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

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

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.

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

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)

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

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

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

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

'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.

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.

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

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

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?

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.

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?

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.

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.

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.

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

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

Profitability ratios Return on capital employed (ROCE) (%): profit before interest and tax × 100 capital employed Net profit margin (%): profit before interest and tax × 100 sales

Profitability ratios Net asset turnover (times): sales capital employed Gross profit margin (%): gross profit × 100 sales

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

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

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

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

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 × 100 share capital and reserves

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

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

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

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

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

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.

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.

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.