R-B-Ch.14 Points to Refresh

Why Do Industry Analysis?

To understand how industries differ in terms of what dictates their return on assets?

Help find profitable investment opportunities

It a part of the three-step, top-down plan for selecting attractive countries, attractive industriea and specific individual companies/stocks for a portfolio

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?


Do firms within an industry show consistent performance over time?


Do firms within an industry show consistent performance over time?

Is there a difference in the risk for alternative industries?


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?

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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Refer Research papers
1. Stephen L. Myers, “A Re-examination of Market and Industry Factors in Stock Price behavior,” Journal of Finance, no.3 (June 1973);695-705
2. Miles Livingston, “Industry Movements of Common Stocks,” Journal of Finance 32, no.2 (June 1977): 861-874.
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Industry – Macroanalysis topics

The business cycle and industry sectors
Structural economic changes and alternative industries
Evaluating an industry’s life cycle
Analysis of the competitive environment in an industry

The Business Cycle and Industry Sectors

Financial Stocks

Towards end of recession, financial stocks rise in value because investors anticipate that bank’s earnings will rise as both the economy and loan demand recover.

Brokerage houses become attractive investments because their sales and earnings are expected to rise as investors trade securities, businesses sell debt and equity, and there is a rise in merger activity during economic recovery.

Consumer durable firms

Once economy begins recovery, consumer durable firms that produce expensive consumer items, such as cars, personal computers, refrigerators, etc. become attractive investments because a reviving economy will increase consumer confidence and personal income.

Once businesses recognize the economy is recovering, they begin to think about modernizing, renovating, or purchasing new equipment to satisfy rising demand and reduce costs.
Thus, capital goods industries such heavy equipment manufacturers, machine tool makers, and airplane manufacturers become attractive.

Cyclical industries

Basic metal industries
Traditionally, toward the business cycle peak, the rate of inflation increases as demand starts to outstrip supply.

Basic materials industries such as oil, metals, and timber, which transform raw materials into finished products become investor favourites.

Because inflation has little influence on the cost of extracting these products and they can increase prices, these industries experience higher profit margins.

Consumer staples
During a recession, some industries do better than others.
Consumer staples outperform other sectors during a recession because, although overall spending may decline, people still spend money on necessities.
Industries with large export components
If a weak domestic economy causes a weak currency, industries with large export components to growing economies may benefit.

Investor should not invest based on upon the current economic environment.

Rather it is necessary to forecast important economic variables at least three to six months in the future and invest accordingly.

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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Refer
For excellent discussion of structural changes in the US economy and the implications for the stock market
William C.Dudley and Edward F.Mckelvey, “the Brave New Business Cycle: No Recession in Sight” (New York: Goldman, Sachs &Co., January 1997).
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Evaluating the Industry Life Cycle
Five Stage Model
Pioneering development
Rapidly accelerating industry growth
Mature industry growth
Stabilization and market maturity
Deceleration of growth and decline

Analysis of Industry Competition
Competition and Expected Industry Returns
Porter’s concept of competitive strategy is described as the search by a firm for a favorable competitive position in an industry

To create a profitable competitive strategy, a firm must first examine the basic competitive structure of its industry

The potential profitability of a firm is heavily influenced by the profitability of its industry

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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Refer
Michael Porter, “Industry Structure and Competitive Strategy: Keys to Profitability,” financial Analysts Journal, 36, no.4 (July-August)
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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
S&P Retail Drug Store Index
Is used to demonstrate valuing industry index.

The index contains three companies
1. Longs Drug Stores
2. rite Aid
3. Walgreen company

Estimating the Required Rate of Return – page 500
the risk-free rate and Expected inflation rate are same for industry as well as market.

Risk premium for the industry versus the market depends on the industry’s
business risk (BR)
financial risk (FR)
liquidity risk (LR)
exchange rate risk (ERR)
country political risk (CR)

Can calculate systematic risk (beta) for the industry to the market beta of 1.0

Business Risk for RSD
Sales of RSD less volatile than PCE.
OPM of RSD less volatile than S&P Ind.
Hence BR for RDS less than Market.

Financial risk

Without accounting for financial leases, the debt of RSD less than market.
If we include financial leases the debt may be more.
We can conclude, this industry probably has financial risk about equal to the market.

Liquidity Risk

Walgreen is liquid in the markets.
Others not so.
A conservative view is that the RDS industry probably has above average liquidity risk.
Exchange Risk and country Risk
Do not exist because the industry is totally domestic.

Summary
For the RDS BR is below market, FR at best equal to, and LR above.
ER and CR non existent.
Consensus overall risk less than market.

Beta estimate = 0.82
Confirms the above analysis.

Specific estimate of k for RSD

R.F.R. = 5.2%
Market Return = 9.2%
K = 5.2 +0.82*4
= 8.48 rounded to 8.5%

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

Earnings Retention Rate
The retention rate data in Exhibit 14.54 indicate that the industry has a higher retention rate (69% vs. 55% for market).

