Solutions for Chapter 8: Questions and Problems
CHAPTER 8
Economic and Industry Analysis
Answers to Questions
1.
The top-down valuation process begins by examining the influence of the general
economy on all firms and the security markets. The next step is to analyze the various
industries in light of the economic environment. The final step is to select and analyze the
individual firms within the superior industries and the common stocks of these firms.
The top-down approach thus assumes that the first two steps (economy-market and
industry) have a significant influence on the individual firm and its stock (the third step).
In contrast, the bottom-up approach assumes that it is possible to select investments (i.e.
firms) without considering the aggregate market and industry influences.
2.
It is intuitively logical that aggregate market analysis precede industry and company
analysis because the government and federal agencies can exert influence on the
aggregate economy via fiscal (changes in government spending, taxes, etc.) and monetary
(changing money supply, interest rates, etc.) policy. Further, inflation, another aggregate
economic variable, must be considered because of its major impact on interest rates and
the spending and saving/investment of consumers and corporations. Therefore, a major
division is the asset allocation among countries based upon the differential economic
outlook including exchange rates (the outlook for the currency).
Again, industry analysis should precede individual security analysis since there are
several factors that are generally national in scope but have a pervasive effect on some
industries - e.g., industry-wide strikes, import/ export quotas, etc. In addition, alternative
industries feel the impact of economic change at different points in the business cycle e.g., industries may lead or lag an expansion. Further, some industries are cyclical (e.g.,
steel, auto), some are stable (utilities, food chains, etc.). Fluctuating exchange rates will
affect some industries more than others.
The thrust of the argument is that very few, if any, industries perform well in a recession,
and a “good” company in a “poor” industry may be difficult to find.
3.
All industries would not react identically to changes in the economy simply because of
the different nature of business. The auto industry for instance tends to do much better
than the economy during expansions but also tends to do far worse during contractions as
consumers’ consumption patterns change. In contrast, the earnings of utilities undergo
modest changes during either expansion or recession since they serve a necessity and thus
their sales are somewhat immune to fluctuations. Also, some industries “lead” the
economy while others only react late in the cycle (e.g., construction).
- 68 Copyright © 2010 by Nelson Education Ltd.
Solutions for Chapter 8: Questions and Problems
4.
The reason for the strong relationship between the aggregate economy and the stock
market is obvious if one considers that stock prices reflect changes in expectations for
firms and the results for individual firms are affected by the overall performance of the
economy. In essence, you would expect earnings of firms to increase in an expansion.
Then, if the P/E ratio remains constant or increases because of higher expectations you
would expect an increase in stock prices and vice versa in a contraction.
5.
Stock prices turn before the economy for two reasons: First, investors attempt to estimate
future earnings and thus current stock prices are based upon future earnings and
dividends, which in turn are determined by expectations of future economic activity. The
second possible reason is that the stock market reacts to various economic series that are
leading indicators of the economy - e.g., corporate earnings, profit margins, and money
supply.
6.
Virtually all research has shown the existence of a strong relationship between money
supply and stock prices as is evident from high R2s when money supply is used to explain
stock price changes. However, it is not possible to use money supply changes to predict
changes in stock prices, and this is not contradictory, since the stock market apparently
reacts immediately to changes in money supply or investors’ attempts to predict this
important variable. As a result, it is impossible to derive excess profits from watching
current or recent past changes in the growth rate of the money supply.
7.
Excess liquidity is the year-to-year percentage change in the M2 money supply less the
year-to-year percentage change in nominal GDP. The economy’s need for liquidity is
given by its nominal growth. Any growth in M2 greater than that indicates excess
liquidity that is available for buying securities, which would drive up prices.
On the other hand, monetary growth in excess of GDP growth may lead to expected
inflation. The rise in expected inflation would cause the nominal RFR to rise, in turn
causing the required return to rise. This effect would lead to a decline in stock prices.
8.
If the market fully anticipates the rise in inflation, the long bond rate should rise. If we
assume annual coupons, the 15-year 10% coupon bond with 8% yield to maturity will go
from a price of $1,171.19 to an 11% yield to maturity and a price of $928.09.
9.
Most of the inputs in determining the price of a bond are known – for instance, the
promised coupon payments, the principal amount, and the dates on which those payments
will be received. The one variable to be estimated is the required return, which can be
found easily by comparing the bond in question to a similar existing bond.
In contrast, the payments on common stock are not known, nor the dates on which they
might be received. Further, the required return is more difficult to estimate.
- 69 Copyright © 2010 by Nelson Education Ltd.
Solutions for Chapter 8: Questions and Problems
10.
Although corporate earnings may rise by 12% next year, that information by itself
is not sufficient to forecast an increase in the stock market. The market level is a product
of both corporate earnings and the earnings multiple. The earnings multiple must likewise
be projected since it is not stable over time. In addition, if the market already anticipates
this rise in earnings, market prices will already reflect this expectation.
11.
The fourth stage of the industrial life cycle is stabilization and market maturity. During
this stage, sales grow in line with the economy. If sales per share for an industry in this
stage of the life cycle were predicted to increase by 20%, this would imply a growth rate
of the aggregate economy of 20%. A sales growth rate of 20% is high for an industry in
the fourth stage of the industrial life cycle.
12.
As an investor, you would like to discover a firm just entering the rapid accelerating
growth stage. During this stage, a firm will experience high sales growth, high profit
margins, and little competition.
13.
An industry that experienced the kind of explosive growth characteristics of stage two
(rapid accelerating growth) was the internet-related industry in the late 1990s.
- 70 Copyright © 2010 by Nelson Education Ltd.
Solutions for Chapter 8: Questions and Problems
CHAPTER 8
Answers to Problems
1. Student Exercise
2. Student Exercise
3. The industry (I) would have a lower P/E than the market (M) because:
(a)
ROE for the industry is lower than the market ROE;
(b)
Growth for the industry is lower than for the market; and
(c)
Beta for the industry is higher (more risk) than for the market
Industry
g = RR × ROE g = .60 × .12 = .072
Market
g = .55 × .16 = .088
Assuming RFR = 6% and Rm = 16%, k = RFR + (Rm – RFR)
k = .06 + 1.05(.16 - .06)
k = .06 + 1.0(.16 - .06)
= .165
= .16
D/E
P/E =
P/E = .40/(.165 - .072)
P/E = .45/(.16 - .088)
k–g
= .40/.093 = 4.3x
= .45/.072 = 6.25x
4. Student Exercise
5. Student Exercise
6. Student Exercise
7. Student Exercise
8. Student Exercise
- 71 Copyright © 2010 by Nelson Education Ltd.