Chapter 10 - Reilly
Macroanalysis and
Microvalution of the Stock
Market
1
Learning outcomes:
• describe the relationship between economic activity and
security markets;
• explain the major economic techniques used to project
the security market;
• describe the impact of monetary policy on share price
movements; and
• describe the leading economic indicators and how it can
be used to predict share prices.
2
Learning outcomes:
• calculate the expected price-to-earnings ratio (P/E) of a market
series by using its expected dividend payout ratio, required rate of
return and expected growth rate of dividends;
• calculate the earnings per share of a share market series;
• calculate the value of a share market series using the earnings
multiplier version of the DDM;
• calculate the expected rate of return of a market series;
• discuss, calculate and interpret the three other price multiples used
to estimate the value of a stock market; and
• explain how the top-down approach can be used to analyse the
valuation of world share markets.
3
The Components of Market Analysis
Macro
Market analysis
Micro
Market valuation:
PV cash flows &
Relative
techniques
4
Macromarket Analysis
• A strong relationship exists between the economy and
the stock market
• Security markets reflect what is expected to go on in the
economy because the value of an investment is
determined by
– its expected cash flows
– required rate of return (i.e., the discount rate)
• Decide on intrinsic aggregate market value
– Overweight country e.g. US stock market if market is
undervalued and vice versa
5
Macromarket analysis
1. Relationship between economy and stock
prices
2. Economic indicators/series
3. Macroeconomic impact of inflation and
interest rates on stock prices
4. World markets
6
1. Economic Activity and
Security Markets
Stock Market as a Leading Indicator
Stock prices reflect expectations of earnings,
dividends, and interest rates
Stock market reacts to various leading indicator
series (corporate earnings, interest rates, money
supply)
Stock prices consistently turn before the economy
does
…so which indicators lead the economy by more
than stock prices?
7
2. Economic Series and Stock
Prices
• Cyclical indicator approach to forecasting
the economy
• This approach contends that the aggregate
economy expands and contracts in
discernable periods
8
Cyclical Indicator Approach to
Forecasting the Economy
• Cyclical indicator categories
– leading indicators
– coincident indicators
– lagging indicators
• Composite series e.g. composite leading indicator
series
9
Cyclical Indicator Categories
• Leading indicators – economic series that usually
reach peaks or troughs before corresponding peaks
or troughs in aggregate economy activity
• Coincident indicators – economic series that
have peaks and troughs that roughly coincide with
the peaks and troughs in the business cycle
• Lagging indicators – economic series that
experience their peaks and troughs after those of
the aggregate economy
10
Cyclical Indicator Categories
Leading indicators:
• Average weekly hours of manufacturing workers
• Weekly initial claims for unemployment insurance
• Index of consumer expectations
• Index of 500 common stock prices (4 month lead)
• Manufacturer’s new orders (non defense)
• Housing starts
• Vendor performance (late deliveries)
• Real money supply – M2
• Interest rate spread – 10 year Treasury bonds less federal
funds rate
11
Cyclical Indicator Categories
Coincident indicators:
• # of non agric employees on payrolls
• Personal income less transfer payments
• Industrial production index
• Manufacturing & trade sales
12
Cyclical Indicator Categories
Lagging indicators:
• Average duration of unemployment
• Ratio – inventories to sales
• Change in labour cost per unit of output
• Banks’ average prime rate
• Comm & industrial loans outstanding
• Ratio – consumer credit to personal income
• Change in CPI for services
13
Cyclical Indicator Categories
• Selected series – economic series that do
not fall into one of the three main groups
• Examples:
– US balance of payments (trade deficit/surplus)
– Federal surplus or deficit (budget
surplus/deficit)
14
Cyclical Indicator Approach to
Forecasting the Economy
Analytical measures of performance (within eco series)
– Diffusion indexes – how pervasive is a movement in
a series, helps to project length and strength of future
expansion
– Trends analysed
– Rates of change : NB– peaks before a series
– Direction of change
– Comparison with previous cycles (faster/slower)
15
Cyclical Indicator Approach to
Forecasting the Economy
• Limitations of cyclical indicator approach
– false signals (reversals, high movements)
– currency of the data and revisions
– no series reflects the service sector
– no series represents the global economy
– political and international developments are not
factored into a statistical system
16
3. Monetary Variables, the
Economy, and Stock Prices
expectations
• Money supply and the economy
• Money supply and stock prices
• Inflation, interest rates, and security prices
17
Money Supply and the Economy
• Declines in the rate of growth of the money
supply have preceded business
contraction by an average of 20 months
• Increases in the rate of growth of the
money supply have preceded economic
expansions by about 8 months
18
Money Supply and Stock Prices
• Open market transactions used to implement
changes in monetary policy
– Central Bank (‘Fed’) buys treasury bonds, creates
