FINS1612 SUMMARIES

Week 5 Equity Markets 3

Part 1 Forecasting Share Price Movements

Recall share price is determined by supply and demand of companys

shares (good expected performance increases demand and thus share price
and vice-versa)

Here we see three methods for explaining movements in supply and

demand

1/5 Fundamental Analysis: Top-Down Approach;

Fundamental analysis Considers macro and micro factors that impact

upon cash flows and future share prices of various industry sectors and
firms
o Macro (Top Down) = interest rates, economic growth, business
investment
o Micro = Firm-specific and relate to managements impact on
company performance.

Top-down approach considerations;

o Economic growth of international economies

Higher the growth rate of the rest of the world bigger demand
for Australian exports.

The sectors benefitting from international growth are

determined by source of the growth
Growth can be driven by increased consumer demand
or increased business investment in equipment.

o Exchange rates (Strong relationship to interest rates)

These affect the domestic currency profit of exporters that

quote their products in foreign currency prices.
A strengthening AUD makes exporting firms worse
of because the AUD value of their exports is lower / more
expensive to the world.

Also affect indirectly via devaluing of currency increasing cost

of imports, thereby increasing inflation (if currency weakens)

o Interest rates

Directly efects profitability by representing the cost of

debt finance for borrowers and the return for finance providers

Indirectly efects profitability A rise may indicate slowing

of economic activity AND could represent a future reduction in
productivity.

o Domestic economy factors;

Growth rate greater growth generally leads to increased

profitability for firms.
BUT can also lead to negative profitability factors such as
Deterioration in balance of payments, increase in inflationary
pressures, pressure on wages, depreciation of the exchange
rate, rises in interest rates.

Balance of payments current account;

If this account is in deficit (total international payments
exceed total international receipts)
o Some export income is diverted to service debt
o Need to borrow foreign currency to service the debt
Indirectly The government may increase interest rates
to slow economic growth and control the debt.

Inflationary pressures
Effect of inflation of firms real profit
Tax treatment of inflation;
o Makes historical-based depreciation allowances
inappropriate
o Combine with higher replacement costs, leads to an
overstatement of after-tax profit
Inventory Inflated selling price of inventory creates an
illusion of inventory profits.

Wage and Productivity Growth

Increase in wages growth raises the amount of business
profit used for salaries.
o Impact most on firms that are highly labourintensive

Government responses to changes in the above factors

2/5 Fundamental Analysis: Bottom-Up Approach;

After identifying the best economies and industry sectors for investment
using the top-down approach the bottom-up approach can be used to
identify the best companies within these

The bottom-up approach considers micro factors using ratios and other
measures of a firms financial characteristics and performance.
o Consideration factors;
Accounting ratios that assess a companys capital
structure, liquidity, debt servicing, profitability, share
price and risk.
o Observing the trend and making comparisons with
firms in the same industry.
Also additional information on key management changes,
corporate governance and strategic direction.

4/6 WEEK 4 Financial Performance Indicators:

Investors are concerned with the future level of a companys performance

because it affects both the profitability of the company and the variability
of the cash flows.

The indicators include;

o Capital structure:

Proportion of company assets (funding) obtained through debt

and equity.
Usually measured by debt to equity ratio (D/E ratio)
o Higher debt increases financial risk of not being
able to meet interest payments
Also measured by proprietorship ratio = ratio of
shareholders funds to total assets.
o This indicates a firms longer term financial
viability/stability. A higher ratio indicates less
reliance on external funding.

o Liquidity;

Ability of a company to meet short term financial obligations

Current ratio = Current assets (Maturing within one
year) / Current liabilities (due within one year) NOT the
best indicator

 Liquid ratio
Current assets inventory (stock on hand) / Current liabilities bank overdraft.

o Debt servicing;

Ability to meet debt-related obligations i.e interest and

repayment of debt.

