Chapter 12

Macroanalysis and
Microvaluation of the Stock
Market
 Economies and Markets
• A strong relationship exists between the
economy and the stock market

• Security markets reflect what is going on in

an economy because the value of an
investment is determined by
– its expected cash flows
– required rate of return
 Techniques for Stock Market
Valuation
• Two techniques are used to make the market
decision:
• (1) the macroeconomic technique, which is
based on the relationship between the
aggregate economy and the stock market;
and
• (2) the microeconomic technique, which
determines future market values by applying
the two valuation approaches
 Economic Activity and
Security Markets
Stock Market As A Leading Indicator
– The economy and the stock market have a
strong, consistent relationship
– Stock prices consistently turn before the
economy does
– Stock prices reflect expectations of earnings,
dividends, and interest rates
– Stock market reacts to various leading indicator
series
Cyclical Indicator Approach
to Forecasting the Economy
This approach contends that the aggregate
economy expands and contracts in
discernable periods
 Cyclical Indicator Approach to
Forecasting the Economy
• National Bureau of Economic Research
(NBER)
• Cyclical indicator categories
– leading indicators
– coincident indicators
– lagging indicators
• Composite series and ratio of series
 Cyclical Indicator Categories
• Leading indicators – economic series that
usually reach peaks or troughs before
corresponding peaks or troughs in aggregate
economy activity
• Coincident indicators – economic series that
have peaks and troughs that roughly
coincide with the peaks and troughs in the
business cycle
 Cyclical Indicator Categories
• Lagging indicators – economic series that
experience their peaks and troughs after
those of the aggregate economy
• Selected series – economic series that do
not fall into one of the three main groups
 Cyclical Indicator Approach to
Forecasting the Economy
• Analytical measures of performance
– diffusion indexes
• trends
• rates of change
• direction of change
• comparison with previous cycles
 Cyclical Indicator Approach to
Forecasting the Economy
• Limitations of cyclical indicator approach
– high variability
– currency of the data and revisions
– no series reflects the service sector
– no series represents the global economy
– political and international developments are
not factored into a statistical system
 Cyclical Indicator Approach to
Forecasting the Economy
• Leading indicators and stock prices
• Other leading indicator series
– CIBCR:
• Long-Leading Index It is intended to provide earlier signals of major
turning points in the economy.
• Leading Employment Index It is meant to forecast changes in U.S.
employment.
• Leading Inflation Index It is intended to forecast U.S. inflation.
• International Leading Indicator Series This is a set of composite
leading indicators for eight other major industrial countries: Canada,
Germany, France, the United Kingdom, Italy, Japan, Australia, and
Taiwan (Republic of China). The series are comparable in data and
analysis to the leading series for the United States.
 Monetary Variables, the
Economy, and Stock Prices
• Money supply and the economy
• Money supply and stock prices
• Inflation, Interest Rates, and Security Prices
Money Supply and the Economy
• The money supply has been suggested as a
predictor of aggregate market behavior
based on its relationship to the economy.
• Recent studies show that the monetary
policy environment has an important impact
on security market returns and also affects
how stocks relate to other variables.
Money Supply and the Economy
• Declines in the rate of growth of the money
supply have preceded business contraction
by an average of 20 months
• Increases in the rate of growth of the money
supply have preceded economic expansions
by about 8 months
 Money Supply and Stock Prices
• Numerous studies have tested the relationship suggested by this
transmission mechanism. The results of these studies have tended to
change over time.
• The initial studies by Sprinkel (1971), Keran (1971), and Homa and Jaffe
(1971) generally indicated a strong leading relationship between money
supply changes and stock prices.
• Subsequent studies by Cooper (1974) and Rozeff (1974) found that
changes in the growth rate of the money supply consistently lagged stock
returns by about one to three months.
• Davidson and Froyer (1982) and Hafer (1985) examined the relationship
of stock returns to anticipated and unanticipated money supply growth and
found that stock prices adjust very quickly to unexpected changes in
money supply growth.
• This implies that to take advantage of this relationship it is necessary to
forecast unanticipated changes in money supply growth.
 Monetary Variables, the
Economy, and Stock Prices
• Other economic variables and stock prices
– growth in industrial production
– changes in the risk premium
– twists in the yield curve
– measures of unanticipated inflation
– changes in expected inflation during periods of
volatile inflation
 Inflation, Interest Rates, and
Security Prices
• Inflation and interest rates
– generally move together
– investors are not good at predicting inflation
• Inflation rates and bond prices
– negative relationship
– more effect on longer term bonds
• Interest rates and stock prices
– not direct and not consistent
– effect varies over time
 Analysis of World Security
Markets
• Leading economic series are available for
virtually all the developed countries, and the
empirical relationships to the economy are quite
similar to those of the United States.
• Real GDP growth is typically consistent with
what is implied by the leading series. Notably, as
discussed in Chapter 1, the growth rate outlook
will vary between countries by at least 4 percent,
ranging from about 1 percent to over 5 percent
(e.g., China).
 Analysis of World Security
Markets
• The monetary environment of a country will
clearly differ from that of the United States
because the monetary authority in each country
will be responsive to the economic outlook for its
country, which is typically different from that of
the United States.
• The inflation outlook will depend on the
monetary environment. It also will be impacted
by the economic environment and the point on
the business cycle (recession or expansion).
 Microanalysis of a
country’s stock market
• Stock Market Analysis
– Application of the DDM and the FCFE models
to the aggregate stock market
– How to arrive at an expected market value and
an expected rate of return for the stock
market?
 Microanalysis of a
country’s stock market
• Stock Market Analysis
– Application of the DDM and the FCFE models
to the aggregate stock market
– How to arrive at an expected market value and
an expected rate of return for the stock
market?
 Microanalysis of a
country’s stock market
• Stock Market Analysis
– Application of the DDM and the FCFE models
to the aggregate stock market
– How to arrive at an expected market value and
an expected rate of return for the stock
market?
 Microanalysis of a
country’s stock market
• Microanalysis of the equity market
considered both approaches to equity
analysis—the present value of cash
flow techniques and the relative
valuation ratio techniques.
 Microanalysis of a
country’s stock market
• The cash flow techniques provided a
range of estimates which indicated that
the rates of return on common stock in
the near term will be similar to the long
run historical returns.
 Applying the DDM
Valuation Model to the Market
• The stream of expected returns
• The time pattern of expected returns
• The required rate of return on the investment
D0 (1  g ) D0 (1  g ) 2
D0 (1  g ) n
Vj    ... 
(1  k ) (1  k ) 2
(1  k ) n