excess liquidity for those who sold the bonds – leads to
increase in bond prices and lower interest rates –
eventually influences corporate bonds, common stocks
and real goods i.e. increase in prices
– Fed sells bonds to reduce money supply – leads to
lower bond prices and higher interest rates, etc etc
• Liquidity transmission implies that monetary
policy change initially appears in financial
markets and then in aggregate economy
19
Inflation, Interest Rates, and
Security Prices
• Critical role of expected inflation and nominal
interest rates in determining the required rate of
return used to derive the value of investments
20
Inflation, Interest Rates, and
Security Prices
• Inflation and interest rates
– generally move together
– investors are not good at predicting inflation
– spread between bond yields and inflation rate not constant
• Inflation rates and bond prices
– negative relationship
– more effect on longer term bonds
• Inflation, Interest rates and stock prices
– not direct and not consistent
– cash flows affected by interest rate and inflation rate changes
– ability of company to pass on increases
– effect varies over time
21
4. Analysis of World Security
Markets
• Leading indicators available for all developed
countries
• Real GDP growth
– Varies by country
– Influences interest rates and cash flows
• Monetary environment (differs per authority)
• Inflation outlook
– Impacted by monetary policy, point in business cycle
22
The Components of Market Analysis
Macro
Market analysis
Micro
Market valuation:
PV cash flows &
Relative
techniques
23
Market Valuation Using Relative
Valuation Approach
• Price = P/E x Earnings
• Importance of two components of value:
1. Estimating the future earnings per share
for the stock-market series
2. Estimating a future earnings multiplier
for the stock-market series
24
Estimating Expected Earnings Per Share
• Estimating expected earnings per share:
– Estimate sales per share for a stock-market series
• Closely correlated with GDP growth rate
– Estimate the operating profit margin for the series
– Estimate depreciation per share for the next year
– Estimate interest expense per share for the next year
– Estimate the corporate tax rate for the next year
25
Estimating Expected Earnings Per Share
• Alternative estimates of corporate net profits
– Direct estimate of the net profit margin based on
recent trends
– Estimate the net before tax (NBT) profit margin
– Estimate an operating profit margin to obtain
EBITDA; estimate depreciation and interest to arrive
at EBT; estimate the tax rate (T) and multiply by (1-T)
to estimate net income
26
Estimating Expected Earnings Per
Share
• Estimating aggregate operating profit margins
– Capacity utilization rate
– Unit labor costs
– Rate of inflation
– Foreign competition
27
Estimating Expected Earnings Per Share
• Estimating depreciation expense
– time series trends
– estimate based on property, plant, and equipment
• sales and asset turnover
• depreciation
28
Estimating Expected Earnings Per Share
• Estimating interest expense
– debt levels
• total assets
• expected capital structure
– interest rates
– subtract result from EBIT to estimate EBT
29
Estimating Expected Earnings Per Share
• Estimating the tax rate
– depends on future political action
– multiply (1-T) times the EBT per-share to estimate the
net income per share
30
Estimating the Earnings Multiplier
for a Stock Market Series
• Determinants of the earnings multiplier (P/E)
– Dividend payout ratio
– required rate of return on common stock
– the expected growth rate of dividends for the stocks
Pi
D /E
 1 1
E1
kg
31
Estimating the Earnings Multiplier
for a Stock Market Series
• Estimating the required rate of return (k)
– inversely related to the earnings multiplier
– determined by risk-free rate, expected inflation, and the
risk premium for the investment
• Estimating the dividend payout ratio (D/E)
– active decision or residual outcome?
– time series plots
– long-run perspective
32
Estimating the Earnings
Multiplier for a Stock Market
Series
• Estimating an Earnings Mutiplier:
– The Direction of Change Approach
– Specific Estimate Approach
Finally…..
• Calculate an Estimate of the Value for the
Market series…..Earnings x P/E
33
Homework
• Questions 3 & 5 (pg291)
• Problems 2-5 page291/292
• Class – example on click up
34
VALUING THE MARKET
USING THE EARNINGS
MULTIPLE METHOD
1. Determine your estimate of the future
market P/E ratio
2. Determine your estimate of the future
market EPS
3. Compare your calculated value with the
current market value (of the market)
35
Determine your estimate of the
future market P/E ratio:
As an analyst you are forecasting the market P/E
ratio using the dividend discount model. Because
the economy has been expanding for 9 years, you
expect the dividend-payout ratio will be at its
low of 40 percent and that long-term
government bonds will rise to 7 percent.
Because investors are becoming less risk averse,
the equity risk premium will decline to 3
percent. The the return on equity will be 12
percent (ROE).
36
Determine your estimate of the
future market P/E ratio:
a) What is the expected (dividend) growth
rate?
b) What is the required rate of return?
c) What is your expectation of the market
P/E ratio?
d) What will be the value of the market index
if EPS is $63?
37
Determine your estimate of the
future market P/E ratio:
38
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