Stock Market Efficiency and Company Valuation - Literature review Example

? Stock Market Efficiency and Company Valuation Introduction The objective of this report is to comprehensively assess the state of the UK stock market by focusing on the aspects that are associated with the efficiency of the stock market. For the fulfillment of this aim, the course of the research that has been conducted in this report is directed towards critically appraising the presence of pricing efficiency in the UK stock market with the incorporation of the conclusions, outcomes and findings that have been derived by researchers in prior academic literature on the subject under discussion. A fundamental feature of this analysis is the assessments on Majestic Wine plc, which is the foremost mixed case wine retailer in the UK. The company is quoted on the Alternative Investment Market (AIM) of the London Stock Exchange, which aims to assist companies that are operating on a smaller scale in meeting their requirements of capital for the purposes of expansion (London Stock Exchange 2013a). The categories of analysis for Majestic Wine plc are based on a range of distinct evaluations, which shall assess the share price movements and information flows to the market for the company and also conduct a comprehensive appraisal of the market price of the company’s shares, in accordance with the value assessments methods that are understood to be standard procedures in company valuation. The Significance of the Efficient-Market Hypothesis (EMH) According to Buckle and Thompson (2004, p174) the practical significance of the hypothesis regarding efficient markets is a notion which cannot be ignored. The application of this hypothesis postulates that the stock market’s agreement with its observations can lead to a situation where predicting changes in share prices are no longer considered to be viable as the market prices are an exact representation of each and every data or information that is present (Buckle and Thompson, 2004, p174). The classifications of features that can assist in the development of a well-informed discussion regarding stock market efficiency are based on the categories of return predictability, event studies and private information. Buckle and Thompson (2004, p175) understand that assessing these concepts with respect to the London Stock Exchange can uncover whether its functioning is efficient or not. Theoretical Implications of EMH and the Random Walk Model Barnes (2012, p46) highlights the theoretical implications of stock market efficiency which is essentially a system where an informational efficient market is said to be the cause of allocative efficiency. Accordingly, the basis of this efficiency is examined on three forms that were developed by Eugene Fama and were termed as weak, semi-strong and strong (Barnes 2012, p46). According to Barnes (2012, p46) the weak form is described as a situation in which any new information regarding a company is represented by movements in the new price on an immediate basis, henceforth; this notion follows the ideology which states that new share movements cannot be determined through movements in old share prices. Analysts term this phenomenon as the ‘random walk’. While, several examinations on UK Stock market have aimed to establish its efficiency, numerous competing literatures have uncovered evidences which invalidate these claims. Dimson and Mussavian (1998, p92; 2000, p9) understand that the findings of numerous studies which report the presence of anomalies is indicative of features which oppose the principal of market efficiency. Researches which have pointed towards the occurrences of such characteristics that are largely inconsistent with economic ideologies aim to comprehend the trends in pricing efficiency within stock markets. A piece of empirical evidence which represents the phenomenon of the ‘random walk’ and the presence of its corresponding concept which is known as the ‘weak-form efficiency’ with respect to the UK stock market can be observed in the research which was conducted by Kendall (1953, p11-25). Kendall (1953, p11-25) noted that fluctuations in stock and commodity prices in a sample size that amounted to 22 reflected unsystematic changes that took place within small gaps in a given period of time, moreover, the magnitude of change in the prices was also understood to be significant which consequently represented the inexistence of a systematic effect. Similarly, the ramifications of the random walk with respect to the UK stock market are also evidenced in the research of Hon and Tonks (2001, p20) who claim that the distinguishing characteristic of this model can be seen through the repeated modifications in stock prices which basically show no correlation and “deviations from this characteristic essentially imply that the market is not necessarily efficient”. Weak-form Efficiency, Semi-strong Efficiency and Short-termism in the UK Stock Market Developing the findings of prior researchers which strongly suggested the authenticity of the weak-form efficient market hypothesis with regards to the UK stock market, Al-Loughani and Chappell (1997, p173-176) examined the applicability of the hypothesis with respect to the London Stock Exchange and the study was conducted during a span of time in which government initiatives and policies