Return on equity: is a function of profit margin, total asset turnover, and leverage
Profit margins are lower for RSD than market.
Retail store - lower margins –higher turnovers

Asset turnover for S&P I.I> 1.06
RDS 2.70
Return on Total assets (ROTA) for market went from 6.54% in 1977 to 5.29% in 2000.
For RDS it went down from 11.56% to 8.89% and averaged 8.35%.
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Refer
For the analysis of components of ROA and its relation to industry’s economics and strategy
Thomas Selling and Clyde Stickney, ‘The Effects of Business Environment and Strategy on a Firm’s Rate of Return on Assets,” Financial Analysts Journal 39, no. 1 (January-February 1983)
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Leverage

For index leverage went up from 2.08 to 3.09.
For industry it went up from 1.53 to 2.00

ROE estimate based on total period average (1977-2000)
Margin*TAT*(Total Assts/Equity)
S&P II 4.82*1.06*2.88 = 14.71
RDS 3.06*2.70*1.93 = 15.95

Historical trend and averages are important.
But don’t forget that expectations about future will determine value of equity shares.

In this particular case, as an analyst, it is necessary to determine whether the change during the recent period (1993-99) is permanent change.
If one uses the average of recent 5 years the ROE figures for the market and industry will be

S&P I.I. 5.84*0.88*3.34 = 17.16
RDS 2.70*2.2.6*2.27 = 13.85

Combining recent ROE with historical RR and Recent RR gives
Growth rate estimates
S&P II 17.16*0.55 = 9.44
S&P II 17.16*0.64 = 10.98

RDS industry 13.85*.69 = 9.56
RDS industry 13.85*.72 = 9.97

Given the decline in g for the industry in recent results it is probably appropriate to use a growth estimate for industry below the recent conservative estimate that 9.5%.

DDM for RDS - Combining the Estimates

K = 0.085
G = 0.095
D0 = $4.80
D1 = $4.80*1.095 = $5.26(Estd.Div. for 2002)
The long constant growth rate is below market at 7%.
Dividend Growth pattern predicted
2003-05 0.095
2006-07 0.090
2008-09 0.080
2010 onward 0.070

Discount dividends and terminal value gives I.V. estimate of $423.45

The current index value is 640.
So according to valuation of this model industry is overvalued by appx. 50%.

Is the valuation justified?
If you cannot justify a value lower than 8.5% for k and a value higher than 7% for g, you have to conclude that this industry is overvalued.



The Earnings Multiple Technique for RDS Industry


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
Forecasting Sales per Share
If analyst has understood the following
1. effect of business cycle on the industry.
2. structural changes that occurred in the industry in the recent period.
3. life cycle stage of the industry

He will be able to incorporate their implications in the estimates for the future.

Three estimation techniques suggested – page 510
Time series analysis of sales of the industry.
Input-output analysis of supply side and demand side.
Analysis of industry-economy relationship.

Time series analysis of industry sales
Analysing this series on a plot along with the sings for business cycle periods (expansions and recessions) and other major events will provide good insight into the behaviour of sales of the industry.
For many industries, it is possible to extrapolate the time series to derive a very useful estimate.

For industries that have experienced consistent growth, this can be a very useful estimate.
If sales growth has been constant rate, you should do the plot on semi-log paper where the constant growth shows as a straight line.

Input-output analysis
The goal of this analysis is to identify long-run sales outlook for its major customers and the supply capabilities and constraints of its suppliers.

Industry-Economy Relationships
The most rigorous and useful analysis involves comparing sales for an industry with one or several aggregate economic series that are related to the good and services produced by the industry.

Industry-Economic Relationship analysis for RDS Industry
Industry sells medical supplies as well as some non medical items like cosmetics, snacks, pop, and liquor.
Therefore, we want series that (1) reflects broad expenditures and (2) that gives weight to medical expenditure


Hence we consider PCE and PCE-Med-care
Both aggregate and per-capita values were given for the two series in Ex.14.12
A Casual analysis will shows that PCE increased at about 7.5% per year.
PCE-med increased at about 10% years.
Now PCE-med constitutes 15% of PCE where it was 9.6% in 1977.

Still one can see a decline in the PCE-med in recent days.
Industry is showing a growth of 13% per year.
The scatter plot in Ex.14.13 shows a good relationship between ind. Sales and PCE-med.

A good relationship was found between ind. Sales and PCE also.
Multivariate models having more variables can also be useful.
For example, for tire industry, new car-production, new-truck production, and a series that would reflect replacement tire demands may be used.

The best relation was found between RDS sales and PCE-med among the possible series.
The regression results was:
% Δ in RDS sales = 5.40 + 0.55(% Δ in PCE med-care)
R² = 0.22

Using the Regression Equation

Find an estimate for PCE from estimates by banks and Financial Institutions.
Estimate the proportion of PCE med-care in PCE.
Find its increase from the previous year.
Use the figure in the equation to derive estimate of RDS sales increase.
Industry Profit Margin Forecast
Industry’s operating profit margin
(EBITDA / Sales)
Depreciation expense
interest expense
tax rate

Industry Profit Margin Forecast
Industry’s operating profit margin
(EBITDA / Sales)
Regression analysis can be done w.r.t. market’s operating margin.
Time series analysis of margin of the industry can be done.
It is a matter of judgement based on the scatter plots and fit of the model whether you use regression analysis or the time series for final estimation.
Long-term considerations including competitive structure are to be taken into consideration.

