Streetbites from the media perspective The efficient market hypothesis!

Transcription

1 Streetbites from the media perspective The efficient market hypothesis!

2 Streetbites from the media perspective The finance equivalent to the perpetual energy machine paradox is the efficient market hypothesis! See textbook pages for related content on this story. Videos for module 3, unit 2-of-2 (TOTAL: 38 ) o Overview of Efficient markets hypothesis (10:47) DEFINITION 9.3 Efficient market hypothesis ( EMH ) A market is efficient with respect to an information event if it is impossible to devise a trading strategy that uses the information to consistently earn economic profit. Small company stocks $10,000 Large company stocks $7,860 $1,000 Long-term corporate bonds Long-term government bonds $2,279 $100 $10 Treasury bills $133 $93 $21 $ FIGURE 9.4 Growth of a $1 investment at year-end 1925 in different asset classes A one-dollar investment in Treasury bills would have grown to become worth $21 (all figures assume automatic reinvestment of the total return). The 1,600% cumulative rate of return from T-bills is pretty big because the 85-year sample period is pretty long. Investment in long-term government bonds results in ending wealth of $93, about thrice the accumulation from T-bills. Long-term corporate bonds grow even more, to $133,

3 and a $1 investment in large company stocks grows to an incredible $2,279. Finally, the average small company stock investment of $1 from 1925 attains an ending wealth in 2010 of $7,860. Consider components of EMH definition 9.3 that are notable. 1. The financial market may be efficient with respect to one information event but not others. The question is the stock market efficient? is underspecified and does not have a definite answer. The nebulous question is like asking whether the market is all knowing, not a good question. Instead, a definite information event must be specified for which a definite yes/no answer exists. For example, a valid question is this: is the stock market efficient with respect to announcement of a stock split? 2. The EMH argues that stock prices quickly respond to new information. The price adjustment process, however, takes (some) time. The length of time varies from seconds, to minutes, and maybe longer for surprising information that is difficult to assess. Lengthy adjustment periods may reflect information complexity rather than market inefficiency. Sometimes, for example, new information about a single event reaches the market in bits and pieces. Consequently, the price response may diffuse across time. The important issue is whether security prices adjust to unanticipated changes in consensus expectations. 3. There is no violation of the EMH simply because a trading strategy uses information and (once) earns economic profit. Instead, the EMH argues that a trading strategy cannot consistently earn economic profit. 4. When the EMH is true then all security prices are fair. With fair prices the consensus expectations push prices to the point that none are undervalued nor overvalued. Security investment earns a return that depends exclusively on risk and unanticipated changes in consensus expectations. 5. The EMH uses economic profit as its benchmark for comparison. Perhaps a trading strategy consistently earns positive accounting profit, but this does not violate the EMH. Instead, the EMH argues that a trading strategy cannot consistently earn returns that exceed fair compensation for risk exposure. Thousands of tests on market efficiency examine many different types of information events. Information events belong to either of three traditional categories. Weak information events pertain exclusively to stock market data such as historical prices, trading volume, price multiples, calendar effects, etc. Semi-strong information events pertain to all publicly available data such as economic or political announcements, corporate news, etc. Strong information events pertain to all data, public and private, such as insider or managerial insights. Irrespective of category, an efficient market exists when a trading strategy cannot use an information event to consistently earn economic profit. The super-majority find tendencies that support the EMH.

4 FF14 Which definition of the information set is consistent with the Efficient Market Hypothesis The Efficient Market hypothesis ( EMH ) claims it is not possible to use an information set to consistently earn excess stock returns. Which statement about different forms of the information set is most accurate? a. for the semi-strong form of the EMH the information set includes calendar, stock market, and all publicly available data b. for the semi-strong form of the EMH the information set includes calendar and stock market data c. for the weak form of the EMH the information set includes calendar, stock market, and all public and privately available data d. for the strong form of the EMH the information set includes calendar and stock market data e. for the strong form of the EMH the information set includes calendar, stock market, and all publicly available data

5 Chapter 3, Unit 2 of 2 Natural dynamics shape the cash flow!

6 Two sides of a balance sheet move step by step together, responsive to measurable natural dynamics follow the cash flow! See textbook pages for relevant readings. Videos for Module 3, Unit 2-of-2 (TOTAL: 8@66 38 ) o Overview of Efficient markets hypothesis (10:47) o Natural growth rate dynamics - g_sustainable (6:04) o Natural growth rate dynamics - stability (7:36) o Forecast TA given g_sustainable (7:43) [GR1] o Introduction to cash flow formulas (6:04) o The cash surplus (1:49) [CF4] o The price-to-cash flow from operations ratio (14:05) [CF3a] o Cash is the equalizer (12:30) [Example 9] NATURAL GROWTH RATES CONTINUED g internal A t R t R t (retention ratio)(roa) 1 (retention ratio)(roa) when ROA Net income t Total assets t (retention ratio)(roa) when ROA Net income t Total assets t1 The sales growth rate at g internal is characterized by a measurable period of stable net profit margin, asset turnover ratio, and payout ratio. Find the Sales growth rate for GR2a on the daily handout!

