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Lecture Presentation Software

to accompany

Investment Analysis and


Portfolio Management
Sixth Edition
by
Frank K. Reilly & Keith C. Brown

Chapter 19
Version 1.2
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Chapter 19
Industry Analysis
Questions to be answered:
• Is there a difference between the returns for
alternative industries during specific time periods?
What is the implication of these results?
• Is there consistency in the returns for individual
industries over time? What do these results imply
regarding industry analysis?

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Chapter 19
Industry Analysis
• Is the performance for firms within an
industry consistent? What is the implication
of these results for industry and company
analysis?
• Is there a difference in risk among
industries? What are the implications of
these results for industry analysis?

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Chapter 19
Industry Analysis
• What happens to risk for individual industries
over time? What does this imply for industry
analysis?
• What are two variables that need to be
estimated whether you use cash flow models
or relative valuation ratios?

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Chapter 19
Industry Analysis
• Given the present value of cash flow valuation
techniques, how does an analyst determine the value
of an industry using the DDM and assuming
constant growth or two stage growth?
• How does an analyst determine the value of an
industry using the free cash flow to equity (FCFE)
model with constant growth or two stage growth?

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Chapter 19
Industry Analysis
• What are the steps involved in estimating
earnings per share for an industry?
• What are the stages in the industrial life cycle
and how does the life cycle stage affect the
sales estimate for an industry?
• What are the five basic competitive forces that
determine the intensity of competition in an
industry and thus, its rate of return on capital?

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Chapter 19
Industry Analysis
• How does the estimating procedure for the
operating profit differ for the aggregate
market versus an industry?
• What are the two alternative procedures for
estimating an industry earnings multiplier?

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Chapter 19
Industry Analysis
• What is involved in a macroanalysis of the
industry earnings multiplier?
• What are the steps in the microanalysis of an
industry earnings multiplier?
• After you estimate an industry earnings
multiplier, how do you determine if the
industry’s multiplier is relatively high or low?

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Chapter 19
Industry Analysis
• How do industries differ in terms of what
dictates their return on assets?
• What are some of the unique factors that
must be considered in global industry
analysis?

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Industry Analysis
• The second step in the three-step
fundamental analysis procedure
• In the first step (chapter 14) we discussed
the macroanalysis of the stock market
• The last step will analyze individual
companies and stocks

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Why Do Industry Analysis?
• Help find profitable investment
opportunities
• Part of the three-step, top-down plan for
valuing individual companies and selecting
stocks for a portfolio

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What Do We Learn
From Industry Analysis?
• Is there a difference between the returns for
alternative industries during specific time
periods?
• Will an industry that performs well in one period
continue to perform well in the future? That is,
can we use past relationships between the market
and an individual industry to predict future trends
for the industry?

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What Do We Learn
From Industry Analysis?
• Do firms within an industry show consistent
performance over time?

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What Do We Learn
From Industry Analysis?
• Do firms within an industry show consistent
performance over time?
• Is there a difference in the risk for
alternative industries?

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What Do We Learn
From Industry Analysis?
• Do firms within an industry show consistent
performance over time?
• Is there a difference in the risk for
alternative industries?
• Does the risk for individual industries vary
or does it remain relatively constant over
time?

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Industry Performance
• Wide dispersion in rates of return in different
industries
• Performance varies from year to year
• Company performance varies within industries
• Risks vary widely by industry but are fairly
stable over time

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Links Between the Economy
and Industry Sectors
• Identify and monitor key assumptions and variables
• Economic trends are either
– Cyclical - up and down with business cycle
– Structural - major change
• Combined changes have implications for the industry
being analyzed
• Switching from one industry group to another over
the course of a business cycle is known as a rotation
strategy

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The Stock Market and
the Business Cycle
Figure 19.2

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The Stock Market and
the Business Cycle
Figure 19.2

peak

trough

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The Stock Market and
the Business Cycle
Basic Figure 19.2
Industries
Excel

Consumer
Consumer peak Staples Excel
Durables
Excel

Capital
trough Goods Excel
Financial
Stocks Excel

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Cyclical Economic Factors
• Inflation
• Interest rates
• International economics
• Consumer sentiment

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Structural Economic Changes
and Alternative Industries
• Social Influences
– Demographics
– Lifestyles
• Technology
• Politics and regulations
– Economic reasoning
– Fairness
– Regulatory changes affect numerous industries
– Regulations affect international commerce
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Theme Investing
• Based on identifying emerging trends, such as:
– Technology
– Aging population
– Freer trade and developing-country growth
• Identification of themes provides insight into
industry analysis

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Estimating Industry Rates of Return
• Present value using required rate of return for the
equity in the industry
• Two-step P/E ratio approach uses expected value
at the end of investment horizon and compute the
expected dividend return during the period
• Valuation using the reduced form DDM
D1 Pi = the price of industry i at time t

