Capital Markets, Market Efficiency and Ratio Analysis

Denzil Watson and Antony Head, Corporate Finance: Principles and Practice, 4th Edition, © Pearson Education Limited 2007

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Lecture 2Capital Markets, Market

Efficiency and Ratio Analysis


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Internal and external finance

Internal finance:• Retained earnings• Efficiency savingsExternal finance:• Equity• Debt• Leasing


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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.

Internal and external finance


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Financial assets

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


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Primary and secondary markets

Primary market: for new issues of sharesSecondary market (second-hand market):• Increases liquidity of shares• Generates pricing information• Barometer of corporate performanceStock exchange markets:• Full market• Alternative investment market (AIM)


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The London Stock Exchange

Full Market• Established in 1801• Over 1,460 UK and 350 overseas

companies on the market• Average market capitalisation: £1bnAIM• Opened in 1995• Now over 1000 companies listed• Average market capitalisation £30m


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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


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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


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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


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'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.


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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.


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Weak form efficiency

Definition:• Security prices reflect past information onlyImplication:• 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


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Semi-strong form efficiency

Definition:• Security prices reflect past information and

all publicly available informationImplication:• It is not possible to make abnormal returns

through studying company accounts, etc.Empirical evidence:• Stock splits• Anticipation of annual reports and mergers


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Strong form efficiency

Definition:• Security prices reflect all available

information, publicly available or notImplication:• It is not possible to make any abnormal

returnsEmpirical Evidence:• Why is insider dealing illegal?• Do professional analysts beat the market?


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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.


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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?


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Market efficiency?

Anomalies in share price behaviour.• Calendar effects• Size anomalies• Value effects• Speculative bubblesBehavioural finance• Investors can make irrational decisions,

which may have persisting effects.


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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.


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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.


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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


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Ratio analysis

Five broad ratio categories:• Profitability ratios• Activity ratios• Liquidity ratios• Gearing ratios• Investor ratios


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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


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Profitability ratios

• Net asset turnover (times): sales

capital employed• Gross profit margin (%):

gross profit × 100sales


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Activity ratios

• Debtors’ ratio or debtor days:debtors × 365 credit sales

• Creditors’ ratio or creditor days: trade creditors × 365

cost of sales


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Activity ratios

• Stock days:stock or inventory × 365

cost of sales• Cash conversion cycle (days):

stock days + debtor days – creditor days


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Activity ratios

• Fixed asset turnover (times):sales or turnover fixed assets

• Sales/net working capital (times):sales or turnover

net current assets


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Liquidity ratios

• Current ratio (times): current assets

current liabilities• Quick ratio (times):

current assets less stock current liabilities


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Gearing ratios

• Capital gearing ratio (%): long-term debt capital × 100

capital employed• Debt/equity ratio (%):

long-term debt × 100 share capital and reserves


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• Interest cover (times):profit before interest and tax

interest charges

Gearing ratios


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Investor ratios

• Return on equity (ROE) (%):earnings after tax and preference dividends

shareholders’ funds• Dividend per share (pence):

total dividend paid to ordinary shareholdersnumber of issued ordinary shares


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Investor ratios

• Earnings per share (EPS) (pence):earnings after tax and preference dividends

number of issued ordinary shares• Dividend cover (times):

earnings per sharedividend per share


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Investor ratios

• Price/earnings ratio (P/E ratio) (times):market price of shareearnings per share

• Payout ratio (%): ordinary dividends x 100

distributable earnings


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Investor ratios

• Dividend yield (%): dividend per share x 100

share price• Earnings yield (%):

earnings per share x 100share price


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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.


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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.


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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.

Capital Markets, Market Efficiency and Ratio Analysis

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