remained largely stagnant. As mentioned previously, the phenomenon of weak-form efficiency entails the occurrence of the random walk model which implies that it is not possible for investors to enjoy higher than average returns by utilizing previous movements in share prices to act as a predictor of future changes in share prices (Barnes 2012, p45). Loughani and Chappell (1997, p173-176) found that despite of general observations which declare the presence of the random walk model, the study did not authenticate this claim. However, the conclusions of a study which was conducted three years later with the objective of expounding upon the findings that were drawn by Loughani and Chappell (1997) stated that the application of the weak-form efficiency hypothesis is indeed justifiable with respect to the London Stock exchange even though, the random walk model cannot be deemed pertinent to the situation (Milionis and Moschos, 2000, p419-421). The vast scope of the research which has been conducted on the UK stock market efficiency indicates that analysts have applied a range of methodologies to establish justifiable outcomes. Cuthbertson, Hayes and Nitzsche (1997, p986) found that as per the applications of the varying assumptions of the VAR methodology, the UK stock market was also found to be characterized by short-termism. Additionally, the findings of prior literature such as the one presented by Marsh (1979, p839) indicates the presence semi-strong efficiency in the UK stock market. It is understood that political dynamics have always played a critical role in impacting the state of the UK stock market. Gemmill (1992, p211) discovered that stock and options prices in London during the peak time of the 1987 elections displayed grave inefficiencies and the occurrence of the same phenomenon was also recorded in the capital during the 1992 elections when the London Stock Exchange experienced semi-strong efficiency while, comparable results indicated that the stock and options market had been more efficient in 1987 than in 1992 (Gwilym and Buckle, 1994, p345). Overview of Majestic Wine Plc’s Financial Performance The scope of the preceding discussion on the UK stock market efficiency focused on an analysis of the state of the nation’s stock markets with respect to the features, concepts and categorizations that are associated with the concept of ‘efficiency’. Consequently, the following examinations in the report aim to apply the conclusions of the discussions that have been conducted thus far within the context of Majestic Wine plc. Majestic Wine plc is a household name in the UK and is quoted on the Alternative Investment Market of the London Stock Exchange which now quotes over 1181 firms (Adams, 2006, p208). The company has adopted several successful strategies over the years to cope with competitive pressures and has managed to increase its profits by enhancing the demand for its products rather than charging higher prices from its customers (Cram, 2006). The recent financial performance of the company has improved, even though, the figures do not represent drastic changes the profit before tax for the financial year ending 1 April 2013 reportedly stood at ?23.7 in 2013 from ?23.5 in 2012, additionally, the overall sales for Majestic Wine plc’s products decreased by 2.1% (Majestic Wine PLC 2013). Share Price Movement and Information Flows Bernhardt and Taub (2005, p2) note that “prices are public information”, while this statement highlights the significance of a commonly held ideology, this notion is also reflective of the advancements in information channels and flows that have been observed in recent times with respect to trading. According to the Majestic Wine PLC Annual Report and Accounts (2012, p51) the company exercised its shares options regularly throughout the financial year for which the weighted average share price stood at ?4.75 in 2012 while, it had been ?3.74 in 2011 and ?2.61 in 2010 (Majestic Wine PLC Annual Report and Accounts 2011, p51). Assessing share price movements, the share prices for Majestic Wine plc during the last six months have fluctuated from 400.00 to 515.00 on July 16, 2013, the latter of which was the highest level reached by the company in terms of share prices in 52 weeks. The share price movements since the release of the company’s preliminary financial report on 1 April 2013 which revealed an increase in the group’s pretax profit to ?23.7 from ?23.2 in the last year have been marked by an overall increasing trend. This trend is distinctively observable through interactive charts which initially show a significant drop in share prices in the mid of April with the company recording its lowest price in the 52 week period which stood at 397.00 on 22 April, 2013. However, the share price movements in the month of July have been significantly positive. Accordingly, Majestic Wine PLC closed at 503.00 on Friday, 26 July 2013. The London Stock Exchange provides the assistance of a comprehensive tool known as the Regulatory News Service (RNS) which has essentially been developed to meet the financial communication needs of businesses (London Stock Exchange 2013b). Consequently, this tool is instrumental to the formulation and execution of Majestic Wine Plc’s strategy which aims to address the associations of the company with its investors. The Regulatory