7 GR2d Find new equity price-to-book ratio given constant p/e and g internal Find below the Company s financial statements for year Balance Sheet, 12/31/2525 Income, 1/1 12/31/2525 $555 Current assets $1,955 Debt Sales $16,200 $3,600 PP&E $2,200 Stockholders equity total costs $15,600 $4,155 Total assets $4,155 net income $600 dividends $290 new retained earnings $310 For 2526 the asset turnover (salestotal assets), net profit margin (=net income sales), payout ratio (=dividendsnet income) and price-to-earnings ratio (now 18.1) will be constant. The number of shares outstanding is 110. The firm seeks maximum growth by relying exclusively on retained earnings; external financing will be zero. What is the equity price-to-book ratio at year-end 2526? { CLUES: g = 8.06% ; P 2526 = $ } a b c d e FOLLOW-UP: What s happened to the debt ratio? Is that good? FORMULA 3.4a, 3.4b, and 3.4c The sustainable growth rate A company with constant asset turnover ratio, net profit margin, dividend payout ratio, and debt-to-equity ratio grows at the sustainable growth rate : g sustainabl e t t t Rt 1D t / SEt A R 1D / SE t (retentionratio)(roe) 1(retentionratio)(ROE) when ROE Net income Stockholders equity t t (retentionratio)(roe) when ROE Net income Stockholders equity t t1 The variables R, A, D, and SE denote New retained earnings, Total assets, Total debt, and Stockholders equity, respectively.

8 Total (A) $1,000 Total (A) $1,177 PANEL A: Status Quo for year 2525 Balance Sheet, 12/31/2525 Income Statement, 1/1 to 12/31/ Debt (D) Sales $3, Equity (SE) total expenses 2,850 $1,000 Liabilities & Equity Net Income 150 Dividends 60 New Retained Earnings (R) 90 PANEL C: Effect on year 2526 of growth at rate g sustainable Balance Sheet, 12/31/2526 Income Statement, 1/1 to 12/31/ Debt (D) Sales $3, Equity (SE) total expenses 3,354 $1,177 Liabilities & Equity Net Income 176 Dividends 70 New Retained Earnings (R) 106 EXERCISES Find below items from the company s income statement. Income, 1/1-12/31/2525 Sales $12,000 all costs $10,800 Net income $1,200 Dividends $920 New retained earnings $280 Total assets at 12/31/2525 equal $3,650 and the debt-to-assets ratio is 45%. If the company is growing at their sustainable growth rate, what are Total assets at 12/31/2526? GR1 ANSWER: Use formula 2.5 to find that the debt-to-equity ratio equals (= 0.45 / (1 0.45)). Apply formula 3.4a and find that g sustainable equals 16.21% (= $280 x ( ) / [$3,650 $280 x ( )]). Total assets at 12/31/2526 therefore equals $4,241 (= $3,650 x ( )).

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10 FORMULA 3.5 Cash flow to shareholders CF to shareholders = Dividends Net equity issues FORMULA 3.6 Cash flow to creditors CF to creditors = Interest Net debt issues FORMULA 3.7 Cash flow to capitalists CF to capitalists = CF to shareholders + CF to creditors.

11 FORMULA 3.8 The link between assets and capitalists CF from assets to capitalists = CF Cash flow from assets identically equals Cash flow to capitalists. This identity assumes that stakeholder cash flows wash out and do not create value. The discussion on the importance of CF to capitalists for allocating resources applies to CF from assets too. For an asset investment to receive financing, capitalists must believe that the venture promises to deliver sufficient future Cash flow from assets to justify the investment. FORMULA 3.9 Cash flow from assets, expanded version CF from assets = EBIT + Depreciation Taxes NWC - Capital expenditures where EBIT = Sales COGS SGA Depreciation, FORMULA 3.10 Cash flow from operations CF from operations = EBIT + Depreciation Taxes = EBITDA Taxes EBITDA, earnings before interest, taxes, depreciation and amortization, is increasingly popular in the financial press From

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13 Comparison of formulas 3.9 and 3.10 reveals that the Cash flow from assets equals Cash flow from operations when the company spends absolutely nothing on Net working capital and PP&E. Usually, though, some funds get used on Net working capital or PP&E so not all Cash flow from operations immediately returns to capitalists. Combining several of the preceding formulas yields a key expression. FORMULA 3.11 Cash flow from assets, summary version CF from assets = CF from operations NWC - capital expenditures Besides cash flow, many analysts watch the company s Cash surplus:

