Equities and Equity Market - Example

Name: Tutor: Course: Date: University: Equities and Equity Market Equity, in general, can be seen as the ownership in any asset, after all, debts associated with that asset are paid off. Equity is commonly represented in the fundamental accounting equation as: Equity= Assets – Liabilities The stock or any other security representing an ownership interest either in a private company or public company represent equity (Brigham and Ehrhardt 2013 p.120). Equity also includes the funds contributed by the owners plus the retained earnings that are commonly referred to as shareholders’ equity. The equity market is the market for trading equity instruments. Equity market can also be seen as a mean of financial intermediation between those people who are willing to save their money and the companies they want to put their savings. This financial intermediation has enabled savers to achieve diversification and liquidity (Hill, Jones and Schilling 2014, p. 136). The equity market reduces risks and permits the time horizon of the savers to differ from the time horizons of the companies. The risk is the centre of the gravity of financial model building in developed equity markets. The equity risk premium is the expected return on the stocks and the excess of the risk-free rate. Equity risk premium is a fundamental quantity in all of the asset pricing for both theoretical and practical applications. The equity risk premium is not only an indicator of the performance of the equity market but also is an indicator of the evolution of the economy, potential expansion of jobless recoveries. It is also treated as the major gauge of the financial stability of any company (Riche, Sitting, Wirth, Cohen, Gibbs, O'Neill, Engelman., Malone, Madsen, Coen and Gaffikin 2012, p.345). The risk and the return on equity are positively correlated. The higher the risk is, the higher the return on equity expected. Just as the return influences asset pricing, the risk and the asset pricing are also directly related. This means that the financial models are therefore not only about risk but also asset pricing. Equities are directly related to the return on the stock. This implies that the equity price is also directly related to the return on stock. Good Profits of a business integrated into a high dividend yield signal are indicated by the ever improving the price of the stock in the equity market. A corollary to expected returns forecasting is forecasting asset class risk (Hill, Jones and Schilling 2014, p. 136). Return on equity is the preferred metric that most management uses to see how the company is doing in the stock markets. To get this, we need to divide the net profit by the equity. There are three major ways in which return on equity is used to evaluate company profitability. The return on equity can be analysed as an absolute number, or it can be compared with other companies, or its trend can be analysed (Brigham and Ehrhardt 2013 p.132). The return on equity is made up of three components: the net profit margin, the asset turnover and the balance sheet leverage. The products of all above three components equal return on equity. Risk measurement in the Equity Market There are few quantities measures of risks for financial assets. One of the ways is to treat the entire groups of the investments as sharing the same risk level. This display the equity market as risky and inappropriate investments for risk-averse investors (Duffie and Singleton 2012, p.78). The other way in which some people measure the risk in the equity market is by looking upon how much information is available about the entity issuing the stock. Equity issued by a well-established company with a solid reputation is considered safer and equity issued by a company that is less known. With time, the companies have started providing their financial data to the public. These includes the basic statistics such as the expected return on equity and the standard deviation of the expected return on the equity. Most of the risk measures used today are constructed based upon the accounting numbers. Profitability ratio and the financial leverage are commonly used to measure used to measure risks in the equity market. However, risks measure should not be based upon past prices because that price does not reflect the true company value. In the past investor in the equity market have used a measure of risks based on past prices and accounting information to make a judgement about the risks. Based on the model there has been no consensus on how best to measure risks and the exact relationship between risk and the expected return. This implies that diversification in risk analysis is beneficial to the investors. Investors should diversify because they care about the risk, and the diversified risk portfolio is, therefore, lower than the risk of individual securities. Another measurement of risk is the mean-variance framework. In this approach, we assume that all is captured in the variance of return on the investment and all other risk measures including accounting ratios (Kim and Long 2014, p.150). This method assumes that the returns are normally distributed, and the investors’ utility functions push them to focus on just expected return and variance. The major setback of this method is that in most cases return on investment is not normally distributed. Capital asset