The Share Market - Essay Example

New announcements by a company and its share value 2007 Typically, share prices of companies reflect the fundamentals of the company’s performance, the business scenario as well as national and international economic environment. While non-stakeholder investors may analyze these aspects of a company’s business on the basis of the available data, there may also be some knowledge that is not in their domain. In such situations, announcements by company directors regarding the company’s performance or future plans may provoke drastic share price movements. However, there may also be circumstances when even a good announcement of the company leaves its share price unaffected or even lower. Google’s shares plunged by $19.75 to close at $481.75 after the announcement on February 1, 2007 of its quarterly results that were better than anticipated by analysts. Although brokers polled by Thomson Financial in December 2006 expected the company to have earnings of $2.92 per share, the company announced its quarterly revenues at $3.18 per share. However, despite outshining its competitors, investors were concerned about the company’s cash outflows on acquisitions and investment in R&D (Infoworld, 2007). Earlier in 2004, however, the same company saw its share skyrocketing to $169.70 October 21, when it announced its revenues to have doubled since the IPO offer of $85 a share in August. This was the time when Google was expanding fast with its innovative products and it had outperformed analysts’ expectations about its role in the search engine market (New York Times, 2007). As Ross et al., explains, “First, the normal, or expected, return from the stock is the part of the return that shareholders in he market predict or expect. This return depends on the information shareholders have that bears on the stock, and it is based on the market’s understanding today of the important factors that will influence the stock in the coming year” (Ross et al. 2003). There is another part, however, which is the uncertain, or risky, part. This usually stems from information that the market is not expecting and that may come as a surprise. Although Google does not offer earnings guidance to analysts, investors have been optimistic about its growth in the early years since 2000 that was reflected in share prices movements after earnings announcements (New York Times, 2007). Over the more recent years, however, investors are concerned that it is spending more in acquisitions leading to cash outflows hence there is limited effect of good earnings announcements. The share market is considered to be ‘efficient’ when new information on the company is quickly absorbed in the share prices. This means that investors cannot expect to earn exceptional amounts through fundamental or technical analysis of the company’s performance or share price movements respectively. Hence, share price movements take the route of a Random Walk and market prices eventually tend towards the efficient price that reflects all available information. This is because all current and past information is reflected in the current share prices. According to the Capital Asset Pricing Model (CAP-M), return on a share depends on the non-diversifiable risk, beta, that is related to the market portfolio. If the share market is efficient, returns on the share will converge towards the average beta. However, researchers have found empirically that earnings to price ratios of shares cannot be explained by the CAP-M because of market anomalies (Wharton, 2006). Several market anomalies exist that induce rapid share price movements following company announcements. Anomalies like insider trading, merger arbitrage, momentum in industry stocks and others mean that there are possibilities of earning exceptional capital revenues on the basis of information (Singal, 2003). Typically, announcements regarding dividends and earnings induce share price movements. The relationship between a firm’s dividend policy and share price movements was first studied by Modigliani and Miller (1961). According to them, dividend payouts simply alter the allocation of funds between the shareholders’ income and capital gains, without affecting the net value. Modigliani and Miller (1961) found dividend policy irrelevant for shareholders’ wealth on the basis of assumptions of perfect capital markets in which there are no transaction costs, rational behavior of economic units, perfect knowledge about firms’ investment policies and cash flows and managers acting on behalf of the firm’s shareholders (Holder et al, 1998). The independence of shareholders’ wealth from the dividend policy will not hold true, however, in the absence of each of these assumptions. In the real world, shareholders expect higher dividends. In most cases, announcements of dividends are usually followed by favorable sentiments in the share market indicating that shareholders’ are positively affected by higher dividend payouts, irrespective of Modigliani-Miller’s dividend irrelevance theory. For example, Microsoft’s share price jumped 5 percent after the company announced on July 19, 2004 that it would double its cash dividend and buy back up to $30 billion of the company’s stocks. The announcement was received with optimism on the part of the investors since the company had for some time been sitting on cash (MSN, 2004). Microsoft announced the plan after the close of the market, when the stock closed 37 cents higher at $28.32. In the after-hour trading, the stock rose another 4 percent to $29.50 (New York Times, 2004). This is perhaps because of the simplifying assumptions of the theory that is typically not adhered to. For example, investors do not usually