Chapter 8: The Efficient Market Hypothesis

Transcription

1 Chapter 8: The Efficient Market Hypothesis Random Walk and Efficient Market Hypothesis If stock prices are predictable it would not hold for long: 1. If model predicts XWY will increase to $10 in 3 days 2. Everyone would buy 3. No one in XYZ would sell 4. Forecast of future price will lead to an immediate price increase stock price will immediately reflect good news implicit in model s forecast. - Finding recurrent stock patterns will fail forecast of favourable future performance would lead to favourable current performance Random Walk 1. Assume information used to predict stock performance already reflected in stock prices 2. Any info on stock being under-priced, investors will buy 3. Stock would immediately rise to fair value 4. Ordinary rates of return expected (compensation for risk) - If prices bid immediately to fair levels given new information; - They must only increase/decrease in response to new information (unpredictable); - If it were predictable, new information = today s information; - Stock prices that change to new must also be unpredictable thus stock prices follow a random walk Efficient Market Hypothesis Hypothesis: market is efficient if security prices immediately and fully reflect all available relevant information. Thus knowledge of that information would not allow an investor to profit from information because share prices already incorporate the information 1. If priced determined rationally only new information will cause them to change; 2. Random walk would be natural result of prices reflecting current knowledge; 3. Predictable stock movements - evidence of market inefficiency; 4. Ability to predict stocks = not all information already reflected in stock prices No easy money rule.

2 - Cumulative returns before takeover attempts - Acquiring firm pays premium - Stock prices jump on day news becomes public - No new information after announcement date no further drifts in prices after announcement date - Midday positive average price movement of stocks that receive positive reports - Top line levels off within 5 minutes (market has fully digested news) - Midday-negative levels within 12 minutes Ratio Analysis: Introduction Growth and Profitability 1. Product Market Strategies a. Operating Management managing revenue and expenses b. Investment Management managing working capital and fixed assets 2. Financial Market Policies a. Financing Decisions Managing liabilities and equity b. Dividend Policy - managing pay out AT profits by TA Average total assets ROE = ROA x Financial Leverage Measures ROA - How much profit per dollar of assets - Organisational performance - Ability to operate more efficiently - Productivity of assets

3 - Higher AT = higher level of management performance EBIT Margin = (Operating Efficiency) x (Production Efficiency) Operating Efficiency Production Efficiency (Gross Profit Margin) Valuation EBIT Margin Margin Sales 1 DISCOUNTED DIVIDENDS VALUATION METHOD Equity Value = PV of expected future dividends - How many $ of sales is retained as GP - Price premium - Efficiency of production Equity Value = DIV 1 (1 + r e ) + DIV 2 (1 + r e ) 2 + Equity Value = DIV 1 (r e g d ) re: return on equity g d : growth of dividends 2 DISCOUNTED ABNORMAL EARNINGS VALUATION METHOD BVE 1 = BVE 0 + NI 1 DIV 1 DIV 1 = BVE 0 + NI 1 BVE 1 Equity Value = BVE + PV of expected future abnormal earnings Abnormal earnings: NI adjusted for capital charge (discount rate multiplied by beginning BVE). Equity Value = BVE 0 + NI 1 r e BVE 0 (1 + r e ) + NI 2 r e BVE 1 (1 + r e ) 2 + Abnormal earnings adjust NI to reflect the fact that accountants do not recognise opportunity cost of equity funds used Asset Value = BVA 0 + NOPAT 1 WACC BVE 0 (1 + WACC) + NOPAT 2 WACC BVE 1 (1 + WACC) 2 +

4 2.1 ACCOUNTING METHODS AND DISCOUNTED ABNORMAL EARNINGS Accounting choices affect both book value and earnings Double entry = estimated values will not be affected by accounting methods Analyst must be aware of biases in accounting data as a result of the use of aggressive or conservative accounting methods 3 VALUATION USING PRICE MULTIPLES Steps: 1. Select measure of performance (earnings, sales CF, book equity ) 2. Estimate price multiples of comparative companies using performance measure 3. Apply comparable multiple to organisation Assumptions: Market determines growth prospect of comparable companies Pricing of other companies are applicable to company being analysed 3.1 SELECTING COMPARABLE COMPANIES Same industry o Many firms operate in different industries o Same industry firms may have different strategies, growth opportunities, profitability Average all comparable comps so differences cancel each other out 3.2 MULTIPLES FOR POOR PERFORMANCE Negative earnings o Exclude company all together o Check acc reports if due to write off can exclude that entry Can use leading multiples (instead of trailing multiples) o Leading multiples less likely to include one-time gains/losses 3.3 ADJUSTING MULTIPLES FOR LEVERAGE Consistency with numerator and denominator for debt and equity or solely equity Overview of Investment Process Week 1 Assets and Investments Investment process: individuals allocate excess funds to investments to increase wealth. They choose between alternative investment assets to make decision based on E(r) and risk. 1) Allocation decisions

5 a. Identify investment options b. Identify investor preferences i. Risk appetite - Cash, fixed interest, property, shares (less to more risky) ii. Investment horizon c. Decide on combination of investment assets and rebalance frequency i. Active investment management trying to beat the market ii. Passive investment management copying an index not trying to beat market 2) Performance management a. Returns and Risks 3) Review stage a. Actual vs Expectations b. Any Amendment needed Step 1: Allocation Decision Allocation is the process in which the investor decides how much of their funds should be invested in the 4 asset classes. This decision is based on their level of risk aversion, holding period requirements and particular management approach they adopt. Financial markets: allow individuals to match CF with consumption needs via investment or borrowing. Derivative securities allow investors and borrowers to adjust CF risk and timing in flexible and low cost manner Asset classes 4 broad classes: equity, cash, fixed interest and property. Equity Cash - Distinguishable by risk and return characteristics - Long-lived securities which provides investor with CF in form of dividends - Ordinary shares o Residual claim o Limited liability - Preference shares o Fixed dividends: limited gains, no voting o Priority over ordinary shares - Dividends is no obligation - Involves a right to residual CF thus is more susceptible to change in business conditions - Comprises of short-term interest-bearing assets - Provide CF in form of single payment at end of security s life - Traded on money market - Low risk because constant return of interest - Examples: bank-accepted bills and treasury notes

6 Fixed Interest - Interest-bearing securities with a fixed term - Longer terms to maturity than cash investments - Traded on the bond market - Low risk interest component - Higher risk than cash assets LT nature makes them susceptible to changes in economy - Examples: T-Bonds, Corporate Bonds Property - Recept of CF in form of rental income and any cap gain from change in value of property itself - May invest via agent or indirectly through property trust via stock exchange - Riskier than cash and fixed interest assets but less risky than equity because RI is typically secured and stable but prop value fluctuates. Value is much larger than rental component. - Defensive Assets o Low risk steady income o Investor: High Risk Aversion (Low Risk Preference) o Includes: Money market instruments (30 Day T Bills, Bank CDs), Fixed Interest securities (T-Bonds, Corporate Bonds) - Growth Assets o High Risk High capital growth Moderate income o Investor: Low Risk Aversion (High Risk Preference) o Includes: Property (direct and indirect), Equity (domestic and international shares) - Derivatives o Options, Futures and other derivatives o Used to hedge or enhance risk Fixed Income Instruments: Corporate Bonds and Mortgage Backed security (MBS) - Corporate Bonds o Riskier than T-Bonds o Investment grade/speculative, secured/ Unsecured - MBS o A security backed up by a pool of mortgages o The pool backer passes through monthly mortgage payments by homeowners and covers payments any homeowners who default