Stock Market Efficiency - Case Study Example

Stock Market Efficiency Stock Market Efficiency According to Fama (1965:55) he says, “An ‘efficient’ market is defined as a market where there are large numbers of rational profit maximisers actively competing, with each trying to predict future market values of individual securities, and where important current information is almost freely available to all participants...... In other words, in an efficient market at any point in time the actual price of a security will be a good estimate of its intrinsic value.” Share price movements The financial markets are regarded as informally efficient. Ultimately, it can enable one to consistently attain returns in excess of the average market returns on a risk adjusted basis. This is so given the availability of information at the particular time the investment is made. An efficient financial market ensures that: the market prices are good indicators of rationally evaluating the economic value; securitized credit has improved financial stability and allocative efficiency; carrying out of mathematical analysis deliver large quantitative measures of trading risk; the market discipline can be utilized as an effective tool in constraining harmful taking of risk. A company usually has a certain number of stocks that are usually available for the investors to buy through the stock market. This is similar to Debenhams Company. The more popular the stock becomes, the faster it will be bought by the investors. This result is an increase in demand and less supply. This causes the prices of the stock to go up because they are few stocks to be purchased (Jain, 2009: 33-35). On the other hand, if a particular stock is unpopular with the investors the stock gets sold. Therefore, on the stock market more stocks are available for purchase. The demand goes down and the supply goes up. As a result, the value of the stock price decreases. According to Stock Market College (2009) asserts that some of the factors that contribute to this movement in the share price include; investor sentiment, it represents the collective expectations of the majority of the stock market participants. People will buy stock because they expect their rise in price, whilst will sell stock if they expect a fall in price. The investor sentiments move the stock prices in the short term. Another factor that causes share price movement is company announcement. Positive news like good guidance from the management causes the stock price to go up. Guidance is when the company’s management makes an official statement regarding the likely future prospects of the company. Debenhams made an announcement to increase their pre-tax profits by investing more in technology and reducing the operational costs. However, some of the announcements can be perceived as negative by the investor. Some of the events that were announced by Debenhams that caused a negative effect on the price of the stock include; reducing dividends, majority share holders selling the stock they owned, and negative growth approximation from the management (Gwinnett, 2013). With regard to analyst’s earnings estimates, if the company fails to meet the estimated earnings of the analysts the share price stumbles. However, this is not usually the scenario for companies that are closely followed by the analysts like the Debenhams. According to (Stock Market College, 2009) argues that for the stocks that do not receive much coverage from the analyst, the forecasts of the earnings may not have any effect. This was the case in Debenhams with the deep value stocks having bad news already built in their share price. Therefore, earnings drive the share prices in the medium term to long term. Fama and French (2004: 137-9) found out that releasing of key economic data causes movements in the stock prices. However, as witnessed in the Debenhams, certain indicators of the economy like the interest rates, inflation, and unemployed figures affects the whole market. Additionally, particular businesses can be affected by release of specific piece of economic information relevant to the specific dynamics of the business. Over the long term, earnings will drive the share prices. This is the reason why most investment analysis revolves around profits and the factors that have an effect on them. As evidenced by the Debenhams Company’s investors, they analysed the company as a potential investment if it has a history of making money Share price movements of Debenhams in the last ten years (London Stock Exchange, 2013). Share Price Movement Price movement of the company for last 10 years. Jan-Mar Apr-Jun Jul-Sep Oct-Dec Annual Open (Rs.) Close (Rs.) (%) Open (Rs.) Close (Rs.) (%) Open (Rs.) Close (Rs.) (%) Open (Rs.) Close (Rs.) (%) Open (Rs.) Close (Rs.) (%) 21 19 -12.32 0.00 0.00 0.00 21 19 -12.32 Open (Rs.) 21.10 Close (Rs.) 18.50 Return (%) -12.32 Month Price Return Open (Rs.) Close (Rs.) (%) January 21.10 20.00 -5.21 February 19.35 18.50 -4.39 According to the London Stock Exchange (2013) shows that Debenhams is making profits in the figure below. Key Fundamentals 01-Sep-12 03-Sep-11 28-Aug-10 29-Aug-09 30-Aug-08 Revenue (£ m)   2229.80 2209.80 2119.90 1915.60 1839.20 Pre-Tax (£ m)   158.30 160.30 139.90 120.80 105.90 EPS  9.80p 9.10p 7.50p 10.00p 9.00p PE  9.85 5.98 7.83 7.95 5.53 PEG  -1.28 -0.28 0.31 -0.72 1.71 EPS Growth  -7.69% -21.33% 25.00% -11.11% 3.23% Dividend Cover  3.27 9.10 n/a 20.00 1.43 Yield  3.00% 2.00% 0.00% 1.00% 13.00% Technical analysis is also used to predict the share price movements. It studies the past volume and price trends to judge the direction of the future price movements. Technical analysis makes an assumption that