Corporate Financial Forecasting, Business Cycle and Accounting Ratios - Assignment Example

CORPORATE FINANCIAL FORECASTING, BUSINESS CYCLE AND ACCOUNTING RATIOS That a positive share price-earnings relationship exists and so does share price and book value relationship would be the basic thing this paper would be highlighting. The financial data that has been tabulated for the year 2008-2009 Question no one Name of company in year 2009 Share price in US dollars Ranbaxy (Pharmaceutical company) 12.34 Mahindra and Mahindra (Automobile company) 24.34 Essar group of companies 18.36 Kirloskar 195.93 Tata 21.73 Market size Name of company in year 2009 Position Ranbaxy (Pharmaceutical company) Has been holding the number one position Mahindra and Mahindra (Automobile company) Has become the second largest automobile company Essar group of companies Has become the second largest company. Kirloskar Has become a good brand name in motor pumps Tata Has become a good information technology company. Book/market Name of company in year 2009 In US dollars Ranbaxy (Pharmaceutical company) 2.55 Mahindra and Mahindra (Automobile company) 4.56 Essar group of companies 2.71 Kirloskar 2.60 Tata 3.80 Volatility Name of company in year 2009 In US dollars Ranbaxy (Pharmaceutical company) 9.36 Mahindra and Mahindra (Automobile company) 2.91 Essar group of companies 9.38 Kirloskar 1.27 Tata 5.33 Leverage Name of company in year 2009 In US dollars Ranbaxy (Pharmaceutical company) 12.72 Mahindra and Mahindra (Automobile company) 62.26 Essar group of companies 18.52 Kirloskar 22.7 Tata 23.02 Equity rising Name of company in year 2009 In US dollars Ranbaxy (Pharmaceutical company) 1251 Mahindra and Mahindra (Automobile company) 3416 Essar group of companies 213 Kirloskar 444 Tata 171 Earnings Name of company in year 2009 In US dollars Ranbaxy (Pharmaceutical company) 153.33 Mahindra and Mahindra (Automobile company) 227 Essar group of companies 863 Kirloskar 352 Tata 190 Data for four years Status Ranbaxy in USD 2007 2006 2005 2004 Share price 426 246 295 363 Earnings 120 50 69 90 Leverage 82.7 183 239 14 Size 100 400 318 263 Bok/market 18 21 19 40 Volatility 7 4.1 6.4 13.5 Equity raising 30 18 11 30 Status Mahindra and Mahindra in USD 2007 2006 2005 2004 Share price 263 613 695 717 Earnings 170 56 12 34 Leverage 56.81 139 509 1901 Size 585 170 376 983 Bok/market 13 34 133 157 Volatility 24 44 84 14.8 Equity raising 0.012 0.028 0.06 0.135 Status Essar group of companies in USD 2007 2006 2005 2004 Share price 370 388 783 746 Earnings 334 135 15 11 Leverage 336 421 471 1011 Size 388 783 2866 1215 Bok/market 127 189 650 763 Volatility 12 16 24 32 Equity raising 0.04 0.06 0.12 0.145 Status Kirloskar in USD 2007 2006 2005 2004 Share price 56.9 56.4 55.8 54.9 Earnings 31.3 70.8 66.6 63.8 Leverage 61 34.3 93.8 93.6 Size 128 125 114 122 Bok/market 24 11 94 47 Volatility 20 30 61 63 Equity raising 34 32.5 11.6 88.7 Status Tata in USD 2007 2006 2005 2004 Share price 93.8 93.6 93.5 92.6 Earnings 87 86.3 86.2 57.4 Leverage 165 206 180 197 Size 148 56 129 127 Bok/market 42.28 71.76 81 230 Volatility 17.5 8.88 712 920 Equity raising 54 83 11 14 Question 1 The Article written by (Burgstahler, D., and I. Dichev. (1997). The relation between variables Corporate earnings have been always considered as a success of market economy. That would be the most important factor in determining the success of the organization and these could be considered as an equity funding; these would be allowing the data on external price and cost shocks. Share price-earnings relationship There has been a normal relationship that could be termed as shareholder price and interest price with the shareholder price tending to fall when the interest price rise and shareholder price tending to rise when interest price rise. The interest price tend to fall when the PER price normally increase and there has been vice versa relationship. One difficulty would be the single entity and macroeconomic level and that would be calculated at residual level and the relationship between the share prices and the market value should be understood. Share prices tend to rise and market to book ratio has been found to be interrelated. Equity book value increases and capital increases and companies have been retaining earnings and asset has been seen as appreciating. The market to book ratio has been closely met with price to earnings ratio and that could be said as price to earnings ratio and return on equity and market value and book value and market value and net income and net income and book value would be PER and ROE. The P/E ration, which is price to earnings ration, has actually been known as relationship between share price vis-à-vis its earnings per share. That would mean that the data between two or more companies ’ P/E would be giving the data of the company that would be a better value and the ratio would be showing the price of the particular stock that would be related to earnings. That could be said as an example in which the earnings could be said as an example of a company making $5 and having share price of $ 50 and that would mean that P/E has been said as 10.The public or the investor would be paying dollar 10 for the every one dollar that has been accumulated by the company and that means the lower the number and better the value of investment. The investors would love growth and high P/E would be