Macroeconomic and Industry Analysis Chapter 12 Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

12-2 Framework of Analysis Fundamental Analysis –Analysis of the determinants of firm value, specifically attempting to forecast the earnings and dividends of a firm. –Top down approach: Analyze economy Analyze industry Analyze firm

12-3 Framework of Analysis Approach to Fundamental Analysis –Industry analysis Critical to understand the competitiveness of the industry –Company analysis Detailed strategic and financial analysis of the firm Why use the top-down approach?

12-4 The Business Cycle Recurring patterns of recession and recovery –Peak –Trough Industry relationship to business cycles –Cyclical industries Industries with above average sensitivity to the state of the economy –Defensive Industries with below average sensitivity to the state of the economy

12-5 Industry Analysis Performance can vary widely across industries –It is difficult to find a good stock in a poor industry

12-6 Figure 12.8 Industry Stock Price Performance, 2008

12-7 Defining an Industry It can be difficult to define an industry –North American Industry Classification System (NAICS) attempts to define industry groups with a four or five digit code: The first two digits broadly define the industry group: NAIC code 23 = construction The last two or three digits define the industry more narrowly

12-8 Sensitivity to Business Cycle Factors affecting sensitivity of earnings to business cycles –Sensitivity of sales of the firm’s product to the business cycles –Fixed costs and leverage Fixed costs are costs that do not vary with the level of production. Fixed costs contribute to higher profitability when sales are high, but will result in lower profitability when sales are lower.

12-9 Sensitivity to Business Cycle –Operating leverage Proportion of fixed operating costs as a percent of total costs Greater operating leverage results in greater swings in profits over the business cycle –Airlines, automobiles –Financial leverage Proportion of fixed financing costs as a percent of total costs Greater financial leverage results in greater swings in profits over the business cycle –Airlines, banks, investment banks

12-10 Figure A Stylized Depiction of the Business Cycle

12-11 Sector Rotation Selecting Industries in line with the stage of the business cycle: Peak Contraction Trough Expanding natural resource firms defensive firms equipment, transportation and construction firms cyclical industries

12-12 Figure Sector Rotation Illustrated

12-13 Industry Life Cycles StageSales Growth Start-up Consolidation Maturity Relative Decline Rapid & Increasing Stable Slowing Minimal or Negative

12-14 Figure The Industry Life Cycle

12-15 Industry Structure and Performance (Porter Model) Determinants of Industry Competition and Profitability Threat of Entry –New entrants reduce profitability –Barriers to entry preserve profitability Large scale required to be profitable (autos) Secure distribution channels Brand loyalty, unique differentiated product Proprietary production technology Intellectual property protections Learning curve effects

12-16 Industry Structure and Performance (Porter Model) Determinants of Industry Competition and Profitability Rivalry between existing competitors –Equal competitors reduce profitability –Slow industry growth, –High fixed costs, –Scale economies, Pressure to cut prices

12-17 Industry Structure and Performance (Porter Model) Determinants of Industry Competition and Profitability Pressure from substitute products –Substitutes limit profitability (propane, natural gas) Bargaining power of buyers –A buyer that purchases a large percent of an industry’s output can limit the selling industry’s profitability (auto parts suppliers) Bargaining power of suppliers –A supplier that controls a key input can limit the buying industry’s profitability (labor unions)