CHAPTER 2
THEORETICAL FOUNDATION
2.1
FUNDAMENTAL ANALYSIS:
Fundamental
Analysts usually start by studying
of past earnings and
an
examination of company balance sheets. Fundamental analysis is supplemented
with further detailed economic analysis, ordinarily including an evaluation of the
quality of the finn's management, the firm's standing within its industry, and the
prospect for the industry as a whole. the hope is to attain some insight into the
future performance of the finn that is not yet recognized by the rest of the market.
The trick is not to identifY finns that are good, but to find finns that are better than
everyone else's estimate.
2.2
ECONOMIC THEORY:
2.2.1
Macro economic and Industry analysis.
To do a "Top down" analysis of a finn's prospects, one starts with the broad
economic environment
by examining the stage of aggregate economy and even the
international economy. The international economy might affect a firm's export
prospects, the price competition which is faced from foreign competitors, or the
profit which is made on investments abroad.
Political risk such as the transfer of government of Hong Kong to China,
the transition to a new leader of a country can influence the value of stock.
Protectionism and trade policy, the free flow of capital, the status of a nation's
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work force and the exchange rate currencies between countries also affect the
operation of the finn.
Rapidly growing Gross Domestic Product indicates an expanding economy
with ample opportunity for a finn to increase sales. The ability to forecast the
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macro economy can translate into a spectacular investment performance, but one
must forecast it better than the competitor to earn an abnormal profit.
The unemployment rate measure the extend to which the economy
operating at full capacity. Most government hope to stimulate
IS
their economies
enough to maintain nearly full employment but not so much as to bring on
inflationary pressures. High rates of inflation often are associated with "over
heated" economies. High inflation rate will bring up the interest rate and reduce
the attractiveness of investments opportunities, because high interest rates reduce
the present value of future cash flows.
Producers'
and
consumers'
optimism or
pessimism
concerning the
economy are important determinant of economic performance. If consumers have
confidence in their future income level, they will be more willing to spend on high
price items.
Business will increase production and inventory levels if producers
anticipate higher demand for their products.
An example of the use of economic
information : If forecast result a tightening of
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money supply, it is a good idea to avoid industries such as automotive and realestate.
2.2.2
Fiscal Policy.
Fiscal policy by government's spending and tax action is part of
"demand side
management", it is the most direct way either to stimulate or to slow the economy.
A decrease in government spending directly deflate the demand
services.
Similarly,
increases in tax
rate
immediately siphon
for goods and
income
from
consumers and result in fairly rapid decrease in consumption.
2.2.3
A Monetary policy.
A monetary policy by manipulating the money supply to affect a demand side of
macro economy. Increasihg in the money supply will lower short - term interest
rates, ultimately encouraging investment and consumption demand. When ''Bank
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Indonesia" buys securities, it simply "write a check", thereby increasing the money
supply.
Other tools are discount rate and reserve requirement ( CAR). Increasing
Capital Adequacy Ratio will affect banks to make less loans with each rupiah of
deposits and stimulate the economy by lowering the effective money supply.
Fiscal and monetary policy are demand - oriented tools that affect the
economy by stimulating the demand
for goods and services. Supply - side
economists ar!,>ue that lowering tax rates will elicit more investment and improve
incentives to work , thereby enhancing economic growth.
2.2.4
Business Cycle.
Business cycle is a repetitive cycles of recession and recovery. In relation to
business cycle, economists classifY industries into two
industries and defensive industries. Cyclical
type , they are cyclical
industries are industries with above
average sensitivity to state qf the economy. In contrast to cyclical industries,
defensive industries have little sensitivity to the business cycle . The cyclical or
defensive
classification corresponds well to the notion of systematic or market
risk.
2.2.5
Leading Economic Indicator.
Leading economic indicator are economic series that tend to rise or fall in advance
of the rest of the economy. The stock market price index is a leading indicator,
because investors are forward looking predictors of future profitability. Some
leading indicators are money supply, contracts and orders for plant and equipment.