14 FORMULA 3.12 Cash surplus cash surplus = Cash = CF from operations from assets NWC(excluding Cash) Capital expenditures CF CF4 Find cash surplus in simplistic setting Find below the Company s balance sheet at year-end Balance Sheet, 12/31/2525 Cash $495 $1,650 Current liabilities Other current assets $705 $1,250 Debt PP&E $3,800 $2,100 Stockholders equity $5,000 $5,000 Total and also for year-end Balance Sheet, 12/31/2526 Cash $540 $720 Current liabilities Other current assets $900 $920 Debt PP&E $2,400 $2,200 Stockholders equity $3,840 $3,840 Total How much is the cash surplus? {ANSWER: $45 } EXAMPLE 9 Combine the balance sheet with income statement items to find cash flows Find below the Company s balance sheet at year-end Balance Sheet, 12/31/2525 Cash $ 90 $200 Current liabilities Other current assets Debt PP&E Stockholders equity (80 shares) $1,070 $1,070 Total For year 2526 the following are forecast: the stock price should end the year at $7.50 per share; Sales equal $2,100; operating margin (= EBIT Sales) is 14%; Depreciation is 15% of PP&E; Interest is 10% of debt; Taxes are 35% of taxable income; Dividends are 60% of Net income. Suppose the company makes sufficient Capital expenditures during 2526 so that it holds PP&E constant. It finances these Capital expenditures by issuing 10 shares during 2526 for $7 per share. The remainder of the Capital expenditures is financed internally. All else remains the same. Find all the different cash flow measures as well as the price-to-earnings, price-to-book, and price-to-cash flow.

15 SOLUTION For convenience forecast the income statement from the preceding facts. Company Income Statement, Jan. 1 Dec. 31, 2526 Sales revenue $2,100 - Other costs (see discussion) Depreciation (@ 15% of PPE) 102 = EBIT (@ 14% of sales) $294 - Interest (@ 10% of debt) 18 = Taxable income $276 - Taxes (@ 35% tax rate) 97 = Net income $179 - Dividends (@ 60% payout) 108 = New Retained Earnings $ 71 The operating margin allows computation of EBIT from Sales. It is unnecessary to compute Other costs. Notice that the income statement does not show in any way the Capital expenditures nor equity issues. These latter items, however, affect the balance sheet for year-end Apply formula 2.11 to compute that SE 2526 equals $832 (= ). For convenience show all that is known about the balance sheet for yearend 2526: Balance Sheet, 12/31/2526 Cash $? $200 Current liabilities Other current assets Debt PP&E Stockholders equity (80 shares) $1,212 $1,212 Total Cash is found such that it equalizes the bottom line. That is, Cash 2526 equals $232 (= $1, ). Now apply the cash flow formulas and find that CF to creditors equals to shareholders interest paid on debt and equals $18 (no new loans are taken out); CF equals Dividends minus new issues and equals $38 (= $108 $70); CF from assets equals the sum of CF to creditors plus CF to shareholders and is $56. The Cash surplus is the change in Cash CF from assets and Cash surplus are consistent with formulas 3.9 and 3.12, respectively. One final comment about this example pertains to the source of the $102 Capital expenditure that the Company pays to the capital goods supplier. The Company sells new shares and raises $70; the remaining $32 is paid in cash. Confirm that if Capital expenditures were zero and no shares were issued, Cash is $32 higher at $264, and Total assets is $1,142.

16 EXERCISES Find below the Company s balance sheet for year-end Balance Sheet, 12/31/2525 Cash $345 $750 Current liabilities Inventory $795 $790 Debt PP&E $4,000 $3,600 Stockholders equity $5,140 $5,140 Total For 2525 the Company s asset turnover ratio (Sales 2525 Total assets 2525 ) is 3.6. Depreciation equals 18% of PP&E, and the operating profit margin (= earnings before interest and taxes Sales) is 9.70%. Interest expense equals 9.60% of Debt. Taxes equal 35% of taxable income, and the payout ratio (=DividendsNet income) is 45%. There are no other items on the income statement for There are 180 shares outstanding. As a prospective investor in the Company s shares, you are especially interested in their financial ratios. You know the price-to-earnings ratio at year-end 2525 equals More significant to you, however, is the price-to-cash-flow ratio (= shareprice operating cash flow per share). What is the company s price-to-cash-flow ratio? CF3a ANSWER: First, find CF from operations. EBIT is $1,795 (= 3.6 x $5,140 x ); Taxes equal $601 (= {$1,795 (.0970 x $790)} x 0.35); and CF from operations equals $1,913 (= $1,795 + (.18 x $4,000) $601). Now find market capitalization: Net income is $1,117 (= {$1,795 (.0970 x $790)} x {1 0.35}); market cap equals $31,607 (= 28.3 x $1,117). The ratio of market cap to CF from operations is identical to the ratio of shareprice to operating cash flow per share and equals 16.5 (= $31,607 / $1,913).