1. Capital Markets, Market Efficiency and Ratio Analysis
Lecture 2
Capital Markets, Market Efficiency and Ratio Analysis

2. Internal and external finance
Internal finance:
Retained earnings
Efficiency savings
External finance:
Equity
Debt
Leasing

3. Internal and external finance
Balance between sources influenced by:
Company attitude to risk and return.
Availability and amount of retained earnings.
Access to capital markets.
Costs of different sources of finance.
Dividend policy.
Investment opportunities.
Historical position.

4. Financial assets Gilts Treasury bills Preference shares
Ordinary shares
Bonds
Loan stock and debentures
Convertibles
Warrants

5. Primary and secondary markets
Primary market: for new issues of shares
Secondary market (second-hand market):
Increases liquidity of shares
Generates pricing information
Barometer of corporate performance
Stock exchange markets:
Full market
Alternative investment market (AIM)

6. The London Stock Exchange
Full Market
Established in 1801
Over 1,460 UK and 350 overseas companies on the market
Average market capitalisation: £1bn
AIM
Opened in 1995
Now over 1000 companies listed
Average market capitalisation £30m

7. What is market efficiency?
Operational efficiency (low transaction costs)
Informational efficiency (low cost, access)
Pricing efficiency (prices of shares reflect all relevant available information)
Allocational efficiency (funds go to most efficient/profitable companies)
Market efficiency concerned with pricing efficiency

8. Perfect capital market
No taxes or transaction costs
Free entry and exit
Many buyers and sellers
Participants are utility maximisers
Information is costless and freely available

9. Perfect versus efficient market
Market does not have to be perfect to be efficient.
Requirements for efficient market:
Low transaction costs/taxes
Informational efficiency, i.e. information available at low cost
No one participant dominates the market

10. 'Beating' the market
There are two approaches for investors attempting to beat the market:
Chartism/technical analysis: drawing charts and using regression to predict prices based on past trends...
Fundamental analysis: use of financial data to predict ‘fair’ price of share – using accounts, share pricing models etc.

11. Efficient Market Hypothesis
‘The price of a security fully and fairly reflects all available and relevant information’ - Fama, 1970.
Academics define three ‘strengths’ of market efficiency and test the market using empirical data.

12. Weak form efficiency Definition:
Security prices reflect past information only
Implication:
Making abnormal returns using trading rules based on study of past share prices is not possible
Empirical Evidence:
Random walk hypothesis
Serial correlation tests, run tests, filter tests

13. Semi-strong form efficiency
Definition:
Security prices reflect past information and all publicly available information
Implication:
It is not possible to make abnormal returns through studying company accounts, etc.
Empirical evidence:
Stock splits
Anticipation of annual reports and mergers

14. Strong form efficiency
Definition:
Security prices reflect all available information, publicly available or not
Implication:
It is not possible to make any abnormal returns
Empirical Evidence:
Why is insider dealing illegal?
Do professional analysts beat the market?

15. Implications of EMH Pointless paying for expensive research
No point studying financial statements
No bargains on the stock exchange
Buy and hold strategy is best
Manipulation of accounts is pointless
Timing of new issues is not critical
Managers just need to focus on making the best investment decisions, since market capitalisation will increase by NPV of project.

16. Market efficiency?
Empirical evidence supports semi-strong form of efficient market hypothesis.
Can sophisticated investors using expert advisors and dealing software exploit market imperfections to make abnormal returns?
Efficiency is generated by the activities of analysts who disbelieve the hypothesis.
What are ‘normal’ or ‘expected’ returns?

17. Market efficiency? Anomalies in share price behaviour.
Calendar effects
Size anomalies
Value effects
Speculative bubbles
Behavioural finance
Investors can make irrational decisions, which may have persisting effects.

18. Scope of ratio analysis
Ratio analysis can be applied to financial statements and similar data in order to
assess performance of a company.
determine whether company is solvent and financially healthy.
assess risk attached to its financial structure.
analyse returns generated for shareholders and other interested parties.

19. Users of ratio analysis
Investors (financial institutions and ordinary investors) need to make decisions about buying and selling company securities.
Company managers need to assess divisional and company performance against competitors and previous years.
Financial institutions need to make decisions about whether to lend to or finance a company.

20. Importance of benchmarks
Ratios must be compared with benchmarks:
Pre-determined targets for ratios set by company, i.e. ROCE > 16%
Ratios of companies of similar size who are engaged in similar business activities
Average ratios for business sector in which a company operates, i.e. with industrial norms
Ratios for the company from previous years, with data adjusted for inflation if necessary

21. Ratio analysis Five broad ratio categories: Profitability ratios
Activity ratios
Liquidity ratios
Gearing ratios
Investor ratios

22. Profitability ratios Return on capital employed (ROCE) (%):
profit before interest and tax × capital employed
Net profit margin (%):
profit before interest and tax × sales

23. Profitability ratios Net asset turnover (times):
sales capital employed
Gross profit margin (%):
gross profit × sales

24. Activity ratios Debtors’ ratio or debtor days: debtors × 365
credit sales
Creditors’ ratio or creditor days:
trade creditors × 365
cost of sales

25. Activity ratios Stock days: stock or inventory × 365 cost of sales
Cash conversion cycle (days):
stock days + debtor days – creditor days

26. Activity ratios Fixed asset turnover (times):
sales or turnover fixed assets
Sales/net working capital (times):
sales or turnover net current assets

27. current assets less stock current liabilities
Liquidity ratios
Current ratio (times):
current assets current liabilities
Quick ratio (times):
current assets less stock current liabilities

28. long-term debt capital × 100 capital employed
Gearing ratios
Capital gearing ratio (%):
long-term debt capital × 100 capital employed
Debt/equity ratio (%):
long-term debt × share capital and reserves

29. profit before interest and tax interest charges
Gearing ratios
Interest cover (times):
profit before interest and tax interest charges

30. Investor ratios Return on equity (ROE) (%):
earnings after tax and preference dividends
shareholders’ funds
Dividend per share (pence):
total dividend paid to ordinary shareholders
number of issued ordinary shares

31. Investor ratios Earnings per share (EPS) (pence):
earnings after tax and preference dividends
number of issued ordinary shares
Dividend cover (times):
earnings per share
dividend per share

32. distributable earnings
Investor ratios
Price/earnings ratio (P/E ratio) (times):
market price of share
earnings per share
Payout ratio (%):
ordinary dividends x 100
distributable earnings

33. Investor ratios Dividend yield (%): dividend per share x 100
share price
Earnings yield (%):
earnings per share x 100

34. Problems with ratio analysis
Balance sheet is a snap shot as it relates to the company's position on one day of the year.
It can be difficult to find a similar company in order to make inter-company comparisons.
May be creative accounting, e.g. off-balance-sheet financing, complex financial instruments.
Ratio analysis should be seen as the start of financial analysis, serving mainly to raise questions, which require deeper investigation.

35. Economic profit and EVA
Economic profit is similar to residual income and equals operating profit after tax minus cost of capital charge on capital employed.
Economic Value Added (EVA) is similar to economic profit, but seeks to find a fair value for invested capital by amending published financial statements.
EVA directs attention to the drivers creating wealth for the shareholder.

36. Economic profit and EVA
EVA suggests shareholder value is created by
seeking ways to increase net operating profit after tax without increasing capital invested.
investing in projects giving returns greater than company’s cost of capital.
reducing capital charge by reducing cost of capital or reducing amount of invested capital.