2.2.6
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Sensitivity to the business Cycle.
Sensitivity to the business cycle determine how sensitive the industry to the
business cycle. Three facfors will determine the sensitivity of a firm 's earning to
the business cycle are sensitivity of sales, operating leverage, financial leverage.
Some industries such as food , drugs and medical services are less sensitive
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because of necessities. Finns with high fixed cost are said to have high operating
leverage, as small swing
in business conditions can have
large
impacts on
profitability. Firm with greater amounts of variable cost as opposed to fixed cost
will be less sensitive to business conditions. Financial leverage causes the firms to
pay interest on debt regardless of sales. They are fixed cost that also increase the
sensitivity of profit to business condition.
2.2.7 Industry Life cycle.
Industry life cycle is stages through which firms typically pass as they mature. The
availability of technologies can create opportunity for highly profitable investment
of resources. Protection of new product by patents can increase the profit margin
of a firm, but high profit rates will induce new finn to enter the industry.
Ultimately, in a mature industry, finn are cash cows, dividends and cash flows are
stable and little risk. Industry life cycle can be divided into four stages, start - up
stage, consolidation stage, maturity
stage, relative decline stage.
!
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Start - up stage are often characterized by a new technology or product such as
CVD player, sales and earnings will grow at an extremely rapid rate since the
new product has not yet saturated its market.
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Consolidation stage is the time when a product become established, industry
leaders begin to emerge. The industry still grow faster than the rest of the
economy as the product penetrates the market place.
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Maturity stage is when the product has reached
its full potential for use by
consumer. the product has become far more standardized, and the producers
are forced to compute to a greater extend on the basis price, firms at this stage
sometimes are characterized as "cash cows".
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Relative decline stage is when the industry might grow at less than the rate of
the overall economy, might even shrink.
2.3
FINANCIAL THEORY.
2.3.I
Financial Statement.
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Annual report to share holders is the most important thing that a company must
present. At some companies, top executives begin to work on the report as much as
six months before its publication, and most hire professional designers and writers
to ensure that the final product looks sharp and read well. Analysts and some
sophisticated investors
prefer straight
forward
financial disclosure
documents.
Investor and analyst want to see annual reports that realistically examine the firms
business affairs and that factually discuss projects which will affect corporate
welfare in the future. They would like to see annual reports become the equivalent
of management
report
cards,
detailing strength
and weakness
and plans for
improvement. Given such information, share holder would be better equipped to
make intelligent investment decision. Some questions may arise from investors are :
do the basic financial statement provide adequate data for investment decisions ?,
what other information might be helpful ?.
Three
financial statements which are analyzed
statement, balance sheet, and, the statement
carefully are Income
of cash flow.
Income statement
showing a firm's revenues and expenses during a specified period.
classes of expenses
Four broad
are cost of good sold, general and administrative expense,
interest expense and tax earnings. Investors pay close attention to ''bottom line",
which is net income. Income statement is a profitability measure over a period of
time.
The balance sheet provides a financial position of the firm at a specified
time. It is about a composition of asset, liabilities and equities. The difference
between assets and liabilities is stock holder's equity or book value of the firm.
The statement of cash flow recognizes only transaction in which cash changes
hands.
If goods are sold now, with payment due in 60 days, the income statement
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will treat the revenue as generated when the sale occurs, and the balance sheet will
be augmented by accounts receivable, but the statement of cash flows will not
recognize the transaction until the bill is paid and the cash is in hand. Another major
difference between the income statement and the statement of cash flows involves
depreciation. The statement of cash flows provides evidence on the well- being of a
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firm.
If the company can not pay dividend or obligation, the company will be in
big problem.
2.3.2 Advantage of Common Stock Financing.
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Common stock does not entail fixed changes. If the company generates the
earnings, it can pay common stock dividends. In contrast to interest on debt,
which must be paid regardless of the level of earning.
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Common stock carries no fixed maturity date, it is a permanent capital which
does not have to be paid back.
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Common stock provide a cushion against losses to the firm's creditors, the sale
of common stock increase the credit worthiness of the firm.
