Economy and Industry Analysis Flashcards
Explain why the following myths are false
- A valuation is an objective search for “true” value
- A good valuation provides a precise estimate of value
- More quantitative models are better
- All valuations are subjective, and depends on your perspective. As assets are also used for diversification the price can differ to investors depending on the diversification it provides to their portfolio.
- There are no precise valuations. Payoff to valuation is greatest when most uncertain. If everyone knows the true valuation harder to make money from that.
- One’s understanding of a valuation model is inversely
proportional to the number of inputs. Simpler valuation models often perform better. The more complex means more things can go wrong
What is the function of the price of an asset in an efficient market.
What is the Growth option trying to capture, why is DCF not applicable
Estimating Cash flows are sensitive to…
Estimating discount rate is affected by ….
Price = PV sum of future expected cash flows and growth options
Growth options captures the companies ability to develop or improve income streams in the future. There are no cash flows so you can’t use DCF to discount. A lot of companies valuation relies on its growth rates.
Estimating cash flows depends largely on company and industry specific factors
Estimating discount rates depends largely on cost of
money which is a function of economy wide factors
What is the formula for FCF and establish the link to the Intrinsic value of a company
For who does the price apply when using this calculation of DFC
FCF = Sales Volume x Profit per sale (in one period)
Sum of PV of expected FCF (in all period) + Growth Option = Intrinsic Value
The price that is calculated from the above equation is from the perspective of the shareholders
Describe the factors that can influence sales volume or profit margins
Firm Competitiveness: Cost of Production, Production Differentiation, Quality of management
Industry attractiveness: Barriers to entry, Leverage capacity
Macroeconomic Setting: They affect the equity return via the discount rate
Explain how QE can affect stock prices
If a country has to employ QE there is a large inflow of money. A condition that has not been factored into asset prices. Money becomes worth less which is reduces the discount rates, the price of stocks and gold increase.
Describe the relationship between discount rates, the cost of money and the value of assets.
How can investors profit or hedge against the risk
Discount rates reflect the cost of money which affects the
value of assets. Unexpected changes in the cost of money affect the value of assets
Investors can choose to try to anticipate changes in interest rates and profit from those changes and/or they can choose assets in their portfolio to hedge against unexpected changes
Why is the sharemarket going up when people expect a recession
Explain why people think that there a bubble forming
The economy is slowing down and so central banks are
lowering the cost of money by increasing money supply
in an attempt to stimulate demand
The challenge is that investors are wary about weak economic growth so they are using the cheaper money to buy safe income yielding assets (e.g. banks, property) rather than using it to invest in new capital
intensive projects.
This is spurring fears that monetary policy is now ineffective and inflating some asset class beyond a “reasonable” level (ie, creating “bubbles”).
This is why Australian shares are best performing since 1900’s
Describe the relationship between Economic growth and Share price
Share prices react to unexpected changes in economic growth
In the long-run, economic growth per se is largely irrelevant to forecasting share prices. Knowing economic growth alone will not help you predict direction of share prices and vice versa
The key factor linking economic growth and share prices is the proportion of profit from economic growth that is captured by existing shareholders
Why are some indication that it is not a good idea to invest in china
That’s the headlines. … in the business centres of Shanghai
and Beijing, the chat is not about how much money everyone is making in the world’s fastest-growing economy. Instead the focus is on just how tough it is to do business out there. Margins are being squeezed, pricing power is almost nonexistent and there are new players entering the field constantly — AFR
Profit margins and Sales volume under pressure. Profits are not that good and pricing power is almost non existent. The performance is relative to expectation not the economy growth, this is why WB invests in companies with high barriers to entry.
Why isn’t there a direct link between economic growth and share market returns.
Economic Growth is a function of productivity of capital equipment and labor.
More machines, more workers = higher economic growth
More efficient machines, more efficient workers = higher economic growth
Better educated, trained workers = higher efficiency
But the parties that benefit from productivity are three parties
- Providers of capital - investors via higher dividends and capital appreciation
- Labour – workers can earn a higher wage
- Consumers – lower prices and higher quality goods
How the gains are distributed across capital, labor and consumers is a function of supply and demand (competition) and political influence.
If the economy is growing the question is who benefits from it the most.
According to the NY times how did Germany contribute to the debt crisis in Europe
2000 to 2010, after-tax income for people in the middle of the income distribution in Germany increased 1.4 percent. Not per year. Total.
Germany took steps to ensure that rising productivity…
translated into more people in the labor force rather than higher wages. The measures worked exceptionally well, which is reflected in both the stagnant wages and a falling German jobless rate
According to the NY times what i a sign of wage inequality and how is this increasing
the most perplexing and important dynamics of the last 30 years: the rise of the 1 percent, a tiny sliver of the population that last year took in almost a dollar out of every $4 generated by the American economy
Some reasons: “a shrinking minimum wage cut into the earnings of the nation’s least-skilled workers while falling trade barriers, deregulation and the decline of labor unions eroded the income of the middle class
Increased productivity and a separation of ownership and management channeled the gains towards providers of capital. This is a disadvantage of economic growth.
Can Economic growth affect the value of a company in the short run if so then how>
An increase in economic growth may help increase the company value in the short run
Economic growth affects company values via its effect on growth options, Expected free cash flows and expected discount rate
If there is a change in the interest rates due to monetary policy response to economic activity the discount rate of the asset will change therefore the value of the company, if the change has not already been factored into the share price.
Economic growth has an effect on what element of price.
Explain how investment in high economic growth have an affect on the value of the company in the short run.