looking at the general public anticipating growth and there has been companies’ track growth and Investors love growth. So a high P/E can be termed as a high expectation on high growth in the forthcoming months that the general public lives on. Certain parameters define this expectation and new product launch, or company’s previous track record is a few of them. If both companies like ‘a’ and ‘b’ has a stock price of dollar 30 and dollar 40 and by looking at these data would not be giving any clear information. The P/E ratio of both the companies would be telling which company is more profitable. Moreover the high P/E ratio has been said to be linked with the business cycle as a company that offers an investment would be getting a good share in the share market. The problems with this study: Investors have to be a caution that has been comparing P/E ratios of various companies. Looking at different industries would be a big problem. That could be said as technological sectors having a P/E of 30 but oil industries would be having P/E of 10. Looking at that type of information for one time would be creating confusion as oil sector would be looking as the easiest and simple choice. Analysis B written by Balsam, S., and R. Lipka. (1998) Forecasting earnings stream has been considered as one of the primary economic variables by financial analysts, which help them connect forecasts into viable measures of security returns. Management decisions and their compensations have been stated as decisions in terms of earning objectives. Creditors, bankers, and investors rely on forecasts to assess the prospects of enterprises’ net cash flow. Forecasts can be based on both past and present earnings. This could be said as the base for showing the role of accounting that has been giving a information that would be tying managerial process and would be linking the firm to environment. Earnings are taken as an important element of fiancé, accounting and economic theory. The business cycle and the role of the creditors, bankers, investors would have to be understood in clear terms and this could be understood by the fact that companies like Infosys that would be having a good earnings would be attracting loan facility from the bank when considered with other companies.That would also include Tata as it is having a strong brand name and that would be attracting investment option from banks. Article C written by Lindenberg, E., M. P. Ross, & S. S. Barney. (1999) The impact of firm size on the share prices of firms making disclosures are usually captured by the earnings response coefficient (ERC). This has been showed that a positive relationship exists between ERC and measures of earnings persistence. More and persistent the earnings, greater is the price response and that should mean a large pool of information content for announcement related to earnings. Researchers opine that since smaller firms tend to make losses (or have greater propensity to do so), which is why earnings from them are not desirably persistent. Consequently, their ERC will be less than the larger firms in the domain. Analysis of unexpected accounting earnings Naïve expectation model is used to compute unexpected earnings. In other words, it is done on the assumption that what you call as next period's expectation is actually the current period's earnings. This method has been used since 1970 and has thus the backing of time and frequent tests. The accounting earnings can be explained as below: EPS = (EASH-PREFDIV-MINOR)/NoEQ (3) where, EASH : earnings attributable to shareholder, PREFDIV : preferred dividends, NoEQ : number of shares measured as average outstanding, MINOR : minority interest, Ues or unexpected earnings are computed by employing using the naive model: UEit = Eit - Ei(t-1) (4) The unit normal variables and their estimation: σ (UEi): standard deviation of UE “Theoretically, goodwill should equal the premium the buyer pays over and above the fair market value of all the acquired company's assets.”. In reality, those who acquire never fix a value on the intangibles. Instead what they do is appraise the tangible assets and dump the remaining into goodwill. Article D written by Vincent, L. (1997) Accounting profit is only an artifact. Economic substance is not changed by either pooling of interest or purchase methods or pooling of interest. Consequently businesses’ economic substance is not affected by subsequent amortization of goodwill. It also does not have any bearing on a company's stock price in either a negative or a positive manner. This further holds true if the market is in an efficient condition. It is generally hypothesized that exclusion or inclusion of goodwill amortization tends to create adjustments on in the capital market capital market on the coefficient on earnings. By using simple earnings capitalization model traditional earnings per share are regressed as against stock prices and so are cash earnings per share and amortization expense and cash earnings per share that excludes amortization of goodwill respectively. Analysis E written by Beresford, D. R. (2001) Test results have recommended and supported the FASB position which says pooling method for business combinations must be eliminated and rules pertaining to goodwill amortization must be changed. To justify the point, and on a per share basis primary earnings, basic earnings and fully diluted