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Common stock can be sold more easily than debt because;
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ft typically carries a higher expected return that does preferred stock or
debt.
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It provides better h,edge against inflation than preferred stock.
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Return from capital gains on common stock are not taxed until gains
are realized.
2.3.3
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Disadvantages Common Stock.
Extend voting right.
• The cost of underwriting and distributing Common stock
are usually higher
than the cost of underwriting and distributing preferred stock and debt.
2.3.4
Bonds.
Bond is a security that obligates the issuer to make specified payments to the
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holder over a period of time. Some types of bond are zero coupon bond , bearer
bond,
convertible bonds, puttable bonds, floating - rate bond,
Debenture bonds.
Junk
bonds,
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• Zero coupon bond
is a bond paying no coupons that sells at a discount and
provides only a payment of par value at maturity.
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Bearer bond
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Call Provision bond is a bond issued with allowing the issuer to repurchase
is a traded bond without any record of ownership.
the bond at specified call price before the maturity date.
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Register bond is a bond which
the issuing firm keeps the records of the
owner of the bond and mail the interest check to the owner.
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Convertible Bond
is a bond with an option allowing the bondholder to
exchange the bond for a specified number of shares of common stock in the
firm.
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Junk Bond
is a speculative, low-rated
or unrated bond , which used as
financing vehicle in leverage buyouts and hostile takeover attempts.
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Debenture Bond is a bond which not backed by specific collateral.
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Floating - rate bonds
are bonds with coupon rates periodically reset
according to a specified market rate, for example libor + 2% or sibor + I .5%.
Bond pricing, value of bond= PV of Coupon+ PV ofPar value.
Bond Yield = Yield to maturity , Yield to Call.
Bond valuation depend on several factors such as ;
1.
Par value is the nominal or face value of a stock or bond.
It is generally
represent the amount of money the firm borrows and promises to repay at
some future date.
2.
Coupon interest rate is the stated annual rate of interest on a bond.
3.
Maturity date is a specified date on which the par value of a bond must be
repaid
4.
Call provisions is a bond contract that gives the issuer the right to pay off the
bonds under specified terms prior to the stated maturity date.
5.
New issues versus outstanding bonds.
The time of a bond is issued, the
coupon is generally set at a level that cause the market price of bond to equal its
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par value. Once a bond has been on the market for a while, it is classified as an
outstanding bond.
Holding period return equals income earned over a period ( including
capital gains or losses) as a percentage of the bond price at the start of the period.
The holding period return can be calculated for any holding period based on the
income generated over that period.
In contrast, the yields to maturity is
the single discount rate at which the
present value of the payment provided by the bond equals it prices. It is the
measure of the average rate of return over the bond's life if it is held until maturity.
Interest rate sensitivity of the bond is related with time to maturity, the
longer the maturity period of a bond the more sensitive the interest rate increases
because higher interest rates have greater impact on more distant future payments.
For more detail readers can look at figure 2. I and figure 2.2.
\.
present value,.:o:.:.f.::..$:.:.1-------------------, I;0%
1.0
0.75
0.5
0.25
2
4
6
8
period
Figure 2 .I : Relation between PV, interest rate , and time :
Source: Weston, Brigham, page 197, 1993
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FUTURE value of$!
4
i = 25°o
3
2
0
I
0
2
4
6
8
10
Figure 2.2 : Relation between future value, growth , interest and time.
Source: Weston, Brigham, page 195 ,1993
Source of Potential profit in bond management:
1.
interest rate forecasting.
2.
relative mispricing.
rebalancing activities or work out period is realigning the prop011ions of assets in
a portfolio as needed.
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Substitution swap is the exchange of one bond for a bond with similar
attributes but more attractively price.
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Intermarket spread sw11p is switching from one segment of the bond market
to another for example switching between government bond and corporate
bond ..
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Rate anticipation swap is an exchange of bond with different maturities .
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Pure yield pickup swap is moving to higher - yield bonds, usually with longer
maturities..