBACK ON GROWTH AND THE P/E RATIO

TABLE 18. 3 EFFECT OF ROE AND PLOWBACK ON GROWTH AND THE P/E RATIO BAHATTIN BUYUKSAHIN, JHU INVESTMENT 65

P/E RATIOS AND STOCK RISK Holding all else equal Riskier stocks will have lower

P/E RATIOS AND STOCK RISK Holding all else equal Riskier stocks will have lower P/E multiples Higher values of k; therefore, the P/E multiple will be lower BAHATTIN BUYUKSAHIN, JHU INVESTMENT 66

PITFALLS IN P/E ANALYSIS Use of accounting earnings Earnings Management Choices on GAAP Inflation

PITFALLS IN P/E ANALYSIS Use of accounting earnings Earnings Management Choices on GAAP Inflation Reported earnings fluctuate around the business cycle BAHATTIN BUYUKSAHIN, JHU INVESTMENT 67

FIGURE 18. 3 P/E RATIOS OF THE S&P 500 INDEX AND INFLATION BAHATTIN BUYUKSAHIN,

FIGURE 18. 3 P/E RATIOS OF THE S&P 500 INDEX AND INFLATION BAHATTIN BUYUKSAHIN, JHU INVESTMENT 68

FIGURE 18. 4 EARNINGS GROWTH FOR TWO COMPANIES BAHATTIN BUYUKSAHIN, JHU INVESTMENT 69

FIGURE 18. 4 EARNINGS GROWTH FOR TWO COMPANIES BAHATTIN BUYUKSAHIN, JHU INVESTMENT 69

FIGURE 18. 5 PRICE-EARNINGS RATIOS BAHATTIN BUYUKSAHIN, JHU INVESTMENT 70

FIGURE 18. 5 PRICE-EARNINGS RATIOS BAHATTIN BUYUKSAHIN, JHU INVESTMENT 70

FIGURE 18. 6 P/E RATIOS FOR DIFFERENT INDUSTRIES, 2007 BAHATTIN BUYUKSAHIN, JHU INVESTMENT 71

FIGURE 18. 6 P/E RATIOS FOR DIFFERENT INDUSTRIES, 2007 BAHATTIN BUYUKSAHIN, JHU INVESTMENT 71

OTHER COMPARATIVE VALUE APPROACHES Price-to-book ratio Price-to-cash-flow ratio Price-to-sales ratio BAHATTIN BUYUKSAHIN, JHU INVESTMENT

OTHER COMPARATIVE VALUE APPROACHES Price-to-book ratio Price-to-cash-flow ratio Price-to-sales ratio BAHATTIN BUYUKSAHIN, JHU INVESTMENT 72

FIGURE 18. 7 MARKET VALUATION STATISTICS BAHATTIN BUYUKSAHIN, JHU INVESTMENT 73

FIGURE 18. 7 MARKET VALUATION STATISTICS BAHATTIN BUYUKSAHIN, JHU INVESTMENT 73

FREE CASH FLOW APPROACH Discount the free cash flow for the firm Discount rate

FREE CASH FLOW APPROACH Discount the free cash flow for the firm Discount rate is the firm’s cost of capital Components of free cash flow After tax EBIT Depreciation Capital expenditures Increase in net working capital BAHATTIN BUYUKSAHIN, JHU INVESTMENT 74

COMPARING THE VALUATION MODELS In practice Values from these models may differ Analysts are

COMPARING THE VALUATION MODELS In practice Values from these models may differ Analysts are always forced to make simplifying assumptions BAHATTIN BUYUKSAHIN, JHU INVESTMENT 75

THE AGGREGATE STOCK MARKET Explaining Past Behavior Forecasting the Stock Market BAHATTIN BUYUKSAHIN, JHU

THE AGGREGATE STOCK MARKET Explaining Past Behavior Forecasting the Stock Market BAHATTIN BUYUKSAHIN, JHU INVESTMENT 76

FIGURE 18. 8 EARNINGS YIELD OF S&P 500 VERSUS 10 -YEAR TREASURY-BOND YIELD BAHATTIN

FIGURE 18. 8 EARNINGS YIELD OF S&P 500 VERSUS 10 -YEAR TREASURY-BOND YIELD BAHATTIN BUYUKSAHIN, JHU INVESTMENT 77

TABLE 18. 4 S&P 500 PRICE FORECASTS UNDER VARIOUS SCENARIOS BAHATTIN BUYUKSAHIN, JHU INVESTMENT

TABLE 18. 4 S&P 500 PRICE FORECASTS UNDER VARIOUS SCENARIOS BAHATTIN BUYUKSAHIN, JHU INVESTMENT 78

Financial Statement Analysis CHAPTER 19

Financial Statement Analysis CHAPTER 19

OVERVIEW Purpose Tools Used Statement analysis Ratio analysis Limitations BAHATTIN BUYUKSAHIN, JHU INVESTMENT 80