pricing model added a riskless and concluded that there existed a superior alternative to investors at every risk level. Risk measure has evolved over the time reflecting in parts of development in statistics and economics, and also the availability of data (Duffie and Singleton 2012, p.78). However, the old methods are still being used together with the new methods. All these method remain relevant, and it is, therefore, the sole duty of the investor to decide the best method to evaluate the risk. Investor Ratio Financial ratio analysis is quite important in identifying the major strength and weakness of the company the investor wants to invest in. This financial analysis indicates whether the company has enough cash to meet basic financial obligations and the capital structure of the whole company (Brigham and Ehrhardt 2013 p.89). An investor should apply financial analysis as they evaluate company performance and weigh potential investments. Equity investment is putting money into an asset with the hope of capital appreciation, dividend or interest earnings. Ratio analysis is the main financial indicators that are usually extracted from the financial statement analysis. The financial statement analysis is used to obtain a quick indicator of the company’s financial performance in various key areas. The investor ratio can be used in a form of trend analysis to identify areas where performance has improved over a given period. The investment decision is usually made by cost-benefit analysis. Cost benefits analysis is an economic analysis tool that helps investors to make a decision on which company to invest their money (Gelman, Carlin, Stern and Rubin 2014, p.234). These analysis indicators the scale of investment which different company can afford at a particular time. It also indicates the period it will take before the investment start to returns and estimate at what rate it will yield. We are going to consider two examples of companies in the United Kingdom. These companies ate Tesco PLC and Aggreko PLC. The net profit margin is given by the following for both companies in year2014 (all calculation are regarding million Euros) Net profit margin (NPM) = (net profit/sales)*100 Aggreko PLC Net profit= 246 Sales=643 NPM= (246/643)*100 = 38.26% Tesco PLC Net profit= 970 Sales=59547 NPM= (970/59547)*100 = 1.63% Asset turnover ratio (ATO) = net profit/average total assets Aggreko PLC Net profit= 246 Average total assets= (1975+2124)/2 ATO= 256/2049.5 = 0.125 Tesco PLC Net profit= 970 Average total assets= (32256+34592)/2 ATO= 970/33424 = 0.0029 Another important ratio analysis we are going to focus on the two companies is leverage ratio. This ratio is used to determine how the best company can manage its debts. There are several ways to express the leverage ratio, but the main factors considered are debts, equity, assets and interest expenses. The most known financial leverage ratio is the debt-to-equity ratio. Leverage ratio (LR) = total debt/ total equity Aggreko PLC Total debt= 835 Total equity=1140 LR= 835/1140= 0.73 Tesco PLC Total debt= 14303 Total equity= 14722 LR= 14303/14722= 0.97 The Return on Equity (ROE) = Net Profit Margin* Asset Turnover * Financial leverage Ratio Aggreko PLC ROE=0.3826 * 0.125 * 0.73= 0.035 Tesco PLC ROE=0.0163 * 0.0029 * 0.97= 0.000045 The stock’s price to earnings ratio is one of the most common measuring ration during the evaluation of security in a stock market. This ratio gives a quick comparison of two securities. The ratio is gotten by dividing the common stock market share price by earnings per share. Aggreko PLC Market share price=14.27 Earnings per share=92.03p P/E= 14.27/0.9203= 15.505 Tesco PLC Market share price=15.32 Earnings per share= 70.82p P/E= 15.32/ 70.82 = 21.632 From the above we can see that in Aggreko PLC the investor requires 15.505 Euro amount of investment to receive a one Euro return. In Tesco PLC, the investor is required to invest about 21.632 Euro to receive a one Euro return. The current ratio is commonly used to measure the company liquidity levels. This is achieved by comparing current assets and current liabilities. Current ratio= current assets/current liabilities Aggreko PLC Current assets= 636 Current liabilities= 405 Current ratio= 636/405 = 1.57 Tesco PLC Current assets= 15572 Current liabilities= 20206 Current ratio=15572/20206 = 0.771 From the above ratio, we can observe that Aggreko PLC is in an excellent position to meet its current financial obligation using the current assets. Aggreko has an acceptable current ratio, and this may instil confidence to the investor. Tesco PLC current ratio is below one which means it cannot be able to meet the current obligation. The price to sales ratio can is be used by investors to compare stocks. These takes the company market capitalization and divide it by the total number of shares sold in that particular year. Price to sales ratio=price per share/annual net sales per share Aggreko PLC Price per share=14.27 Net sales=826m Number of shares=267m Sales per share= (826/267) = Price to sale ratio= 14.7/0.364 = 40.385 Tesco PLC Price per share=15.32 Net sales=9300m Number of shares=8107m Sales per share= (9300/8107) =1.147 Price to sale ratio= 15.32/ 1.147 = 13.357 From the above it can be seen Aggreko PLC are willing to pay 40.385 Euros for every 1 Euro invested in their stock. On the other hand, Tesco PLC is willing to