FINS1612 – SUMMARIES Week 5 – Equity Markets 3 Part 1 – Forecasting Share Price Movements Recall share price is determined by supply and demand of company’s shares (good expected performance increases demand and thus share price and vice-versa) Here we see three methods for explaining movements in supply and demand 1/5 Fundamental Analysis: Top-Down Approach; Fundamental analysis Considers macro and micro factors that impact upon cash flows and future share prices of various industry sectors and firms o Macro (Top Down) = interest rates, economic growth, business investment o Micro = Firm-specific and relate to management’s impact on company performance. Top-down approach considerations ; o Economic growth of international economies Higher the growth rate of the rest of the world – bigger demand for Australian exports. The sectors benefitting from international growth are determined by source of the growth ¥ Growth can be driven by increased consumer demand or increased business investment in equipment. o Exchange rates (Strong relationship to interest rates) These affect the domestic currency profit of exporters that quote their products in foreign currency prices.
Recall share price is determined by supply and demand of company’s shares (good expected performance increases demand and thus share price and vice-versa)
Here we see three methods for explaining movements in supply and demand
1/5 Fundamental Analysis: Top-Down Approach;
Fundamental analysis Considers macro and micro factors that impact upon cash flows and future share prices of various industry sectors and firms
o Macro (Top Down) = interest rates, economic growth, business investment
o Micro = Firm-specific and relate to management’s impact on company performance.
Top-down approach considerations;
o Economic growth of international economies
Higher the growth rate of the rest of the world – bigger demand for Australian exports.
The sectors benefitting from international growth are determined by source of the growth
¥ Growth can be driven by increased consumer demand or increased business investment in equipment.
o Exchange rates (Strong relationship to interest rates)
These affect the domestic currency profit of exporters that quote their products in foreign currency prices.
¥ A strengthening AUD makes exporting firms worse off because the AUD value of their exports is lower / more expensive to the world.
Also affect indirectly via devaluing of currency increasing cost of imports, thereby increasing inflation (if currency weakens)
o Interest rates
Directly effects profitability – by representing the cost of debt finance for borrowers and the return for finance providers
Indirectly effects profitability – A rise may indicate slowing of economic activity AND could represent a future reduction in productivity.
o Domestic economy factors;
Growth rate – greater growth generally leads to increased profitability for firms.BUT can also lead to negative profitability factors such as Deterioration in balance of payments, increase in inflationary pressures, pressure on wages, depreciation of the exchange rate, rises in interest rates.
Balance of payments current account;
¥ If this account is in deficit (total international payments exceed total international receipts)
o Some export income is diverted to service debt
o Need to borrow foreign currency to service the debt
¥ Indirectly – The government may increase interest rates to slow economic growth and control the debt.
Inflationary pressures –
¥ Effect of inflation of firm’s real profit
¥ Tax treatment of inflation;
o Makes historical-based depreciation allowances inappropriate
o Combine with higher replacement costs, leads to an overstatement of after-tax profit
¥ Inventory – Inflated selling price of inventory creates an illusion of inventory profits.
Wage and Productivity Growth
¥ Increase in wages growth raises the amount of business profit used for salaries.
o Impact most on firms that are highly labour-intensive
Government responses to changes in the above factors
2/5 Fundamental Analysis: Bottom-Up Approach;
After identifying the best economies and industry sectors for investment using the top-down approach the bottom-up approach can be used to identify the best companies within these
The bottom-up approach considers micro factors using ratios and other measures of a firm’s financial characteristics and performance.
o Consideration factors;
¥ Accounting ratios that assess a company’s capital structure, liquidity, debt servicing, profitability, share price and risk.
o Observing the trend and making comparisons with firms in the same industry.
¥ Also additional information on key management changes, corporate governance and strategic direction.
4/6 WEEK 4 Financial Performance Indicators:
Investors are concerned with the future level of a company’s performance because it affects both the profitability of the company and the variability of the cash flows.
The indicators include;
o Capital structure:
Proportion of company assets (funding) obtained through debt and equity.
