ReillyBrown IAPM 11e PPT Ch09

CHAPTER 9
The Top-Down
Approach to
Market, Industry,
and Company
Analysis
©2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or
posted to a publicly accessible website, in whole or in part. 8-1
9.1 Introduction to Market Analysis
(slide 1 of 4)
• The first stage of top-down analysis is to
examine the attractiveness of a particular market
• The two components:
1. The macroanalysis of the relationship between the
aggregate securities markets and the aggregate
economy
2. The specific microvaluation of the stock market
employing the valuation approaches
• Exhibits 9.1, 9.2, 9.3
(slide 2 of 4)
(slide 3 of 4)
(slide 4 of 4)
9.2 Aggregate Market Analysis
(Macroanalysis) (slide 1 of 2)
• Economic growth leads to higher stock prices
• An easy conclusion: Study GDP growth to
predict stock prices
• Problems with this approach:
1. Preliminary GDP data is released approximately one
month after each quarter ends
2. The preliminary GDP data will be revised
3. The stock market moves ahead of the economy
9.2 Aggregate Market Analysis
(Macroanalysis) (slide 2 of 2)
• Other measures of the economy:

1. The leading, coincident, and lagging
economic indicators
2. Sentiment indicators
3. Interest rates
9.2.1 Leading, Coincident, and Lagging
Indicators (slide 1 of 9)
• Leading Indicators
• Includes economic series that usually reach peaks or
troughs before corresponding peaks or troughs in
aggregate economic activity
• Coincident indicators
• Includes four economic time series that have peaks or
troughs that roughly coincide with the peaks and
troughs in the business cycle
• Lagging indicators
• Includes seven series that experience their peaks and
troughs after those of the aggregate economy
• Exhibits 9.4, 9.5, 9.6, 9.7, 9.8, 9.9, 9.10
• There are no perfect indicators

• The Conference Board acknowledges the
following limitations that are also
discussed in Koenig and Emery (1991):
• False signals
• Timeliness of the data and revisions
• Economic sectors not represented
9.2.2 Sentiment and Expectations Surveys
(slide 1 of 2)
• Consumer expectations are considered relevant as
the economy approaches cyclical turning points
• The intuition is that consumers must have
confidence in order to spend
• Consumer spending accounts for approximately 70
percent of gross domestic product
• Two widely followed surveys of consumer
expectations are reported monthly:
• The University of Michigan Consumer Sentiment Index
• The Conference Board Consumer Confidence Index
• Exhibit 9.11
9.2.2 Sentiment and Expectations Surveys
(slide 2 of 2)
9.2.3 Interest Rates (slide 1 of 9)
• In addition to the leading economic indicator

series and sentiment indicators, the final
approach to tracking the economy is to follow
interest rates
• Specifically:
• The real federal funds rate
• The yield curve (the term spread)
• The risk premium between Treasury bonds and
BBB bonds
• The Fed model
• The Real Federal Funds Rate
• Analysts want to know the level of the federal funds rate
and whether it is intended to stimulate the economy or
restrict the economy
• The natural rate, (the neutral rate), is the rate that would
be neither stimulative nor restrictive
• It is important to know whether Fed policy is
accommodative or restrictive
• If policy is accommodative, then the Fed is trying to increase growth
• If policy is restrictive, then the Fed will be trying to slow the
economy to control inflation, which is not beneficial to stock prices
• Exhibit 9.12
• The Yield Curve

• The yield curve is probably the single most important
economic indicator that an analyst can watch
• A normal yield curve is one in which longer-term yields are
greater than short-term yields
• A flat yield curve occurs when long-term rates are similar to
short-term rates
• An inverted yield curve occurs when the long-term yields are
lower than short-term yields
• The yield curve has inverted prior to every recession
since 1970
• Exhibit 9.13
• Risk Premium
• Analysts also examine the risk premium on
bonds:
• The difference between BBB corporate bonds and
the yield on U.S. Treasury bonds
• A larger spread indicates fear in the markets
and indicates that investors are requiring
additional compensation for taking risk
• Exhibit 9.14
• The Fed Model

