ReillyBrown Chapter 9 Fall 2019

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
• The first stage of top-down analysis is to

examine the attractiveness of a particular market
• The two components:
1. The macro-analysis of the relationship between the
aggregate securities markets and the aggregate
economy
2. The specific micro-valuation of the stock market
employing the valuation approaches
• Exhibits 9.1, 9.2, 9.3
9.2 Aggregate Market Analysis (Macro-
analysis)
• 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 (Macro-
analysis)
• Other measures of the economy:

1. The leading, coincident, and lagging
economic indicators
2. Sentiment indicators
3. Interest rates
4. All intended to give some idea of future
9.2.1 Leading, Coincident, and Lagging
Indicators
• 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
Indicators
Indicators
Indicators
Indicators
Indicators
Indicators
Indicators
Indicators
• 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
9.2.3 Interest Rates
• 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 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
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
9.3.2 Multiplier Approach
• P/E Multiple
• Estimate two variables: the earnings per
share and the multiplier
• To estimate the multiplier, estimate:
• The growth rate
• Future EPS
• Future P/E ratio (compare to historical)
9.3.4 Macrovaluation and Microvaluation of
World Markets
• Each market is different
• economies are growing at different rates
• different economic data
• risks are different, accounting standards are different
• 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
9.5 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
• The Business cycle
• Different industries tend to perform well or poorly in

different parts of the business cycle
• Sector rotation, monitor economic trends and attempt

to move investments from one sector (or industry
within a sector) to another sector (or industry) as
economic trends change (Jeff Mercer paper)
The Business Cycle and Industry
Sectors
9.5.1 The Business Cycle and Industry
Sectors
• 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) – Baby Boomers vs. Gen Z
• Lifestyles
• How people live, work, form households, consume, enjoy
leisure, and educate themselves – change as wealth increases
• 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
• When predicting industry sales and

profitability, view the industry over time
and divide its development into stages
similar to those that humans progress
through life
• It is important to ask how long the industry
will remain in a particular stage of the life
cycle
• Exhibits 9.23
9.5.3 Industry Life Cycle
9.5.4 Industry Competition
• Industry competition has a tremendous impact

on profitability
• Porter’s 5 Forces
• 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 9.25
Porter’s Five Forces
9.5.4 Industry Competition
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
9.6.2 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 (channel checking):
• 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
9.7 Global Industry Analysis
• 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
• 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
(Detectible? Efficient Markets?)
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 – Beta?
9.8.3 Cyclical Companies and Stocks
• Cyclical Companies
• Companies whose sales and earnings will be
heavily influenced by aggregate business
activity
• Examples - 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
• Could 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
• 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
9.9.1 Firm Competitive Strategies
• 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
9.9.1 Firm Competitive Strategies
• 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
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
9.11 Lessons form Some Legends
• Three investing legends:

• Peter Lynch, Warren Buffett
9.11 Lessons form Some Legends
• 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
• 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
• 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?

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ReillyBrown Chapter 9 Fall 2019

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CHAPTER 9

• The first stage of top-down analysis is to

• Other measures of the economy:

• There are no perfect indicators

• In addition to the leading economic indicator

• The Yield Curve

• After analyzing the health of the economy and

• For a macroanalysis of industries,

• Different industries tend to perform well or poorly in

• Sector rotation, monitor economic trends and attempt

• 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

• A company’s competitive strategy can either be

• After analyzing the company from

• Three investing legends:

• Peter Lynch looks for the following favorable

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