¥ Usually measured by debt to equity ratio (D/E ratio)
o Higher debt increases financial risk of not being able to meet interest payments
¥ Also measured by proprietorship ratio = ratio of shareholder’s funds to total assets.
o This indicates a firm’s longer term financial viability/stability. A higher ratio indicates less reliance on external funding.
o Liquidity;
Ability of a company to meet short term financial obligations
¥ Current ratio = Current assets (Maturing within one year) / Current liabilities (due within one year) – NOT the best indicator
¥ Liquid ratio
Current assets – inventory (stock on hand) / Current liabilities – bank overdraft.
o Debt servicing;
Ability to meet debt-related obligations i.e interest and repayment of debt.
Measured by debt to gross cash flow ratio
¥ Indicates number of years of cash flow required to repay total firm debt.
Also measured by interest coverage ratio.
¥ Earnings before finance lease charges, interest and tax / finance lease charges and interest.
o Profitability;
Wide variation exists in the definition and measurement of profitability;
¥ EPS;
¥ EBIT to total funds ratio;
o EBIT/ Total funds employed (shareholder’s funds and borrowings)
¥ EBIT to long term funds ratio;
o EBIT/ Long-term-funds (total funds less short term debt)
¥ ROE (Return on equity);
o Net income / equity (shareholders’ funds)
o Share Price;
Represents investors’ view of the PV of the future net cash flows of a firm
Performance indicators of share price include;
¥ Price to Earnings (P/E) ratio (higher is more growth in future NCF)
o Share price divided by EPS
¥ Share price to net tangible assets ratio (P/NTA)
o Measures the theoretical premium or discount at which a firm’s share price is trading relative to its NTA
o Risk
Variability (uncertainty of the share price)
¥ Recall systematic vs. non-systematic risk
3/5 Technical Analysis;
Explains and forecasts share price movements based on past price behaviour
Assumes markets are dominated at certain times by mass psychology, from which regular patterns emerge.
Method 1 Moving averages (MA) models
o Smooth out a series facilitating the identification of trends in the series
Assuming a five-day moving average, the MA is calculated by taking the average of the price series for the preceding five days.
o Gives trading rules of;
Buy when the price series cuts the MA from below
¥ Buy when the MA series is rising strongly and the price series cuts or touches the MA from above for only a few observations.
SELL when the MA flattens or declines and the price series cuts the MA from above
¥ SELL when the MA is in decline and the price series cuts or touches the MA from below for only a few observations
o Typically, for daily price series both 10-day (short-term) and 30-day (medium-term) moving averages are calculated.
o Weighted MA = most recent information given the greatest weight
Note: Technical Analysis – Validity
Even where techniques have no apparent underlying validity – if they are followed by enough participants they may
impact on share price behaviour at times.
More likely to forecast successfully when share prices move out of a range explained by economic and financial
fundamentals.
Method 2 Charting - Investigating patterns in price charts using techniques such as
o Trend lines (regular movements in share prices)
Uptrend line – connecting the lower points of rising price series
Downtrend line – Connecting the higher points of falling share series.
Return line – line drawn parallel to a trend line to create a trend channel.
¥ Critical issue: Determining when trend line will change.
o Support and resistance lines
Support levels – where there is sufficient demand to halt further price falls.
Resistance levels – where there is sufficient supply to halt further price increases
¥ Strong levels – historical support of resistance
¥ Weak levels – support and resistance based on more recent activity
o Continuation patterns – Sideways share trading that does not normally signal a change in trend.
Triangles – composed of a series of price fluctuations, each smaller than its predecessor.
¥ Symmetrical triangle (no change in trend)
¥ Ascending Triangle (uptrend)
¥ Descending triangle (downtrend)
Pennants and flags – formed during a sharp rise in prices (the pole); then trading volume reduces and increases suddenly to take prices sharply higher.
o Reversal patterns – occur after a major market move,
Head and shoulders pattern – three successive rallies and reactions, the second rally being stronger than 1st and 3rd.