prices take a random trend. Therefore, one can judge the future movement of the price and basing on these past trends helping investors to make decisions. Ultimately, market trends are the ones that determine the prices (Gupta, 2006:36). With the Debenhams trading at 82.80p, it is evidenced that the online sales were the standout factor accounting for 12.6% of the total sales for the past 18 weeks. This is higher compared to 9.3 percent last year. Debenhams has adopted a new segmental analysis which shows how better the enterprise is managed. This provides sales and operating profit information in two segments. The growth of sales in the UK may be attributed to: the modernized 32 stores registered a good performance; growth in online sales; improvement in the marketing activities that drove sales and improved perceptions about the brands of Debenhams; introduction of initiatives to improve on the basic retail practices of the un-invested core stores (Dennis & Harris, 2012). Market price in an efficient market The efficient market efficiency hypothesis (EMH) is used as the corner stone of the modern financial theory and controversial and disputed at times. It is based on three versions: weak form EMH that prices on the traded assets; semi-strong form EMH that claims that prices change instantly to reflect new public information; the strong form EMH that claims prices reflect even the hidden information (Desai, 2009: 123-125). The EMH investment theory stipulates that it not possible to “beat the market” because the efficiency of the stock market causes the existing share prices to always incorporate and reflecting on all the relevant information. Trading of stocks usually occurs at their fair value on the stock exchange, this makes it impossible for the investors to sell or purchase the undervalued stocks for the inflated prices. With regard to this, it is impossible to outperform the overall market through market timing or expert stock selection. Consequently, the only way an investor can then obtain higher yields is through buying of the riskier investments. According to Gupta (2006:43-45) reported that Debenhams Company has divided its mode of working to ensure boosted revenues thus the segmental performance. The UK segment which has 154 stores recorded increased revenue of 2% to £ 1,860.3 million. This is attributed to a number of factors like: good performance from the 32 modernized stores as the previous modernized programmes delivered first year lift only; the improved performance from the un-invested core stores; market share gains in health, women’s ware, and men’s ware; improvement of marketing strategies; growth on online sales. Consequently, to ensure an efficient market the asset prices are to fully reflect all the information available in the market. Contribution corporate finance theories Maximization of profits and shareholders wealth always goes hand in hand. A company maximizes on the shareholder wealth by investing in those projects that will increase cash flow and profits for the firm, looking for ways of cutting the variable costs and fixed costs, and finally creating products that will lead to an increase in revenue. The managers of Debenhams Company followed the above so as to boost the shareholder’s wealth. This is because by taking the aforementioned into consideration, the firm increases the shares of its stock which in turn increases the wealth of the shareholder. The Debenhams total basic and diluted earnings per share were 9.8 pence as at September 2012, compared to 8.6 pence in August 2011. This also led to an increase in number of shares from 1,281.3 million to 1,286.5 million. This makes it a highly cash generative business. The cash is used in the following; investing in the business to support the four pillars of the company’s strategy, growing the dividend cover in line with maintaining the dividend cover of the three times earnings, moving towards the one times net debt to the EBITDA over the medium-term, returning the surplus cash to the shareholders through the long-term share buyback program thus improving their wealth (Tirole, 2011: 101-103). The share buy back programme of the Debenhams as at October 2011announced that the company intended to begin a long term share buy back programme as the leverage approached 1 times. The program was to start with an initial purchasing of £20 million shares during the subsequent six (6) months. Consequently, it was completed on August 2011. The total numbers of shares purchased were 23.6 million consuming £ 20.1 million and are currently being held as treasury shares. In summary, stockholder wealth maximization is the most appropriate goal for the managerial decisions. The risk and timing that are associated with the expected earnings per share and cash flows are to be considered in order to maximize the price of the firms common stock. Practices for effective corporate management The management should ensure that the company invests in a project that yields a greater return than the minimum acceptable hurdle rate. The hurdle rate should be higher for the riskier projects and the reflection of the financial mix used. The returns of the firm should be measured basing on the amount of cash floe generated and the project’s negative side effects. The management is to make sure that it chooses a financial mix that matches the assets that are being financed and the hurdles rate are minimized. In the event that there are not enough investment s that will earn the hurdle rate, then return the cash to the shareholders through dividends and paybacks (Quiry et. al, 2011: 238-241) The management is to ensure that they make decisions in way that adds value to the firm. A