OVERVIEW Purpose Tools Used Statement analysis Ratio analysis Limitations BAHATTIN BUYUKSAHIN, JHU INVESTMENT 80

FINANCIAL STATEMENTS Balance Sheet Common Sized Trend or Indexed Income Statement Common Sized Trend

FINANCIAL STATEMENTS Balance Sheet Common Sized Trend or Indexed Income Statement Common Sized Trend or Indexed Statement of Cash Flows BAHATTIN BUYUKSAHIN, JHU INVESTMENT 81

TABLE 19. 1 CONSOLIDATED STATEMENT OF INCOME FOR HEWLETT-PACKARD, 2006 BAHATTIN BUYUKSAHIN, JHU INVESTMENT

TABLE 19. 1 CONSOLIDATED STATEMENT OF INCOME FOR HEWLETT-PACKARD, 2006 BAHATTIN BUYUKSAHIN, JHU INVESTMENT 82

TABLE 19. 2 CONSOLIDATED BALANCE SHEET FOR HEWLETT-PACKARD, 2006 BAHATTIN BUYUKSAHIN, JHU INVESTMENT 83

TABLE 19. 2 CONSOLIDATED BALANCE SHEET FOR HEWLETT-PACKARD, 2006 BAHATTIN BUYUKSAHIN, JHU INVESTMENT 83

TABLE 19. 3 STATEMENT OF CASH FLOWS FOR HEWLETT-PACKARD, 2006 BAHATTIN BUYUKSAHIN, JHU INVESTMENT

TABLE 19. 3 STATEMENT OF CASH FLOWS FOR HEWLETT-PACKARD, 2006 BAHATTIN BUYUKSAHIN, JHU INVESTMENT 84

ACCOUNTING VERSUS ECONOMIC EARNINGS Economic earnings Sustainable cash flow that can be paid to

ACCOUNTING VERSUS ECONOMIC EARNINGS Economic earnings Sustainable cash flow that can be paid to stockholders without impairing productive capacity of the firm Accounting earnings Affected by conventions regarding the valuation of assets BAHATTIN BUYUKSAHIN, JHU INVESTMENT 85

PROFITABILITY MEASURES ROE: measures the profitability for contributors of equity capital ROA: measures the

PROFITABILITY MEASURES ROE: measures the profitability for contributors of equity capital ROA: measures the profitability for all contributors of capital Leverage has a significant effect on profitability measures BAHATTIN BUYUKSAHIN, JHU INVESTMENT 86

TABLE 19. 4 NODETT’S PROFITABILITY OVER THE BUSINESS CYCLE BAHATTIN BUYUKSAHIN, JHU INVESTMENT 87

TABLE 19. 4 NODETT’S PROFITABILITY OVER THE BUSINESS CYCLE BAHATTIN BUYUKSAHIN, JHU INVESTMENT 87

TABLE 19. 5 IMPACT OF FINANCIAL LEVERAGE ON ROE BAHATTIN BUYUKSAHIN, JHU INVESTMENT 88

TABLE 19. 5 IMPACT OF FINANCIAL LEVERAGE ON ROE BAHATTIN BUYUKSAHIN, JHU INVESTMENT 88

ROE, ROA AND LEVERAGE BAHATTIN BUYUKSAHIN, JHU INVESTMENT 89

ROE, ROA AND LEVERAGE BAHATTIN BUYUKSAHIN, JHU INVESTMENT 89

DECOMPOSITION OF ROE = Net Profit x Pretax Profit (1) Tax x x Burden

DECOMPOSITION OF ROE = Net Profit x Pretax Profit (1) Tax x x Burden BAHATTIN BUYUKSAHIN, JHU INVESTMENT Pretax Profit EBIT (2) Interest Burden x x EBIT Sales (3) x x Sales Assets (4) x Assets Equity x (5) x Margin x Turnover x Leverage 90

TABLE 19. 6 RATIO DECOMPOSITION ANALYSIS FOR NODETT AND SOMDETT BAHATTIN BUYUKSAHIN, JHU INVESTMENT

TABLE 19. 6 RATIO DECOMPOSITION ANALYSIS FOR NODETT AND SOMDETT BAHATTIN BUYUKSAHIN, JHU INVESTMENT 91

TABLE 19. 7 DIFFERENCES BETWEEN PROFIT MARGIN AND ASSET TURNOVER ACROSS INDUSTRIES BAHATTIN BUYUKSAHIN,

TABLE 19. 7 DIFFERENCES BETWEEN PROFIT MARGIN AND ASSET TURNOVER ACROSS INDUSTRIES BAHATTIN BUYUKSAHIN, JHU INVESTMENT 92