Measured by debt to gross cash flow ratio

Indicates number of years of cash flow required to
repay total firm debt.

Also measured by interest coverage ratio.

Earnings before finance lease charges, interest and
tax / finance lease charges and interest.

o Profitability;

Wide variation exists in the definition and measurement of

profitability;
EPS;
EBIT to total funds ratio;
o EBIT/ Total funds employed (shareholders
funds and borrowings)
EBIT to long term funds ratio;
o EBIT/ Long-term-funds (total funds less short
term debt)
ROE (Return on equity);
o Net income / equity (shareholders funds)

o Share Price;

Represents investors view of the PV of the future net cash flows

of a firm

Performance indicators of share price include;

Price to Earnings (P/E) ratio (higher is more growth in
future NCF)
o Share price divided by EPS
Share price to net tangible assets ratio (P/NTA)

o Measures the theoretical premium or discount at

which a firms share price is trading relative to its
NTA
o Risk

Variability (uncertainty of the share price)

Recall systematic vs. non-systematic risk

3/5 Technical Analysis;

Explains and forecasts share price movements based on past price

behaviour

Assumes markets are dominated at certain times by mass psychology, from

which regular patterns emerge.

Method 1 Moving averages (MA) models

o Smooth out a series facilitating the identification of trends in the
series

Assuming a five-day moving average, the MA is calculated by

taking the average of the price series for the preceding five
days.

o Gives trading rules of;

Buy when the price series cuts the MA from below

Buy when the MA series is rising strongly and the price
series cuts or touches the MA from above for only a few
observations.

SELL when the MA flattens or declines and the price series cuts
the MA from above

Note: Technical Analysis Validity

SELL when the MA is in decline and the price series cuts

or touches
MA from below
a few observations
Even
where the
techniques
havefor
noonly
apparent

validity
if they
are
followed by
o Typically,underlying
for daily price
series both
10-day
(short-term)
and 30-day
enough
participants
they
may
impact
on
share
(medium-term) moving averages are calculated.
price behaviour at times.

o Weighted MA = most recent information given the greatest

weight
More likely to forecast successfully when share

prices move out of a range explained by

economic and financial fundamentals.

Method 2 Charting - Investigating patterns in price charts using

techniques such as
o Trend lines (regular movements in share prices)

Uptrend line connecting the lower points of rising price

series

Downtrend line Connecting the higher points of falling share

series.

Return line line drawn parallel to a trend line to create a

trend channel.
Critical issue: Determining when trend line will change.

o Support and resistance lines

Support levels where there is sufficient demand to halt

further price falls.

Resistance levels where there is sufficient supply to halt

further price increases
Strong levels historical support of resistance
Weak levels support and resistance based on more
recent activity

o Continuation patterns Sideways share trading that does not

normally signal a change in trend.

Triangles composed of a series of price fluctuations, each

smaller than its predecessor.
Symmetrical
triangle (no
change in trend)
Ascending Triangle
(uptrend)
Descending
triangle
(downtrend)

Pennants and flags formed during a sharp rise in prices (the

pole); then trading volume reduces and increases suddenly to
take prices sharply higher.

o Reversal patterns occur after a major market move,

Head and shoulders pattern three successive rallies and

reactions, the second rally being stronger than 1st and 3rd.

Left shoulder formed by volume-strong rally on

uptrend, followed by reduced-volume reaction

Head second rally increases price before reaction

moves price back to previous low
Right shoulder final rally market by reduced volume
indicating price weakness

4/5 Program Trading;

Buy and sell strategies generated by computer programs that range

between;
o Simple buy/sell orders based on moving averages
o Complex monitoring of both derivatives and share markets for the
purpose of hedging a share portfolio.

This increases the speed at which prices change

5/5 Random Walk and Efficient Market Hypothesis;

These are two theories on security values and changes in price

o Random walk; - PRICE OF SHARE INDEPENDENT OF PREVIOUS
PRICE

Share price is assumed to be formed by investors expectations

of future cash flows. i.e Intrinsic Value

Price will change in response to new information and since

information arrives in a random fashion stock prices
adjust in an unpredictable fashion.