narrower objective maximizes on the stockholders wealth. When the stock is being traded and the market is viewed as being efficient, then the straight objective of decision making is to maximize on the stock price (Lumby & Jones, 2006: 65-69). A great deal of evidence exists to show that the share prices area better metric for corporate governance. Solutions to corporate financial management issues The decisions that are made with regard to financial planning and analysis by the management should be comprehensive. This involves transforming the financial data into a form that cold be utilized to monitor the financial condition. There is need to evaluate the productive capacity. The management should ensure that it determines the additional or reduced finance that is required. This activity depends on the financial statement which shows the assessment of the cash flows and the developed plans to ensure that there is adequate flow of cash to support the attainment of the businesses goals and objectives (Jain, 2009). The making of investment decisions that establishes the type of assets the firm would posses is paramount. In addition, the good corporate financial management is to maximize on the shareholders wealth as it is reflected in the share prices other than the profit maximization. The EVA is the most popular measure of utilized to establish if the investment is generating wealth for the shareholders (Correia et. al, 2012:145-149). The making of financial decisions is to be driven towards the long term or short term goals and objectives. However, some of these decisions are dictated by necessity. The objective of financial management is to make interrelated business decisions based on investment financing, and the dividend policy. Theoretical based solutions to current corporate practice With regard to financial risk and treasury management, the management has the obligation to establish an overall treasury policy and the approved authority levels within which the operations of the treasury must function. Debenhams Company has defined the function of the treasury policy as the management of risks within the agreed framework while not taking any speculative positions. Ultimately, all the financial decisions are based on some theory of capital market pricing (Fama & French, 2004:144). The corporate financial theory focuses on the maximization of financial wealth because stock price is constantly updated and easily observable. Also if the investors are rational, the stock prices will provide a reflection of the wiseness in decision making. Lastly, it is the objective of the stock price in performance outlining how to pick projects, how to finance them, and how much will be paid for the dividends (Morrison & Wilhelm, 2007:78-80). Effective communication to specialist and non-specialist audiences The non-specialist audience is the one that should be made emphasis to. This is because most of them are not conversant with the content you may be presenting. Examples of non-specialist audiences include; policymakers, members of the public, media, committees of funding bodies, and researchers.  Being able to effectively communicate information to such audiences is therefore highly valued by many organizations and beyond.  On the contrary, specialist audience requires an elaborate and comprehensive understanding of the stock market efficiency. Specialist audience can drive the company forward (HovAjnyi, 2009). But communicating with non-specialists needs a different structure and approach to writing speeches, or preparing presentations for specialist conferences. The key principles of communicating effectively with the busy non-specialist audiences include: knowing your audience by comprehending their busy minds; ensuring structures for engaging non-specialist audiences like attention grabbing and sustaining interest; effective use of language; the different requirements of written and oral communication Reference List Correia, C., Flynn, D. K., Uliana, E., & Wormald, M. (2012). Financial Management. Atlanta: Juta. Dennis, C., & Harris, L. (2012). Marketing the e-Business. New York: Routlegde Publishers. Desai, S. (2009). Efficient Market Hypothesis. London: Harpet Business. Fama, E. F., & French, K. R. (2004). The Capital Asset Pricing Model: Theory and Evidence . Journal of Economic Perspectives , 135-141. Fama, E. (1965). Random Walks in Stock Market Prices. Financial Analysts Journal , 21, 55-59. Gupta, A. (2006, December 15). Retrieved March 29, 2013, from Technical analysis to predict share price movements: http://articles.economictimes.indiatimes.com/2006-12-15/news/27455252_1_technical-analysis-average-price-trends Gwinnett, G. (2013, January 8). Retrieved March 29, 2013, from Weakness is buying opportunity: http://www.proactiveinvestors.co.uk/companies/news/52131/debenhams HovAjnyi, G. (2009). Essentials of Corporate Communication: Implementing Practices for Effective Reputation Management. European Journal of Marketing , 563-565. Jain, P. (2009). Financial Management. New York: McGraw Hill-Education. Lumby, S., & Jones, C. M. (2006). Corporate Finance: Theory and Practice. Boston: Cengage Learning. Morrison, A. D., Wilhelm, Jr., W. J., 2007. Investment Banking: Institutions, Politics and Law. Oxford University Press, Oxford, UK Quiry, P., Fur, Y. L., Salvi, A., Dallochio, M., & Vernimmen, P. (2011). Corporate Finance: Theory and Practice. Nw Jersey: John Wiley & Sons. StockmarketCollege. (2009, July). Retrieved March 30, 2013, from What Causes Stock Price Movements: http://www.stock-market-college.com/stock-price-movements.html Tirole, J. (2011). The Theory of Corporate Finance. New Jersey: Princeton University Press. Read More