© 2000 John Petroff
|
|
© 2000 John Petroff |
Success or failure of all businesses depends not only on how well conceived are management's decisions as they relate to products, markets and production methods, but on well these decisions that correctly anticipate economic conditions. A financial analyst should investigate if management decisions are consistent with current and anticipated economic conditions. The scope and time horizon of economic analysis would normally vary with the time dimension of the financial decision at hand. For instance, in a decision to invest funds for retirement into a company stock, one looks at trends in the next decade or two: that is, beyond the immediate business cycle. At the opposite, in accepting a client for open account purchases, it is the next three months that would be of prime concern. Avoiding open account clients that may fail in a year or two, is desirable; but it would be a poor business policy to reject open account sales because of distant uncertainties: credit must be approved as long as there is no justification to suspect that the client will not pay within the 90 days. What needs to be known in this case is whether economic conditions will change so drastically within three months that the client will default.
Economic analysis is an essential underlying foundation for industry analysis of Chapter 14 and ratios analysis of prior chapters. Relatively speaking, the extent of effort for economic analysis is possibly less than for industry analysis, and but a fraction of company analysis. An analyst does not have to start an economic analysis from scratch every time he/she looks at a company. One would normally be already fully aware of major economic trends, current state of the economy, type of fiscal and monetary policy, and proposed legislation. In addition, one should maintain a continuous watch for signals that indicate that conditions are changing, and that predictions need to be modified. There is also less to be done by an analyst him/herself because there are many well-informed specialists in economics and politics, that are eager to discuss their views in the media. The government also publishes sensitive economic information on a regular basis. By contrast, expert opinion about specific products, companies and industries are much harder to come by.
Yet, the volume of relevant economic news lulls many professionals in believing that they are sufficiently informed, and consequently, turning points are missed and trends are misinterpreted. Thus, it is advisable to have a systematic tactic of periodic (say, once a week) complete reevaluation of economic conditions on the basis of newly published data and events. Another consideration is that this field of economic predictions is notoriously perilous. Even the wisest economists are known to make errors. And a common approach of relying on a consensus forecast is far from providing assurance of avoiding mistakes. The responsibility for error rests with the analyst: it is his decision to rely on the opinion he wishes. The best advice is to do some or most of the interpretation of data and projection oneself. That does not mean that a financial analyst must also become a learned economist and spend a considerable amount of time on this subject. As it will be apparent in the following sections, there are just a few key aspects that must be checked. In fact, this chapter is the shortest of the manual. Things have been kept to a workable minimum; not because it is not important, but because a lot has been written elsewhere. There are plenty of courses and textbooks one may want to consult. What will be presented here is the bare essential for financial analysis.
There are three sections in this chapter.
A- Long term trends
B- Business cycles
C- Economic forecasting for financial analysts
Much of the previous chapter paid attention to industry sales being affected by changes in consumer income over the business cycle. And rightfully, much of this chapter is devoted to a description of the business cycle, and then, to methods of predicting it. Notwithstanding these cyclical movements, consumer demand is growing at a steady pace along with the overall national income and output. Consumer demand is also changing over the long run under the influence of social, political, cultural and economic trends, that justify innovations. It is to these secular trend that we turn first.
See review questions Q-15.1 through Q-15.3.
| Previous: Industry analysis comments |
|
Next: Trends |