TABLE 19. 8 GROWTH INDUSTRIES FINANCIAL STATEMENTS, 2004 – 2007 ($ THOUSANDS) BAHATTIN BUYUKSAHIN,

TABLE 19. 8 GROWTH INDUSTRIES FINANCIAL STATEMENTS, 2004 – 2007 ($ THOUSANDS) BAHATTIN BUYUKSAHIN, JHU INVESTMENT 93

TABLE 19. 9 SUMMARY OF KEY FINANCIAL RATIOS: LEVERAGE, ASSET UTILIZATION, LIQUIDITY, PROFITABILITY AND

TABLE 19. 9 SUMMARY OF KEY FINANCIAL RATIOS: LEVERAGE, ASSET UTILIZATION, LIQUIDITY, PROFITABILITY AND MARKET PRICE BAHATTIN BUYUKSAHIN, JHU INVESTMENT 94

FIGURE 19. 1 DUPONT DECOMPOSITION FOR HEWLETTPACKARD BAHATTIN BUYUKSAHIN, JHU INVESTMENT 95

FIGURE 19. 1 DUPONT DECOMPOSITION FOR HEWLETTPACKARD BAHATTIN BUYUKSAHIN, JHU INVESTMENT 95

TABLE 19. 10 FINANCIAL RATIOS FOR MAJOR INDUSTRY GROUPS BAHATTIN BUYUKSAHIN, JHU INVESTMENT 96

TABLE 19. 10 FINANCIAL RATIOS FOR MAJOR INDUSTRY GROUPS BAHATTIN BUYUKSAHIN, JHU INVESTMENT 96

ECONOMIC VALUE ADDED Difference between return on assets (ROA) and the opportunity cost of

ECONOMIC VALUE ADDED Difference between return on assets (ROA) and the opportunity cost of capital (k) EVA is also called residual income EVA can be positive or negative for firms that have positive earnings BAHATTIN BUYUKSAHIN, JHU INVESTMENT 97

TABLE 19. 11 ECONOMIC VALUE ADDED, 2007 BAHATTIN BUYUKSAHIN, JHU INVESTMENT 98

TABLE 19. 11 ECONOMIC VALUE ADDED, 2007 BAHATTIN BUYUKSAHIN, JHU INVESTMENT 98

TABLE 19. 12 KEY FINANCIAL RATIOS OF GROWTH INDUSTRIES, INC BAHATTIN BUYUKSAHIN, JHU INVESTMENT

TABLE 19. 12 KEY FINANCIAL RATIOS OF GROWTH INDUSTRIES, INC BAHATTIN BUYUKSAHIN, JHU INVESTMENT 99

TABLE 19. 13 GROWTH INDUSTRIES STATEMENT OF CASH FLOWS ($ THOUSANDS) BAHATTIN BUYUKSAHIN, JHU

TABLE 19. 13 GROWTH INDUSTRIES STATEMENT OF CASH FLOWS ($ THOUSANDS) BAHATTIN BUYUKSAHIN, JHU INVESTMENT 100

COMPARABILITY PROBLEMS Accounting Differences Inventory Valuation Depreciation Inflation and Interest Expense Fair Value Accounting

COMPARABILITY PROBLEMS Accounting Differences Inventory Valuation Depreciation Inflation and Interest Expense Fair Value Accounting Quality of Earnings International Accounting Conventions BAHATTIN BUYUKSAHIN, JHU INVESTMENT 101

INTERNATIONAL ACCOUNTING DIFFERENCES Reserves – many other countries allow more flexibility in use of

INTERNATIONAL ACCOUNTING DIFFERENCES Reserves – many other countries allow more flexibility in use of reserves Depreciation – US allows separate tax and reporting presentations Intangibles – treatment varies widely BAHATTIN BUYUKSAHIN, JHU INVESTMENT 102

FIGURE 19. 2 ADJUSTED VERSUS REPORTED PRICE-EARNINGS RATIOS BAHATTIN BUYUKSAHIN, JHU INVESTMENT 103

FIGURE 19. 2 ADJUSTED VERSUS REPORTED PRICE-EARNINGS RATIOS BAHATTIN BUYUKSAHIN, JHU INVESTMENT 103

THE GRAHAM TECHNIQUE Careful analysis of a firm’s financial statements could turn up bargain

THE GRAHAM TECHNIQUE Careful analysis of a firm’s financial statements could turn up bargain stocks Purchase common stocks at less then their working-capital value Give no weight to plant or other fixed assets Deduct all liabilities in full from assets BAHATTIN BUYUKSAHIN, JHU INVESTMENT 104