¥ Left shoulder – formed by volume-strong rally on uptrend, followed by reduced-volume reaction
¥ Head – second rally increases price before reaction moves price back to previous low
¥ Right shoulder – final rally market by reduced volume indicating price weakness
4/5 Program Trading;
Buy and sell strategies generated by computer programs that range between;
o Simple buy/sell orders based on moving averages
o Complex monitoring of both derivatives and share markets for the purpose of hedging a share portfolio.
This increases the speed at which prices change
5/5 Random Walk and Efficient Market Hypothesis;
These are two theories on security values and changes in price
o Random walk; - PRICE OF SHARE INDEPENDENT OF PREVIOUS PRICE
Share price is assumed to be formed by investor’s expectations of future cash flows. i.e Intrinsic Value
Price will change in response to new information and since information arrives in a random fashion – stock prices adjust in an unpredictable fashion.
Each observation in the (price) series is assumed to be independent of the previous one
There is an equal probability that the next price will move up, down or remain unchanged.
o Efficient Market Hypothesis (EMH); - PRICE ADJUSTS IMMEDIATELY TO NEW INFO
Proposes that markets are information-efficient if prices adjust immediately to new information
It is not possible for an investor to make abnormal profits through superior information
¥ Weak form – historical price data reflected in share price
¥ Semi-strong form – all publicly available information is reflected in share price.
¥ Strong-form – public and private information is fully reflected in share price.
Week 5 – Equity Markets 3 Part 2 – Basic concepts and calculations (financial Maths)
FV – Future Value ( Single period cash flow )
The amount an investment is worth after one of more periods
Need the following elements;
o C ( = PV) – Important when reversing to find PV
o r (interest rate)
o t (time period)
o NOTE 365 in Australia – 360 in USA and EUR
Formula & example (Simple interest) :
Formula & example ( Compound interest) – Compounding:
Finding the Present Value – Discounting ( Single period cash flow )
Option 1 – Rearrange FV:
If we recall that the FV of a single period cash flow is as below (recalling that C is PV)
Hence to rearrange to find PV;
Where Ct is the FV at a particular time that will be given or assumed.
Option 2 – Using Table A.2:
We should note also that we could simply use Table A.2
A note on HPY (Holding Period Yield):
This is the yield on securities sold in the secondary market prior to maturity
HPY > YTM when market yield declines from the yield at purchase>>> IR have decreased and the price of the security increases
HPY < YTM when market yield increases from the yield at purchase >>>(IR increase, Security price decreases)
Finding the Present Value – Discounting ( Ordinary Annuity )
Option 1 – Discount Each Cashflow using single cash flow formula:
Let us observe an example in which an annuity pays $200 at the end of each period for 3 years and has an interest rate of 10%
Hence we must discount each amount and summate;
Option 2 – Formula for PV of ordinary annuity:
Option 3 – Using Table A.3 :
Finding the Present Value – Discounting ( Annuity Due )
Option 1 – Single Cash flow formula and individual discounting:
Options 2 & 3 – Modifying the Ordinary Annuity Formula / Table Shortcut:
Either add the (1+r) as we did for FV to the ordinary Annuity Formula;
Or, after finding ordinary Annuity with Table A.3 – add the (1+r);
Finding the Present Value – Discounting (Deferred Annuity )
Option 1 – Single Cash flow formula ( Modifying t ):
Options 2 & 3 – Modifying Formula or Table-found value:
For example – A 7 year Annuity that pays 100 at the end of each period but only begins paying at the end of the third period:
Depending on what was the chosen method for an ordinary annuity, this value is divided by the formula to adjust for the time until payments begin.
o I.e – we are finding the PV for when payments begin and then discounting back to period 0
o Note that step 1 could be the table-found value times by C
Different Types of interest rate;1. Nominal Interest Rates (i Nom - APR)
The rate that is quoted by financial institutions and written on the contracts
o Need to know the compounding periods to give this number any meaning