• The Fed model came from Alan Greenspan’s
Monetary Report to Congress in the summer of 1997
• In this report, he showed a simple valuation model
that indicated stocks were overvalued
• The Fed model says that the S&P 500 should be
worth next year’s earnings divided by the yield on the
10-year Treasury bond
• For a long period of time, the correlation between this
model’s predicted value for the S&P 500 and actual
stock prices was very high
• Exhibit 9.15
9.3 Microvaluation Analysis
• After analyzing the health of the economy and

the trajectory of the business cycle, the analyst’s
goal is to calculate an actual estimate of the
value of the market
• Valuation techniques:
• A free cash flow to the equityholder (FCFE) model
• Relative valuation
• In addition, as part of valuation, Robert Shiller’s
cyclically adjusted price–earnings (CAPE) ratio
will be examined
9.3.1 FCFE to Value the Market
(slide 1 of 7)
• In order to use the FCFE model, you will
need an estimate of next year’s cash flows
and the discount rate
(slide 2 of 7)
• Cash Flows
• Estimating the cash flows can be done in
several ways
• Use consensus estimates for earnings per share
• Use the consensus estimate for earnings per share
for the S&P 500
• Build a model organically by estimating:
1. Growth rate of sales
2. Operating margin
3. Interest expense
4. Tax rate
• Exhibit 9.17
(slide 3 of 7)
(slide 4 of 7)
• Growth Rate of Sales per Share

• Start with sales per share for the year that just
ended and estimate growth of sales
• Operating Margin
• To move from sales per share to operating
profit, you must multiply the sales per share
by the operating margin
• Consider economic factors that impact the
operating margin and how they are changing
(slide 5 of 7)
• Interest Expense
• Interest expense must be deducted from operating
profit
• Interest expense depends on two factors: the amount
of debt and the interest rate
• Tax Rate
• Consider the current tax rate and any political action
that is being considered
• Weigh the trend in which goods are produced and
sold (due to the difference in tax rates in different
jurisdictions)
(slide 6 of 7)
• The Discount Rate

• Use the cost of equity for the overall market
• Using the capital asset pricing model, the risk
free rate and the risk premium is needed
• Exhibit 9.18
(slide 7 of 7)
9.3.2 Multiplier Approach (slide 1 of 2)
• P/E Multiple
• To use a price–earnings multiple approach, an
analyst needs to estimate two variables: the
earnings per share and the multiplier
• To estimate the multiplier, an analyst needs to
estimate:
• The growth rate
• The cost of capital
• The return on equity
9.3.2 Multiplier Approach (slide 2 of 2)
9.3.3 Shiller P/E Ratio (slide 1 of 2)
• Also known as the cyclically adjusted

price–earnings (CAPE) multiple
• In this approach, the numerator is the same: It
is the value of the S&P 500
• The denominator, however, is different
• Instead of simply using the past year’s
earnings (or next year’s earnings, if you are
using a forward multiple), inflate past earnings
to the current year (and then average them)
• Exhibit 9.20
9.3.3 Shiller P/E Ratio (slide 2 of 2)
9.3.4 Macrovaluation and Microvaluation of
World Markets
• Each market is different—for example, economies are
growing at different rates, different economic data may
exist for each country, risks are different, accounting
standards are different, and different types of companies
may inhabit the public markets
• Three important factors:
1. The basic valuation model and concepts apply globally
2. While the models and concepts are the same, the input values
can and will vary dramatically across countries, which means
values will differ and opportunities will differ
3. The valuation of nondomestic markets will almost certainly be
more onerous because of several additional variables or
constraints that must be considered
• Exchange rate risk
• Country risk
9.4 Introduction to Industry Analysis: Why
Industry Analysis Matters (slide 1 of 2)
• Once an analyst has decided to make an
allocation to a particular market, she must
decide which industries are worthy of investment
• Profit-seeking firms have determined that industry
analysis matters, as evidenced by the fact that
investment firms often assign analysts to cover a
particular industry
• While returns vary among industries and even for
stocks within an industry, and risk varies among
industries, it does seem that an industry’s overall risk
can be relatively stable over time
• Exhibit 9.21
9.4 Introduction to Industry Analysis: Why
Industry Analysis Matters (slide 2 of 2)
9.5 Industry Analysis
• For a macroanalysis of industries,

