CFA Level I - Reading 57 & 58

An analyst should take into account how broad structural changes will affect specific industries over time. Four types of structural changes are:

• Demographics: Demographic factors include age distribution and population changes, as well as changes in income distribution, ethnic composition of the population, and trends in the geographical distribution of the population. As a large segment of the population reaches their twenties, residential construction, furniture, and related industries will see increased demand. An aging of the overall population can mean significant growth for the healthcare industry and developers of retirement communities.
• Lifestyles: An example of the effect of changing lifestyles on industry growth prospects is the increase in meals consumed outside the home and catalog sales, as the percentage of families with two employed spouses has increased. Consumption patterns are also affected by current perceptions of what is "in style" and trends in consumer tastes in recreation, entertainment, and other areas of discretionary expenditure.
• Technology: Changes in technology have had very important consequences for many industries over time. Change in the technology of transportation and communications have certainly had important effects on these industries, both in terms of products and services consumed but also in their production and pricing. Technological advances in computers and microprocessors in general have lead to sweeping changes in how inventory is managed and how products are distributed in many industries, particularly in the retailing industry.
• Politics and regulation: Changes in the political climate and changes in specific government regulations can also have significant effects on particular industries. The imposition of tariffs on steel will lead to increased domestic production and profitability; the rise of terrorist activity has helped some industries and imposed costs on others such as the airline and shipping industries; and requirements of a minimum wage and the widespread expectation of employment benefits packages have affected hiring practices and production methods, especially in labor intensive industries. Regulation of the introduction and sale of everything from new drugs to genetically engineered crops has important implications for many industries as well. 

A firm’s earnings per share (EPS) can be estimated using the following equation:

Expected EPS = [(sales)(EBITDA %) – depreciation – interest](1 – tax rate)

A firm’s expected earnings multiplier (P/E) can be calculated using either of two methods:

1. Macroanalysis approach estimates the company’s P/E ratio by comparing it to industry and market P/E ratios.
2. Microanalysis approach calculates a point estimate of the firm’s expected P/E ratio.

Estimate the firm’s projected dividend payout ratio, D₁/E₁. This is done with comparative analysis of the firm’s payout history, stated goals, and industry.

Estimate the firm’s required rate of return on equity: k = RFR + [E(R_MKT – RFR)]Beta

Estimate the firm’s expected growth rate: g = (retention rate)(ROE)

Compute the firm’s future earnings multiplier: (P/E)₁ = (D₁/E₁) / (k – g)

One way to evaluate the purchase of a stock is to compare the intrinsic value (based on the present value of expected dividends or cash flows) to the current market price. An alternative is to assume that the market price will move to the intrinsic value over some period and then compare the expected total return over the period to the investor’s required rate of return.