News Service proudly assists the transportation of financial news amongst investors which encompasses both regulatory and price-sensitive announcements that are related to the companies operating within the United Kingdom (London Stock Exchange 2013b). By utilizing the information based resources of London Stock Exchange’s Regulatory News Service (RNS) this section of the paper will critically assess latest news and announcements that have been recently released and made public to the investors and how they have impacted the share prices of the company. On 19 November 2012, the company announced its interim results which reported a 3.9% increase in profits along with a 5.3% rise in dividends. These financial results coincided with an increase in the company’s share price which stood at 475.00 after experiencing a consistently declining trend and reaching a low at 465.00 on 16 November 2012. Majestic Wine Plc had reported consistently poor financial performance in the same month in 2011 when share prices reached a low of 353.00 on 22 November that year. Apart from information flows that report price-sensitive announcements and interim or final financial performance that has been achieved by the company, a company’s financial communications system may also report changes in the management and other alterations that have the possibility of impacting investor relations strategies. For example, on 8 August 2012 Majestic Wine Plc released an announcement regarding changes in the Board of Directors and share prices experienced a drastic increase to 530.00 on 7 August 2013 from 510.00 on 6 August 2013. This trend may be associated with speculator expectations regarding the impending changes in the Board of Directors. Consequently, this increase in share price on 7 August 2013 can also be associated with the resolutions that were expected to be passed on 8 August 2013 as decided in the Annual General Meeting of Majestic Wine Plc, the notice for which was to shareholders on 8 July 2013. Market Price of Shares The market price of the company’s share can be evaluated in accordance with the standard methods of valuation that are widely accepted by analysts as being appropriate procedures of representing a company’s intrinsic value. The Discounted Cash Flow (DCF) postulates that a company must consider its cash flows, expenditures and expected income in its valuation of shares, moreover, this method incorporates the discounted rate as a means of considering the impact of inflation and business prospects on the resources of the company. According to the Majestic Wine PLC Annual Report and Accounts (2012, p15) the company’s cash flows from its operations increased to ?25.4 from last year after experiencing an increase of ?2.9. Furthermore, the growth prospects of Majestic Wine plc have also been viewed in a positive light by analysts who predict an overall rise in the demand for high-quality wine in the UK. This observation was translated in an 8% increase in the company’s sales and an expansion in the organization’s customer base to 568,000 (Majestic Wine PLC Annual Report and Accounts, 2012, p6). The overall business landscape for Majestic Wine plc is highly positive with predictions for further improvement; this notion postulates that these observations are expected to be reflected in the market price for the company’s shares in years to come. Deliverance of strong and consistent financial performance implies that an organization is more likely to reward its shareholders should a situation such as this prevail. Majestic Wine plc is committed to rewarding its shareholders on their investment and this is evident from the director’s recommendation of an interim dividend of 3.8p and a final dividend of 11.8p in 2012 which is a 20% increase from the dividend that was recommended in the past year (Majestic Wine PLC Annual Report and Accounts, 2012, p14). These observations suggest that the value of the company’s dividends is expected to rise in the coming financial years which may increase the demand for Majestic Wine plc’s shares on the London Stock Exchange in accordance with the dividend discount method of valuation. Conclusion The application of standard value assessment methods in this report has been a consequence of comprehending the overall financial state of Majestic Wine plc. While, the Annual Report and Accounts of the company have been of tremendous assistance in the achievement of this objective it is important to highlight certain limitations in this regard, the absence of which could have enhanced the aforementioned evaluations for the organization. These limitations include the unavailability of past financial records for the company from credible sources. This consideration hindered the establishment of market trends that are based over a significant period of time. However, the presence of recent data and financial records on the company greatly assisted the establishment of latest conclusions. Bibliography AL-LOUGHANI, N., & CHAPPELL, D. (1997). On the validity of the weak-form efficient markets hypothesis applied to the London stock exchange. Applied Financial Economics, vol. 7 no. 2, pp. 173-176. BARNES, P. (2012). Stock Market Efficiency Insider Dealing and Market Abuse (Ebk-Epub). Gower Publishing, Ltd.. BERNHARDT, D., & TAUB, B. 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