earnings, even if any one is better than the other two, when run regression on the simple earnings capitalization model with the annual data from Standard and Poor's Compustat database of corporate annual report for the years 1975 through 1993, show consistent findings with the present-day theories that it is three measures that provide investors with practical information in valuing stock prices. Arguably it is held that instead of reporting one measure, it is more informative and valuable to report two measures, and the new standard per share for diluted and basic earnings is as informative as the old standard requiring that requires fully diluted earnings and primary earnings per share. New earnings per share, often called "cash earnings per share," to distinguish from the traditional earnings per share, by adding back the amortization of goodwill and other intangible assets to the reported traditional earnings per share after taxes but before extraordinary items. It comes as a surprise and not so expected news for investors when the difference between expected and actual earnings is taken into account. This surprise element is reacted towards and captured by the investors through the share price changes encountered during trading activity. The surprise element becomes more evident in an emerging market than the developed market. In the former the surprise element gains more significance since the information transmission is relatively inefficient. Analysis F written by (Lindenberg, E., M. P. Ross, & S. S. Barney. (1999). The FASB’s pooling of interest method has been fought fiercely by new economy and high-tech companies, saying financial analysts and investors were driven by rigid price/earnings ratios to value companies. Financial analysts have argued that stock prices are regressed against traditional earnings cash earnings per share excluding amortization and amortization expense and new cash earnings and respectively. The price model is as below: Pt = β0 + β1bt + β2xt + εt.------------------------------------------------------(1) At time t. Pt is the price of the firm’s equity, bt the book value, xt is earnings. Whereas, the return model can be written as: Rett = β0 + β1xt/Pt-1 + β2Δxt/Pt-1 + εt.------------------------------------------(2) Where, Rett = , Δxt = xt – xt-1 and dt = dividend at time t.( Roberts, B. (1999). Both surprise and “stale” component are reflected in the current earnings. Application of the return model renders the “stale” component as less relevant in comparison to the component that defines surprise in the market. Analysis G written by Moehrle, S. R., J. A. Reynolds-Moehrle, And J. S. Wallce. (2001). On a general note, current earnings’ “stale” component does not explain much on the current return i.e., the dependent variable. However, on application of the price model cumulative effect of earnings information is reflected by the current stock price. That means both rather than one i.e., market’s surprise element and “stale” components of the current earnings have a lot relevant to the current stock price, again a the dependent variable. Analysts opine that in order to mask the effects of the non-wealth-maximizing investments, accounting discretion can be used by managers to increase reported earnings. (Francis, J., and K. Schipper. (1999). P/E ratio defines the stocks that these funds select. The P/E approach is actually a stricture-sort-of that makes sure that too heavy a price is not paid for buying a company. This, in turn, makes sure that the long term returns are above average and the risk below it. (Hayn, C. (1995). Analysis of stock market is done by these funds on the basis of the price-to-earnings ratio of investments and stocks, which exhibit a trend towards the realization of their values. It is held that better risk-adjusted returns are shown by low P/E stocks. This is considered to be suitable for investors who can’t take high-capacity risk and are looking at a investment horizon that is long-term. Will invest in companies poised for a sharp turnaround /substantial improvement in profitability. Max 30 % of net assets in Rolling P/E > BSE Sensex .Can also invest in debt / money market instruments to a maximum of 20% of its net assets.( Collins, D. W., M. Pincus and H. Xie. (1999). Volatile markets and past experience have shown that "booking profits" at regular intervals is an extremely beneficial approach to investing. Dividend received will be Tax-free income in the hands of the investor. Profits are expected in a disciplined manner on pre-determined targets of five and ten percent appreciation in the NAV. Possibility of multiple dividend triggers would ensure repeated automatic profit booking by way of dividends at the pre-set trigger levels as chosen by the investor. Pre-set dividend triggers serve as an effective hedging tool against the volatile nature of equity investments. Name (%) of Net Assets Software and Consultancy Services 23.38 Petroleum, Gas and petrochemical products 12.20 Auto & Auto Ancillaries 8.43 Non Ferrous metals 6.10 Banks 5.67 Current Assets 5.08 FMCG 4.81 NBFC 4.01 Media and Entertainment 3.70 Food & Food Processing, Beverages 3.69 Question 3 The most important factors in determining the success of the organization are Business Competitiveness, Management Competitiveness, Growth Prospects and Other Fundamental Parameters. The financial data that has been