Does high economic growth by itself lead to an increase in share price
How does disagreement between the management and the shareholder in times of high economic growth
Economic growth or lack of it has an impact on growth options:
When high economic growth is expected, investors value companies making investments that can capture the profits from that growth. The company need to be in a position to take advantage of this rather than let new competitors capture the benefits.
High economic growth by itself does not lead to increased profitability if new competition enters the market or if labour costs capture most of the growth or if consumers benefit from improved technology and lower costs
Often tension between management’s and investors’ view
Management may think investors are too focused on the short-term and crippling growth options by demanding distribution of profits
Investors may think managers are excessively optimistic and/or moving outside their area of competence and/or want to “empire build” at shareholders’ expense.
How are growth options developed and under what circumstances should a company invest in growth options
Growth options may be developed via investments that provide a competitive advantage in earning profits in the future
If the company is well placed to make those investments the investors are better off if the company doesn’t distribute all its “free cash flows” to investors but retains it. If the company is not well placed the company creates more value by returning free cash flows to investors.
Management must convince investors so to position the company favorable to capture profits in the future therefore they need to retain profits as opposed to distribution.
Give a 3 point summary of economic growth and share prices
What are the implication of a strong and weak economy in the short run
Share prices react to unexpected changes in economic growth. In the short term
In the long-run, economic growth is largely
irrelevant to forecasting share prices knowing
economic growth alone will not help you predict direction
of share prices and vice versa
Key factor in forecasting is proportion of profits from
economic growth that is captured by existing shareholders
as opposed to new entrants to the market, labour or
consumers
Strong economy : More competing attractive investments, cost of money is higher
Weak economy: Not many attractive investment, cost of money is low
Describe FFM and the categories under it (not covered but super useful)
DEGREE OF ACTUAL AND POTENTIAL COMPETITION
Rivalry amount existing firms :
Industry growth, Concentration, Differentiation, Switching costs, fixed/variable costs, excess capacity, Exit barriers
Threat of new Entrants:
Scale economies, First mover advantage, distribution access, Switching costs, Relationships, Legal Barriers
Threat of substitutes:
Relative price and performance, Buyers willingness to switch
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BARGAINING POWER IN INPUT AND OUTPUT MARKETS
Bargaining power of buyers:
Switching costs, differentiation, Importance of product for cost and quality, number of buyers
Bargaining power of suppliers
Switching costs, differentiation, importance of product for cost and quality, number of suppliers, Volume per supplier
Joseph Schumpter defines creative destruction as:
A process in which the old ways of doing things are endogenously destroyed and replace by new ways
Explain supply and demand in the mining sector and the implication of this
Supply of natural resource reserves is a function of
discovered reserves, technology and price. Normal discount rates make it uneconomic for resource companies to be concerned about looking for reserves much more than 10 years out
Finite” supply is a “red herring” We thought this was the case for oil but as soon a prices started to increase the price cam crashing down since the development of new technologies of fracking increased supply.
Supply of natural resources is “lumpy” due to large capital costs in bringing on new capacity and large step changes in total output when new mines/fields brought into production. One implication is that supply does not adjust quickly to changes in demand; price carries all the burden of adjustment in the short run
Demand is a function of size of economy and growth but is not reliably predictable
Implications: Lumpy supply and unpredictable demand
characteristics of natural resources means that the
sector is typified by “booms and busts” when, as is
frequently the case, supply and demand is mismatched
Currently, demand is high relative to supply but in not so-distant past the reverse was true
Explain the mining and distribution process in 7 steps
- . Exploration: Impossible to predict composition
of any ore reserve; only conclusively established once mined - . Mining: done in blocks, explosives loosen blocks
- Crushing: Take ore chunks and break into
uniformly sized pieces Lumps & Fines - Processing: Sort ore content from impurities
- Blending/Planning: Achieve homogeneity in
stockpiles - requires judgment (knowledge &
experience vital) - Rail transport
- Port operation: Loading allowed opportunity to
blend; Once cargo on board, client usually takes
ownership (FOB)
Why use a top down approach
That the state of a company’s industry, the local economy and global economy matters affect equity returns
What is the fundamental takeway
There isn’t a necessary correlation between what happens in the real economy and what happens in the financial market
WHY??
When comparing different investment strategies why should you not only look at the different metrics, what should you look for to make and investment.
When comparing companies you should not compare the financail metric between two companies as this could already be factored into the share price. It is not a good source of information.
We need to compare the Gaps between companies, the gap between intrinsic value and the market price.
In realtions to stock return what is meant by the term “surprise”
Markets move based on shifts in conditions; conditions that have been and have not been priced in. Once the conditions that have not been priced in is discovered the movement is relative to the discrepancy.
Explain the implication if interest rate remain stable if the markets were expecting a cut.
What are the problems faced by geln stevens on lowering interest rates.
If investors expect interest rates to fall then the price of assets will increase, on rate day if the interest rate does no fall then the price of the assets that previously rose will reverse - this is the the condition that has not been factored in taking effect.
The problem on interest rates is lowering interest rates is favorable to stimulate the weakening economy but lowering interest rates will put further pressure for housing prices to increase in an already “heated” market.
What are the advantages and disadvantages of holding cash, why would you hold cash
If assets are overvalued and going to crash. It can viewed as insurance to that crash.
But the disadvantage is the opportunity cost and the possible returns that could be acquired by putting the cash to work for you. Inflation and currency risk
Explain why economic growth is not necessarily associated with higher market equity returns
A stronger economy reflects stronger aggregate demand in general but it is possible that demand for particular products wont increase
In a growing economy competition also increases, reducing margins and pricing power.
What are the four main aeras of business economics
Business organisation
Management
Expansion
Strategy