examine four components:
1. Cyclical impacts
2. Structural impacts
3. The life cycle of the industry
4. The competitive forces within an industry
(Porter analysis)
9.5.1 The Business Cycle and Industry
Sectors (slide 1 of 2)
• The business cycle refers to the period of time
from which an economy’s output of goods and
services peaks, contracts (in a recession),
recovers from the prior expansion to reach the
prior peak (recovery), and then grows further
(expansion)
• Different industries tend to perform well or poorly in
different parts of the business cycle
• Some investors try to engage in sector rotation,
where they monitor economic trends and attempt to
move their investments from one sector (or industry
within a sector) to another sector (or industry) as
economic trends change
9.5.1 The Business Cycle and Industry
Sectors (slide 2 of 2)
• Sector rotation examples:
• Toward the end of a recession, financial stocks often
recover first
• This did not happen in 2009, and it serves as evidence that
every cycle is different
• Consumer durable goods do well as the economy
recovers
• Capital goods tend to do well as the economy moves
past recovery and into expansion
• Cyclical companies tend to move in anticipation of the
business cycle, turning up in anticipation of recovery
and turning down at signs of economic weakness
• Consumer staples tend to outperform during an
economic slowdown
9.5.2 Structural Economic Changes Impact
the Industry (Noncyclical Factors)
• Demographics
• Crucial to both the demand side (consumption) and the supply
side (particularly labor)
• Lifestyles
• Deals with how people live, work, form households, consume,
enjoy leisure, and educate themselves
• Technology
• Can affect numerous industry factors, including a product or
service and how it is produced and delivered
• New technology can completely change an industry
• Politics and Regulation
• Can have a tremendous impact on industries
• Reflects social values, and the result is that today’s social trend
may be tomorrow’s law, regulation, or tax
9.5.3 Industry Life Cycle (slide 1 of 3)
• When predicting industry sales and

profitability, insight can be gained from
viewing the industry over time and dividing
its development into stages similar to
those that humans progress through
• It is important to ask how long the industry
will remain in a particular stage of the life
cycle
• Exhibits 9.22, 9.23
9.5.4 Industry Competition (slide 1 of 3)
• Industry competition has a tremendous impact

on profitability
• Michael 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 because the potential
profitability of a firm is heavily influenced by the
profitability of its industry
• Exhibit 9.24, 9.25
9.6 Estimating Industry Rates of Return
• The analyst should value an industry just

as the overall market was valued
• Use discounted cash flows or relative
valuation
• Build a model or use multiples
9.6.1 Estimating the Cost of Capital
(slide 1 of 2)
• The simplest way to calculate k is to use
the capital asset pricing model.
• To know the industry’s historic beta, regress
the returns of a particular industry against a
market index
• Estimate the cost of capital by considering all
of the significant risks: business risk, financial
risk, liquidity risk, exchange rate risk, and
country risk
• Exhibit 9.26
9.6.1 Estimating the Cost of Capital
(slide 2 of 2)
9.6.2 Sales Growth Estimates
• At the industry level, sales growth estimates can