Each observation in the (price) series is assumed to be

independent of the previous one

There is an equal probability that the next price will move up,
down or remain unchanged.

o Efficient Market Hypothesis (EMH); - PRICE ADJUSTS

IMMEDIATELY TO NEW INFO

Proposes that markets are information-efficient if prices adjust

immediately to new information

It is not possible for an investor to make abnormal profits

through superior information

 Weak form historical price data reflected in share price

Semi-strong form all publicly available information is
reflected in share price.
Strong-form public and private information is fully
reflected in share price.

Week 5 Equity Markets 3

Part 2 Basic concepts and calculations
(financial Maths)

FV Future Value (Single period cash flow)

The amount an investment is worth after one of more periods

Need the following elements;

o C ( = PV) Important when reversing to find PV
o r (interest rate)
o t (time period)
o NOTE 365 in Australia 360 in USA and EUR

Formula & example (Simple interest):

Formula & example (Compound interest)

Compounding:

Finding the Present Value Discounting

(Single period cash flow)
Option 1 Rearrange FV:

If we recall that the FV of a single period cash flow is as below (recalling

that C is PV)

Hence to rearrange to find PV;

Where

Ct is the FV at a particular time that will be given or assumed.

Option 2 Using Table A.2:

We should note also that we could simply use Table A.2

A note on HPY (Holding

Period Yield):

This is the yield on securities sold in the secondary market prior to

maturity

HPY > YTM when market yield declines from the yield at purchase
>>> IR have decreased and the price of the security increases

HPY < YTM when market yield increases from the yield at purchase
>>>(IR increase, Security price decreases)

Finding the Present Value Discounting

(Ordinary Annuity)
Option 1 Discount Each Cashflow using single cash
flow formula:

Let us observe an example in which an annuity pays $200 at the end of

each period for 3 years and has an interest rate of 10%

Hence we must discount each amount and summate;

Option 2 Formula for PV of ordinary annuity:

Option 3 Using Table A.3:

Finding the Present Value Discounting

(Annuity Due)
Option 1 Single Cash flow formula and individual
discounting:

Options 2 & 3 Modifying the Ordinary Annuity

Formula / Table Shortcut:

Either add the (1+r) as we did for FV to the ordinary Annuity Formula;

Or, after finding ordinary Annuity with Table A.3 add the (1+r);

Finding the Present Value Discounting

(Deferred Annuity)
Option 1 Single Cash flow formula (Modifying t):

Options 2 & 3 Modifying Formula or Table-found

value:

For example A 7 year Annuity that pays 100 at the end of each period but
only begins paying at the end of the third period:

Depending on what was the chosen method for an ordinary annuity, this
value is divided by the formula to adjust for the time until payments begin.
o I.e we are finding the PV for when payments begin and then
discounting back to period 0
o Note that step 1 could be the table-found value times by C

Diferent Types of interest rate;

1. Nominal Interest Rates (iNom - APR)

The rate that is quoted by financial institutions and written on the

contracts
o Need to know the compounding periods to give this number any
meaning

2. Efective Annual Interest Rates (EFF) / Equivalent Annual Rate

(EAR)
>>>Altered annual interest rate for annual compounding

The rate of interest that is actually being earned by the investor

o The interest rate that would generate the same future value if annual
compounding had been used.
o Note that if m = 1, then the nominal equals the efective

Formula is as follows;
Essentially (1+r)^n but
factoring in multiple
compounding per year

3. Periodic Interest Rates (iPER)

>>>Changing N when
compounding more
often to convert
nominal rates into
annual compound
interest.

The rate charged by a lender in each period (where period can be

quarter, year etc)

This is the rate that usually appears on timelines and is used in

calculations.