Pi = D1 = the expected dividend for industry i in period 1 equal

k−g
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
Copyright forbyindustry
© 2000 i All rights reserved
Harcourt, Inc.
Estimating the Required Rate of Return
• Influenced by the risk-free rate
• Expected inflation rate
• Risk premium for the industry versus the market
– business risk (BR)
– financial risk (FR)
– liquidity risk (LR)
– exchange rate risk (ERR)
– country political risk (CR)
• Or compare systematic risk (beta) for the industry to
the market beta of 1.0
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Estimating the Expected Growth Rate
• Earnings and dividend growth are
determined by the retention rate and the
return on equity
– Earnings retention rate of industry compared
to the overall market
– Return on equity is a function of
• the net profit margin
• total asset turnover
• a measure of financial leverage
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Industry Valuation Using the Free Cash
Flow to Equity (FCFE) Model
+ Net income
- Capital expenditures
- ∆ in working capital
- Principal debt repayments
+ New debt issues
Estimates: FCFE1
V=
k−g
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Relative Valuation Ratio Techniques
• Price-earnings ratios (P/E)
• Price-to-book value ratios (P/BV)
• Price-to-cash flow ratios (P/CF)
• Price-to-sales ratios (P/S)

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The Earnings Multiple Technique
• Estimating earnings per share
– start with forecasting sales per share
• Industrial life cycle
• Input-output analysis
• Industry-aggregate economy relationship
– earnings forecasting and analysis of industry
competition
• competitive strategy
• competitive environment
• industry operating profit margin
• industry earnings estimate
• industry earnings multiplier
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Sales Forecasting and
Industry Life Cycle

• Pioneering development
• Rapidly accelerating industry growth
• Mature industry growth
• Stabilization and market maturity
• Deceleration of growth and decline

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Sales Forecasting and
Input-Output Analysis

• Identify suppliers and customers


• Future demand from customers
• Ability of suppliers to provide goods
and services required
• Extended to global industries, include
worldwide suppliers and customers
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Sales Forecasting and
the Industry-Economy Relationship
• Compare industry sales to aggregate
economic series related to the goods
and services provided by the industry

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Forecasting Earnings Per Share
• Analysis of industry competition
• Analysis of competitive structure
• Porter’s concept of competitive
strategy

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Competitive Structure of an
Industry
• Porter’s Competitive Forces
– Rivalry among existing competitors
– Threat of new entrants
– Threat of substitute products
– Bargaining power of buyers
– Bargaining power of suppliers

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Industry Profit Margin Forecast
• Industry’s operating profit margin
(EBITDA / Sales)
– Depreciation expense
– interest expense
– tax rate

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Industry Profit Margin Forecast
Industry’s operating profit margin
(EBITDA / Sales)
• Regression analysis
• Time series analysis
• Long-term consideration including competitive
structure

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Industry Profit Margin Forecast
Depreciation expense
• Generally increasing time series
• Specific estimate technique using the
depreciation expense/PPE ratio
• Subtract depreciation from operating profit
margin to determine industry’s net before interest
and taxes

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Industry Profit Margin Forecast
Interest expense is a function of financial leverage
and interest rates
1. Calculate the annual total asset turnover (TATO)
2. Use your current sales estimate and an estimate
of TATO to estimate total assets next year
3. Calculate the annual long-term (interest bearing)
debt as a percent of total assets,
4. Estimate long-term debt for the next year

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Industry Profit Margin Forecast
Interest expense (cont.)
5. Calculate the annual interest cost as a percent of
long-term debt and analyze the trend
6. Estimate next year’s interest cost of debt for this
industry based upon your prior estimate of
market yields
7. Estimate interest expense based on the following
estimates: (Interest Cost of Debt) (Outstanding
Long-Term Debt)

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Industry Profit Margin Forecast
Tax rate
• Regression analysis
• Time series plot
• After estimating the tax rate, multiply the
EBT per share value 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
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Estimating an Industry Earnings
Multiplier
• Macroanalysis
– relationship between multiplier for the
industry and the market
– variables that influence the multiplier:
• required rate of return (k)
– function of the nominal risk-free rate plus a risk
premium
• expected growth rate of earnings and dividend
• dividend payout ratio

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Estimating an Industry Earnings
Multiplier
• Microanalysis
– Estimate the variables that influence the industry
earnings multiplier and compare them to the
comparable values for the market P/E
– Industry multiplier versus the market multiplier
– Comparing dividend-payout ratios
– Estimating the required rate of return (k)
– Estimating the expected growth rate (g)
g = Retention Rate (b) X Return on Equity (ROE)
= (b) X (ROE)

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Other Relative Valuation Ratios
• Price-to-book value ratio
• Price-to-cash flow ratio
• Price-to-sales ratio

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Global Industry Analysis
• Profit performance
– EPS, ROE, Debt/Equity
– Relative value (P/E, P/CF, P/B)
• World supply, demand and cost components
• Different valuation levels due to accounting
conventions
• Impact of exchange rates on the total industry
and the firms within it

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End of Chapter 19
–Industry Analysis

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Future topics
Chapter 20
Company Analysis and Stock Selection
• Value
• Growth
• Strategies

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