be aided by knowledge of three approaches:
• Time series analysis:
• Overlaying industry sales with the business cycle and
estimating changes
• Input/output analysis:
• Identifying suppliers and customers; looking for long-run
sales outlooks for supplies and customers
• Industry–economy relationship:
• Identifying the economic variable that has the most
significant influence on industry demand
9.6.3 Other Considerations
• The following are a few ideas specific to industry
analysis:
• It can be very difficult to apply regression and time-
series analysis
• The industry tax rate may be vastly different from the
overall market tax rate
• Relative valuation often involves comparing the
industry multiple to the market multiple
• Always understand the underlying fundamentals that
drive a multiple
• It is always important to ask yourself why the market
views an industry in a particular way
• What is the market missing? What will change?
9.7 Global Industry Analysis
• Because so many firms are active in foreign markets
and because the proportion of foreign sales is
growing for many firms, it is necessary to consider
the effects of foreign firms on industry returns
• Global industry analysis is growing in importance, as
documented by Cavaglia, Brightman, and Aked
(2000)
• Prior research showed that country factors dominated
industry factors in terms of explaining equity returns,
but the Cavaglia et al. study presented evidence that
industry factors have been growing in importance and
currently dominate country factors
9.8 Company Analysis
• The final questions in the fundamental

analysis procedure are:
• Which are the best companies within these
desirable industries?
• What is the intrinsic value of the firm’s stock?
• How does the intrinsic value compare with the
market value?
9.8.1 Growth Companies and Growth
Stocks
• Growth Companies
• Historically, consistently experience above-average
increases in sales and earnings
• Theoretically, yield rates of return greater than the
firm’s required rate of return
• Growth Stocks
• Necessarily the stocks of growth companies
• A growth stock has a higher rate of return than other
stocks with similar risk
• Superior risk-adjusted rate of return occurs because
of market undervaluation compared to other stocks
9.8.2 Defensive Companies and Stocks
• Defensive Companies
• The firms whose future earnings are more likely to
withstand an economic downturn
• Low business risk
• No excessive financial risk
• Typical examples are public utilities or grocery chains
—firms that supply basic consumer necessities
• Defense Stocks
• The rate of return is not expected to decline or decline
less than the overall market decline
• Stocks with low or negative systematic risk
9.8.3 Cyclical Companies and Stocks
• Cyclical Companies
• They are the companies whose sales and
earnings will be heavily influenced by
aggregate business activity
• Examples would be firms in the steel, auto, or
heavy machinery industries
• Cyclical Stocks
• They will have greater changes in rates of
return than the overall market rates of return
• They would be stocks that have high betas
9.8.4 Speculative Companies and Stocks
• Speculative Companies
• They are the firms whose assets involve great risk but
those that also have a possibility of great gain
• A good example of a speculative firm is one involved
in oil exploration
• Speculative Stocks
• Stocks possess a high probability of low or negative
rates of return and a low probability of normal or high
rates of return
• For example, an excellent growth company whose
stock is selling at an extremely high P/E ratio
9.8.5 Value versus Growth Investing
• Growth stocks will have positive earnings

surprises and above-average risk adjusted
rates of return because the stocks are
undervalued
• Value stocks appear to be undervalued for
reasons besides earnings growth potential
• Value stocks usually have low P/E ratio or
low ratios of price to book value
9.9 Connecting Industry Analysis to
Company Analysis
• Company analysis is the final step in the

top-down approach to investing
• Search for companies that will be favorably
influenced by these economic and structural
factors
• The company must have an attractive
valuation
9.9.1 Firm Competitive Strategies
(slide 1 of 3)
• A company’s competitive strategy can either be
defensive or offensive
• A defensive competitive strategy involves positioning
the firm to deflect the effect of the competitive forces
in the industry
• An offensive competitive strategy is one in which the
firm attempts to use its strengths to affect the
competitive forces in the industry
• Porter (1980a, 1985) suggests two major
competitive strategies: low-cost leadership and
differentiation
(slide 2 of 3)
• Low-Cost Strategy
• The firm that pursues this strategy is determined to
become the low-cost producer and, hence, the cost leader
in its industry
• Differentiation Strategy
• With the differentiation strategy, a firm seeks to identify
itself as unique in its industry in an area that is important to
buyers
• Focusing a Strategy
• Whichever strategy it selects, a firm must determine where
it will focus this strategy
• A firm must select segments in the industry and tailor its
strategy to serve these specific groups
• Exhibit 9.27
(slide 3 of 3)
9.9.2 SWOT Analysis (slide 1 of 2)
• Internal Analysis
• Strengths
• Give the firm a comparative advantage in the
marketplace
• Perceived strengths can include good customer
service, high-quality products, strong brand
• image, customer loyalty, innovative R&D, market
leadership, or strong financial resources
• Weaknesses
• Weaknesses result when competitors have
potentially exploitable advantages over the firm
9.9.2 SWOT Analysis (slide 2 of 2)
• External Analysis
• Opportunities
• These are environmental factors that favor the firm
• They may include a growing market for the firm’s products
(domestic and international), shrinking competition, favorable
exchange rate shifts, or identification of a new market or
product segment
• Threats
• They are environmental factors that can hinder the firm in
achieving its goals
• Examples would include a slowing domestic economy,
additional government regulation, an increase in industry
competition, threats of entry, etc.
9.10 Calculating Intrinsic Value
• After analyzing the company from