presented in mean Mean 2.172 0.080 1.751 0.020 1.303 Median 1.225 0.090 1.553 0.019 0.852 Standard Deviation 3.884 0.452 1.465 0.094 2.907 Descriptive statistics of Share price, earnings, leverage, sizeBook/market, Volatility and Equity raising for full sample. The result of yearly as well as pooled regression of stock price against earnings and book value per share. The adjusted R2 for the yearly and pooled regression indicates that earnings and book value per share explain the variation in stock prices about 20.2 percent (2002), 37.8 percent (2003), 30.9 percent (2004) and 24.5 percent (pooled). The results show that the regression coefficients of earnings per share and book value per share are significantly positive at p < 0.001 level in year 2002, year 2003, year 2004 and pooled. Value-relevance of earnings and book value Sample Adj. R2 b1 b2 n Pooled 0.245 2 0.812 730(7.605) (8.458) 2002 0.202 0.999 0.847 264(2.819) (6.121) 2003 0.378 4.630 0.390 275(8.676) (3.247) 2004 0.309 5.391 0.856 191(5.405) (3.203) The coefficient of earnings is positive and significant (β1 = 3.148, p < 0.001). This represents market’s reaction to earnings in the absence of FCF agency problem. However, the market’s reaction to earnings for firms with FCF agency problem is significantly lower. This can be seen from a negative and significant coefficient on the FCFAP*EARN interaction variable (β4 = -2.848, p < 0.001). The value relevance of earnings declines from 3.148 to 0.300 (3.148-2.848) in the presence of FCF agency problem. Similarly, the coefficient of book value is positive and significant (β2 = 1.148, p < 0.001) which represents the market’s reaction to book value in firms without FCF agency problem. However, for firms with FCF agency problem, the market’s reaction to book value is reduced. It appears from the regression that the coefficient on the FCFAP*BV interaction variable is negative and significant (β5 = -0.927, p < 0.001). The value relevance of book value declines from 1.148 to 0.221 (1.148-0.927) in the presence of FCF agency problem. Multicollinearity problem appears if the level of tolerance is below 10% and VIF value is greater than 10. Table 4 shows the level of tolerance and VIF value for seven investigated independent variables. Since there is no level of tolerance below 10% and VIF greater than 10, we can conclude that the regression model used in this study does not suffer a serious multicollinearity problem. Share price of Tata in the years The share price that has been stated in the year 2009 Book market value in the year 2009 The leverage value in the year 2009 The role of the business cycle The profits ,dividents and other aspects of the ompanies and business has been expected to rise when the economies has been performing and there has been link with stock market and the financialperformance.That has been said as an example when the share price of Infosys rising when they come out with positive quater result and the share price tumbling when the company comes out with negative quater result.There has been rise in the Indian stock price when the general result comes out and there has been tumbling when negative evnets like terror attacks has happened.This could be stated as example like the Indian share price dropping when Mumbai terror attacks happened and when congress came back to power,the share price increased.Coming to companies when the fraud of Sathyam infotech came out the share prices tumbled and that has meant that scams has led to the disinterst of the general public.The business cycle would be related to the general mood of the public and that would be affecting macroeconomics. References Business and Economy, Volume 4 Issue 11,31 July-August 13 ,2009,pp.100-125. Balsam, S., and R. Lipka. (1998). Share prices and alternative measures of earnings per share. Accounting Horizon 12, 234-249. Beresford, D. R. (2001). Congress looks at accounting for business combinations. Accounting Horizon 15, 73-86. Burgstahler, D., and I. Dichev. (1997). Earnings, adaptation and equity value. The Accounting Review 72, 187-215. Collins, D. W., M. Pincus and H. Xie. (1999). Equity valuation and negative earnings: The role of book value of equity. The Accounting Review 74, 29-61 Francis, J., and K. Schipper. (1999). Have financial statements lost their relevance? Journal of Accounting Research 37, 319-352. Hayn, C. (1995). The information content of losses. Journal of Accounting and Economics 20, 125-153. Jennings, R., J. Robinson, R.B. Thompson II & L. Duvall. (1996). The relation between accounting goodwill numbers and equity values. Journal of Business Finance and Accounting 23(4), 513-533. Jennings, R., M. LeClere & R.B. Thompson II. (2001). Goodwill amortization and the usefulness of earnings. Financial Analysts Journal 57(5), 20-28. Lindenberg, E., M. P. Ross, & S. S. Barney. (1999). To purchase or to pool: Does it matter? Journal of Applied Corporate Finance 12, 32-47. Moehrle, S. R., J. A. Reynolds-Moehrle, And J. S. Wallce. (2001). How informative are earnings numbers that exclude goodwill amortization? Accounting Horizon 15, 243- Roberts, B. (1999). FASB tries to eliminate pooling of interest: Will the move slow the high-tech acquisition frenzy? Electronic Business, 25(12), 26. Vincent, L. (1997). Equity valuation implications of purchase versus pooling accounting. The Journal of Financial Statement Analysis, 5-19. Read More