have perfect information about the firm’s intrinsic values. The asymmetry of information exists between the firm’s managers and investors and the release of certain information immediately affects the firm’s share value. Dividend payouts have a signaling effect on the firm’s value in that it indicates that the firm will continue to pay out higher dividends in the future and also will be committed to higher earnings to sustain the dividend payouts. Also, higher dividend also indicates lower free cash flows of the firms, a phenomenon that is favorably accepted by investors in the face of conflict of interest between managers and investors of firms. Free cash flow usually affects the firm’s value negatively since investors perceive it as an indication to financial slack on the part of the managers. In both cases, higher dividend payouts increase the share value and higher shareholder value of the firm (Natti, 2006). Despite the theory of irrelevance of the dividend policy, investors prefer dividend earnings out of their risk-averse nature rather than out of love of risks. Dividends are in the nature of predictable investment flows while capital gains are uncertain. Moreover, in the context of market imperfections like agency costs and taxes, dividends become all the more relevant for investor preferences. The positive impact of the signaling incentive of dividends becomes the economic rationale for firms’ dividend policies. Besides indicating the future earnings pattern, the stability of the firm’s dividend policy also eliminates the uncertainties involved in share price fluctuations. However, the share price movement is really related to the reason behind the dividend policy, that is the earnings growth of the firm, and a downturn of the share price may be reversed only with a rise in the actual earnings of the firm (Shapiro, 1990). Company announcements on stock splits often result in movement in share prices. Through stock splits, shareholders receive more shares for the same proportion of their equity holding. This step by the company does not fundamentally change the operations, earnings or the shareholding pattern. Yet, as Fama et al (1969) found, share prices rise by an abnormal amount just prior to the stock split. Grinbaldt et al (1984), too, found that stock prices typically react positively to stock split and dividend announcements when there are no other company-specific announcements. Further, stock prices rise by a larger amount on or around the ex-dates of the stock split and the dividend. The research found that the share price rise cannot be explained by cash dividends but through the signaling effect. Thus, company announcements like earnings forecasts, dividends and stock splits often induce large movements in share prices. Although theoretically, investors should be unaffected by such announcements, as predicted by the Modigliani-Miller theorem or the Capital Asset Pricing Model, in reality share prices respond to company announcements. According to the Efficient Market Hypothesis (EMH), equilibrium stock price returns affected by news, which is unforecastable, cannot be forecast. EMH tests may be conducted by joint hypothesis of behavior of both stock prices and returns by assuming that agents react to news rationally (geocities). This is because the announcements play a signaling role of the company maintaining the growth momentum and the dividend payouts. Also, although share price returns are theoretically expected to converge to the market average, beta, anomalies in the share market result in share prices to be away from the average. Hence, announcement by the company directors affect the share prices that have not absorbed all the relevant information. Works Cited Fama et al, 1969, The Adjustment of Stock Price to New Information, International Economic Review, Vol 10. No9 Grinblatt, Mark S et al., 1984, The valuation effect of stock split and stock dividends, Journal of Financial Economics, Vol 13 Issue 4, December Holder, Mark E., et al., 1998, Dividend policy determinants: an investigation of the influences of stakeholder theory - Special Issue: Dividends, Financial Management, Autumn, http://www.findarticles.com/p/articles/mi_m4130/is_3_27/ai_53649447 Miller, M.H. and F. Modigliani, 1961, "Dividend Policy, Growth, and the Valuation of Shares," Journal of Business (October), 411-433. Natti, Keisuke, 2006, Does Dividend Policy Enhance Shareholders’ Value, http://www.nli-research.co.jp/eng/resea/econo/eco060309.pdf Ross, Stephen A., Westerfield, Randolph W., Jordan, Bradford D. Fundamentals of Corporate Finance, New York, NY: McGraw Hill, 2003. Shapiro, A.C., 1990, Modern Corporate Finance, New York, NY, Macmillan Publishing Co. Singal, Vijay, Beyond the Random Walk: A Guide to Stock Market Anomalies and Low Risk Investing, Oxford University Press, 2003 Wharton, Financial Market Anomalies, 2006, http://finance.wharton.upenn.edu/~keim/research/NewPalgraveAnomalies(May302006).pdf Infoworld, Wall Street Beat: Google Drops but confidence high, February 1, 2007, http://www.infoworld.com/article/07/02/01/HNgoogledrops_1.html New York Times, At Google, Earnings Soar, and Share Prices follow, October 22, 2004, http://www.nytimes.com/2004/10/22/technology/22google.html?ex=1184817600&en=f773e9c235f288f3&ei=5035&partner=MARKETWATCH MSN, Microsoft’s $75 billion cash reward, July 21, 2004, http://money.cnn.com/2004/07/20/technology/microsoft/index.htm New York Times, Microsoft to bestow $75 billion windfall on its shareholders, July 2004, http://www.nytimes.com/2004/07/20/technology/20CND-GATES.html?ex=1248062400&en=c310938ec1212d42&ei=5090&partner=rssuserland http://www.geocities.com/vwh_chan/Financial_Econometrics_Summary.pdf Read More