qualitative and quantitative perspectives,
the analyst must calculate the stock’s
intrinsic value
• Most analysts will create a discounted
cash flow model (using either dividends,
FCFE, or FCFF) and will also use relative
valuation
9.10.1 Some Additional Insights on Valuation—
For Individual Companies (slide 1 of 2)
• Additional concepts to consider with respect to

valuation:
• Blindly using historic growth rates or margins is
incorrect
• When examining the sales of a company, always
study how the sales mix is changing
• The growth rate of a company is going to be
influenced by where the industry is in its life cycle,
structural changes, industry competition, and
economic trends
• When looking at historic growth, always try to
distinguish between organic growth and acquired
growth
9.10.1 Some Additional Insights on Valuation—
For Individual Companies (slide 2 of 2)
• Remember what your cost of equity represents

• When estimating the profit margin of a specific
company, be sure to understand the competitive
strategy (low cost or differentiation)
• Realize that it is important for you to have
quarterly estimates for the next year
• When doing relative valuation, compare the
company to its historic multiple, competitors in the
industry, an overall industry multiple, and the
market multiple
9.10.2 Analyzing Growth Companies
(slide 1 of 10)
• A growth company is a company that has the
opportunity to reinvest significant amounts of
capital at rates of return that are higher than the
firm’s cost of capital
• This means that the analyst must consider three
issues:
1. The amount of capital invested in growth investments
2. The relative rate of return earned on funds retained
3. The time period for these growth companies
9.10.2 Analyzing Growth Companies (slide 2
of 10)
• If using the constant growth model and you
are modeling a company that is earning more
than its cost of capital, you are making some
strong assumptions:
• Earnings and dividends are growing at a constant
rate
• The firm is investing larger and larger dollar
amounts in projects that generate returns greater
than their cost of capital
• The firm can do this for an infinite amount of time
of 10)
• The purpose of the growth duration model is to help
evaluate the high P/E ratio for the stock of a growth
company by relating its P/E ratio to the firm’s rate of
growth and duration of growth
• A stock’s P/E ratio is a function of three factors:
1. The firm’s expected rate of growth of earnings per share
2. The stock’s required rate of return
3. The firm’s dividend payout ratio
• The growth duration model is based on two
assumptions:
1. Equal risk between the firms that you are analyzing
2. No significant differences in the payout ratios
of 10)
• This relationship implies that the P/E ratios of
the two stocks are in direct proportion to the
ratio of composite growth rates raised to the Tth
power
• Allowing g to represent the high-growth
company and a to represent the market or
slower growth company, solve for T by using the
following equation:
of 10)
• The growth duration model answers the