offer 13.357 Euro for every 1 Euro invested. However, the investor should not depend on this ratio only because some stock may be undervalued and represent a good bargain to entice investors. From these above ratios, we can comfortably deduce that Aggreko PLC is performing better than Tesco PLC. Figure 1: Statement of Changes in Equity for the year 2012 for Aggreko PLC Figure 2: Statement of Tesco PLC capital resources for the year 2013 Implication of equity valuation models According to Brigham (2013), equity valuation can be defined as an art or science of determining what a security of asset is worth. He insists that the value of the security is much dependant crucially on the asset pricing model one chooses. The asset price is valued as the present value of the expected cash distributions and expected proceeds from the sales. Mukanzi (2013) refer equity valuation as periodic cash distributions as dividends. The dividend should include any cash distributed to the shareholders particularly through share buybacks. This method is commonly referred as the present value model. According to these model individual and companies makes an investment because they expect a rate of return after some period. The model equates the dividends expected to the free cash flow. This means that dividend paying capacity should be reflected in the cash flow estimates rather than expected dividends. Gordon came up with a model of equity evaluation. Gordon insists that dividends are the correct metric to use for valuation purposes. He observed that dividend growth rates are forever. According to Gordon (1962), dividend growth rate is perpetual and never change. The required rate of return does not also change over time. In this model, the dividend growth rate is strictly less than the required rate of return. Gordon estimates intrinsic value as the present value of a growing perpetuity. Because of the assumption of constant growth rate, these model is appropriate for valuing the equity of dividend of those companies that pay a dividend that are relatively insensitive to the business cycle. According to Ciepley (2013), the method of comparable is the most widely used model for analysts reporting valuation judgements by price multiples. This model compares relatives values estimated using multiple values (Ciepley 2013 p.159). The economic rationale underlying the method of the comparable model is the law of one price i.e. identical assets should sell at the same price. This method has the advantage of allowing relative comparison. Ciepley (2013) suggests that this model is popular with investor because the multiples can be calculated easily and some are available in financial institutions. Equity can also be evaluated using asset based valuation. In this model company uses estimates of the market or the company’s assets and liabilities (Ciepley 2013 p.162). This model usually works well for the companies that do not have a high proportion of intangible assets. It also does well in those companies with a high proportion of current assets and current liabilities. Using the company balance sheet the analyst can value the company’s assets and liabilities. Conclusion Equity is the share of ownership an investor has in a given private or public company. Equity commonly referred to as stock is traded in a market called equity market. The major characteristic of the equity market is the amount of risk involved. An investor should have ample knowledge on all the type of risks in the equity market. To manage the risk in the stock market, we need first to measure it. We look at the various model of risk evaluation. The risk measure is very important in the financial markets. Risk measure has evolved and still is going to evolve over the time. This mean that the investor must try to keep up with ever-changing risk measure. The best way to determine the best performing companies in an equity market to look at their financial ratios. This ratio gives a quick overview of the performance. The investor can focus on the company performance without having to go through all financial statements. This ratio is the main input in making an investment decision. References List Brigham, E. and Ehrhardt, M., 2013. Financial management: theory & practice. Cengage Learning. Ciepley, D., 2013. Beyond public and private: toward a political theory of the corporation. American Political Science Review, 107(01), pp.139-158. Duffie, D. and Singleton, K.J., 2012. Credit Risk: Pricing, Measurement, and Management: Pricing, Measurement, and Management. Princeton University Press. Gelman, A., Carlin, J.B., Stern, H.S. and Rubin, D.B., 2014. Bayesian data analysis (Vol. 2). London: Chapman & Hall/CRC. Kim, S.H.H. and Long, M.S., 2014. Why Market Returns Favor Democrats in the White House. Michael S., Why Market Returns Favor Democrats in the White House (November 11, 2014). Hill, C., Jones, G. and Schilling, M., 2014. Strategic management: theory: an integrated approach. Cengage Learning. Mukanzi, G., 2014. The effect of earnings on dividend policy of cyclical firms listed at the Nairobi securities exchange (Doctoral dissertation, University of Nairobi). Riche, M.F., Sinding, S., Wirth, T., Cohen, T., Gibbs, S., O'Neill, B., Engelman, R., Malone, E., Madsen, E.L., Coen, A. and Gaffikin, L., 2012. A pivotal moment: Population, justice, and the environmental challenge. Island Press. Read More