D1 Pi D1 / E1
V j  Pj  
kg E1 kg
 Applying the DDM
Valuation Model to the Market
Pi D1 / E1

E1 kg

Determinants of the Earnings Multiplier:

1. The expected dividend payout ratio
2. The required rate of return on the stock
3. The expected growth rate of dividends for the stock
 Market Valuation Using the
Reduced Form DDM
• Estimating k and g for the U.S. equity market
• The nominal risk-free rate
• The equity risk premium
• The current estimate of Risk Premium and k
• Estimating the growth rate of dividends (g)
g = f(b,ROE)
ROE = Net Income / Equity
 Estimating Growth Rate
• Growth rate of dividends is equal to
– Retention rate - the proportion of earnings
retained and reinvested
– Return on equity (ROE) – rate of return earned
on investment
 An increase in either or both of these variables
causes an increase in the expected growth rate
(g) and an increase in the earnings multiplier
 Return on Equity (ROE)
Net Income

Common Equity

Net Income Sales Total Assets

  
Sales Total Assets Common Equity

Profit Total Asset Financial

= Margin
x Turnover x Leverage
 Market Valuation Using the Free
Cash Flow to Equity (FCFE) Model
FCFE is:
+ Net Income
+ Depreciation Expense
- Capital Expenditures
-  in Working Capital
- Principal Debt Repayments
+ New Debt issues
 Market Valuation Using the Free
Cash Flow to Equity (FCFE) Model

• The Constant Growth FCFE Model

• The Two Stage Growth FCFE Model

D
k g
p
 Market Valuation Using Relative
Valuation Approach

• The price-earnings ratio (P/E)

• The price-book value ratio (P/BV)
• The price-cash flow ratio (P/CF)
• The price-sales ratio (P/S)
 Market Valuation Using Relative
Valuation Approach
• Two-part valuation procedure
D1
V j  Pj 
kg
Pj D1  1 k  g

D1 Pj  k  g
 Market Valuation Using Relative
Valuation Approach
• Importance of both components of
value
1. Estimating the future earnings per share
for the stock-market series
2. Estimating a future earnings multiplier
for the stock-market series
 Estimating Expected Earnings Per
Share
• Estimating expected earnings per share
Estimate sales per share for a stock-market series
Estimate the operating profit margin for the series
Estimate depreciation per share for the next year
Estimate interest expense per share for the next year
Estimate the corporate tax rate for the next year
• Estimating Gross Domestic Product
• Estimating sales per share for a market series
 Estimating Expected Earnings Per
Share
• Alternative estimates of corporate net profits
– Direct estimate of the net profit margin based on recent
trends
– Estimate the net before tax (NBT) profit margin
– Estimate an operating profit margin to obtain EBITDA;
estimate depreciation and interest to arrive at EBT;
estimate the tax rate (T) and multiply by (1-T) to
estimate net income
 Estimating Expected Earnings Per
Share
• Estimating aggregate operating profit margins
– Capacity utilization rate
– Unit labor costs
– Rate of inflation
– Foreign competition
 Estimating Expected Earnings Per
Share
• Estimating depreciation expense
– time series trends
– estimate based on property, plant, and equipment
• sales and turnover
• depreciation
 Estimating Expected Earnings Per
Share
• Estimating interest expense
– debt levels
• total assets
• expected capital structure
– interest rates
– subtract result from EBIT to estimate EBT
 Estimating Expected Earnings Per
Share
• Estimating the tax rate
– depends on future political action
– multiply (1-T) times the EBT per-share to estimate the
net income per share
 Estimating the Earnings Multiplier
for a Stock Market Series
• Determinants of the earnings multiplier
– Dividend payout ratio
– required rate of return on common stock
– the expected growth rate of dividends for the stocks

Pi D1 / E1

E1 kg
 Estimating the Earnings Multiplier
for a Stock Market Series
• Estimating the required rate of return (k)
– inversely related to the earnings multiplier
– determined by risk-free rate, expected inflation, and the risk
premium for the investment
• Estimating the dividend payout ratio (D/E)
– active decision or residual outcome?
– time series plots
– long-run perspective
 Estimating the Earnings
Multiplier for a Stock Market
Series
• Estimating an Earnings Mutiplier: An
Example
– The Direction of Change Approach
– Specific Estimate Approach

• Calculating an Estimate of the Value for the

Market series
 Other Relative Valuation Ratios
• Price to book value ratio (P/BV)
• Price to cash flow ratio (P/CF)
• Price to sales ratio (P/S)