question of how long the earnings of the
growth stock must grow at this expected
high rate, relative to the nongrowth stock,
to justify its prevailing above-average P/E
ratio
of 10)
• Example
• Exhibit 9.28
of 10)
of 10)
• An Alternative Use of T
• Instead of solving for T and then deciding
whether the figure derived is reasonable, use
this formulation to compute a reasonable P/E
ratio for a security relative to the aggregate
market (or another stock) if the implicit
assumptions are reasonable for the stock
involved
of 10)
• Factors to Consider
• When using the growth duration technique,
remember the following factors:
1. The technique assumes equal risk, which may be
acceptable when comparing two large, well-
established firms in the same industry to each other
2. Which growth estimate should be used? We prefer to
use the expected rate of growth based on the factors
that affect g
3. The growth duration technique assumes that stocks
with higher P/E ratios have the higher growth rates
9.10.2 Analyzing Growth Companies (slide
10 of 10)
• Inconsistency between the expected

growth and the P/E ratio could be
attributed to one of four factors:
1. There is a major difference in the risk
involved
2. Growth rate estimates are inaccurate
3. The stock with a low P/E ratio relative to its
expected growth rate is undervalued
4. The stock with a high P/E and a low expected
growth rate is overvalued
9.11 Lessons form Some Legends
(slide 1 of 2)
• Three investing legends: Peter Lynch,
Warren Buffett, and Howard Marks
9.11 Lessons form Some Legends
(slide 2 of 2)
• Peter Lynch looks for the following favorable
attributes when he analyzes firms:
1. The firm’s product is not faddish; it is one that
consumers will continue to purchase over time
2. The company has a sustainable comparative
competitive advantage over its rivals
3. The firm’s industry or product has market stability
4. The firm can benefit from cost reductions
5. The firm buys back its shares or management
purchases shares, which indicates that its insiders
are putting their money into the firm
9.11.2 Tenets of Warren Buffett
(slide 1 of 2)
• Business Tenets
• Is the business simple and understandable?
• Does the business have a consistent operating
history?
• Does the business have favorable long-term
prospects?
• Management Tenets
• Is management rational?
• Is management candid with its shareholders?
• Does management resist the institutional imperative?
9.11.2 Tenets of Warren Buffett
(slide 2 of 2)
• Financial Tenets
• Focus on return on equity, not earnings per share
• Calculate “owner earnings”
• Look for companies with high profit margins
• For every dollar retained, make sure the company has
created at least one dollar of market value
• Market Tenets
• What is the intrinsic value of the business?
• Can the business be purchased at a significant
discount to its fundamental intrinsic value?
9.11.3 Tenets of Howard Marks
(slide 1 of 2)
• The following list contains some of the many
important ideas from his book: The Most Important
Thing
• To succeed, you must engage in second-level thinking
• An investor must have an accurate sense of intrinsic value
• There are times when some investors are forced to sell
• Risk is the risk of permanent capital loss
• Risk is greatest when other investors say that there is no
risk
• Almost everything in business is cyclical
9.11.3 Tenets of Howard Marks
(slide 2 of 2)
• The market is a pendulum that swings between fear and greed
• The way to avoid trouble is to avoid greed, fear, envy, dismissal
of logic, following the herd, and ego
• To be a successful investor, you must understand intrinsic value,
be able to act when prices deviate from value, understand past
cycles, understand how bad behavior can hurt you, and
remember the idea that when things seem too good to be true,
they are
• A great investor must be able to buy when other investors are
despondent and selling
• You should keep a list of potential investments
• You must exercise patience
• You have to understand what you know and what you do not
know
• You should always have context about where we are right now

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CHAPTER 9

• Other measures of the economy:

• There are no perfect indicators

• In addition to the leading economic indicator

• The Yield Curve

• The Fed Model

• After analyzing the health of the economy and

• Growth Rate of Sales per Share

• The Discount Rate

• Also known as the cyclically adjusted

• For a macroanalysis of industries,

• When predicting industry sales and

• Industry competition has a tremendous impact

• The analyst should value an industry just

• At the industry level, sales growth estimates can

• The final questions in the fundamental

• Growth stocks will have positive earnings

• Company analysis is the final step in the

• After analyzing the company from

• Additional concepts to consider with respect to

• Remember what your cost of equity represents

• The growth duration model answers the

• Inconsistency between the expected

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