Regression and Time series techniques can be useful tools, but neither technique should be applied mechanically.
Mathematical techniques should be considered a supplement to the economic analysis of the competitive environment for the industry.
The analyst has to be aware of price areas, contract negotiations, building plans or foreign competition etc.

Industry Depreciation Forecast

Depreciation expense can be estimated
W.r.t to market depreciation estimate (regression)
Time series analysis of ind depreciation
Specific estimate based on estimate of PPE for the industry

Industry Depreciation 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

Specific estimate technique using the depreciation expense/PPE ratio

1. calculate the annual PPE turnover for the RDS industry.
2. Based on your sales estimate and your PPE turnover ratio estimate, estimate the expected PPE for the year.
3. Calculate the annual depreciation expense as a percent of PPE for the RDS industry
Industry Interest Expense Forecast – page 518
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
Industry Interest Expense 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)
Industry Tax Expense 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
Actual Estimate of EPS for 2002 for RDS industry
The outlook for PCE is for an increase of 5.0% in 2001(to about $7,100 BIL) AND A 3.6% INC. IN 2002 (TO $7,355 BIL).
PCE med care will be 14.8% of PCE in 2001 and 2002.
This gives PCE med as $1,088 billion in 2002.
Using this result in regression equation estimated earlier gives RDS sales estimate in 2002 as $870.

OPM for a retail drug store industry was 6.88% in 1999.
Although the OPM for the S&P II declined during 2000,RDS margins were expected to be stable at about 6.55.
The aggregate OPM was expected rebound in 2002 starting year of expansion.
Thus the OPM for RDS is expected to increase also. Hence estimate = 6.6%

Operating Profit - RDS index =.066*$870
= $57.42.
Depreciation estimate RDS 2002
The PPE turnover had tended to decline during the recent period.
A conservative estimate would be a PPE turnover of 7.40.
As the sales estimate is $870, the PPE estimate will be $117.57 for 2002.
Dep. Expense/PPE ratio was is in 10 and 12% range during 1997-2000.
The recent fiver year average indicates an estimate of 10.6%.
10.6% of $117.57 = $12.46
Hence PBIT = $57.42 - $12.46 = $44.96
Interest Expense Estimate for RDS for 2002 – p.519
Sales estimate $870
TAT has average about 2.15 over the most recent years
Hence total assets for 2002 = $405
Long-term interest bearing debt average about 15% for the RDS.
Implies debt next year = $405*0.15 = $61.
Int. expense during the most recent period has averaged 6.85% for this industry.

Based upon the expectation of a small increase in market interest rates during 2002, we would estimate this interest rate to be 7.00% in 2002.
Hence interest expense = 0.07*$61 = $4.27
Tax Expense p 519
Ex. 14.19.
Except for 1997, the RDS tax rate has moved with the economy’s tax rate.
But you have to consider pending national legislation and unique industry tax factors.
The tax rate of the RDS has been consistently higher than the aggregate.
The aggregate is expected to be stable in 2001 and 2002.
Hence a rate of about 39% seems to be appropriate for RDS.

This implies tax of 15.87 (40.69*0.39)
Hence EPS = 40.69 – 15.87 = 24.82
This implies a net profit margin for the RDS industry of 2.83% (24.82/870) which is slightly below the recent experience.
We will round up the estimate to $25.

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
P/E ratio Relationship between industry and market
Study Reilly and Zeller (1974) showed a significant relationship P/e ratios for 71 S& P industries and S&P Ind. Index.
Between 1977 and 1999, ratio for drug stores was generally higher above the market’s.
In 1989 market P/E ratio went up and industry ratio was stable.

This was reversed in 1996 and industry ratio went above market.
Also industry ratio is less volatile.
Still the analyst has answer why the RDS multiplier is higher and also whether it will persist?

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)

Comparing dividend payout ratios

Analyzing data in Ed.14.5 indicates that the retention rates in RDS are consistently higher than the aggregate (69% vs. 54%)
This indicates higher payout for S&P, which implies higher P/E for S&P.

Comparing the required rate of return

Estimate of k for the industry is 8.5.
Estimate for the market is 9.5.
Hence industry P/E must be higher than the market P/E
Comparing growth rate
Industry growth rate estimate is 9.5.
S& p II growth rates are estimated to be between 8.10% and 11.0%. The mean is 9.5%.
But we opt to bear the high value, we may take it as 10%.
Hence based on growth industry can be below market.

Thus overall the market may have a higher multiple.

As our estimate for P/E for S&P II is 30 to justify prevailing market price, industry P/E may be estimated as 25.
Estimate of Industry value
Expected EPS = $25
It is not possible to derive a specific estimate as g>k.
The comparative estimate gives 25 with a range of 20 to 30
Industry value range can be 500$-$625-$750
The industry index is overpriced w.r.t to expected value and slightly underpriced with respect to optimistic value.