Summary and Conclusions
The key to unlocking stock market analysis, irrespective of volatility, is an understanding of theories of share price determination that underpin its performance. Traditional financial theory assumes that:
Shareholder wealth maximisation (increased share price) is based upon the economic law of supply and demand in a capital market that may not be perfect but reasonably efficient.
Investors respond rationally to new information (good, bad or indifferent) and buy, sell, or hold shares in a market without too many barriers to trade.
As a consequence, yesterday's trading decision (and price) is independent of today's state of play and investment is a "fair game" for all.
However, the view taken here is that irrespective of whether markets are efficient, investors are rational and prices or returns are random, the investment community still requires standards of comparison to justify their latest trading decisions and stay in their comfort zone. And in this respect, despite its deficiencies, traditional finance theory has much to offer.
Explained simply, stock market performance is not an absolute but relative. It must be related to some standard of comparison. For example, has a firm's current share price risen, fallen, or stayed the same, relative to the market the market as a whole, its own business sector and its direct competitors since yesterday, or over the past 52 weeks say, as revealed by the financial press? And if so, how does its return, evidenced by either dividend yields or P/E ratios, fit into a comparative performance analysis?
To answer these questions we shall therefore begin our analyses with the theoretical determinants of share price and specifically the capitalisation of a perpetual annuity. This concept underpins the derivation of maintainable dividend yields and the P/E ratio, which are published world wide in the financial press.
As we shall discover, this model enables current shareholders and prospective investors (including management) to evaluate the risk-return profiles of their latest dividend and earnings expectations vis a vis current share prices for any company of interest.
Moving on, we shall explain and analyse how share price listings that encompass dividends (the yield and cover) and earnings (the P/E ratio) are used to implement trading decisions (i.e. whether to "buy, sell or hold").
Having clarified the inter-relationships between these universally available measures, by which individual investors analyse stock market performance, we shall then explore two practical applications of stock market data that corporate management can implement to maximise shareholder wealth. Both applications not only provide an opportunity to reflect upon the relevance of dividend policy and overall profitability to investment and financial decisions. They also represent the most important strategic decisions that management is ever likely to encounter.
The first case concerns an unlisted company coming to the capital market for the first time that requires an aggregate "flotation" value and "offer for sale" price per share. Particular attention is paid to the dividend yield, dividend cover and price earnings (P/E) ratio required by future shareholders.
The second evaluates various valuation models and methodologies, which underpin acceptable "bid prices" that support rational managerial motives for acquiring another business as a "going concern" in the event of a "predatory" takeover
Having read this text, you should also be in no doubt that:
The derivation of a share's price that utilizes NPV cash flow analyses of prospective earnings or dividends, rather than historical data drawn from published financial accounts, represents an ideal wealth maximisation criterion throughout the investment community.
1. Fisher, I., The Theory of Interest, Macmillan, 1930.
2. Fama, E.F., "The Behaviour of Stock Market Prices", Journal of Business, Vol. 38, 1965.
3. Mackay, L.L. D., (originally published in 1841), Extraordinary Delusions of Madness of Crowds, Farrar, Strauss and Giroux, 2011.
4. Kindleberger, C.P. and Aliber, R.Z., Extraordinary Manias, Panics and Crashes: A History of Financial Crises, Palgrave and MacMillan, 2011.
5. Shiller, R.J., Irrational Exuberance, Princeton University Press, 2005.
Strategic Financial Management: Exercises (SFME), Chapter One, 2009. Portfolio Theory and Financial Analyses (PTFA), Chapter One, 2010. Portfolio Theory and Investment Analysis (PTIA), Chapter One, 2010.