Stock Market Efficiency - Case Study Example

Stock Market Efficiency (WH Smith Plc)   Introduction The efficiency of stock prices can be judged with the help of the information available from the market. The hypothesis for efficient markets states that the information available from the market is efficient. This means that not only all related publicly available information of the past is reflected from the price of the stock but also predicts the related information of future. The efficiency of stock prices can be classified as weak, semi-strong and strong. Efficiency of stock prices can be termed as weak when only the public available information of the past is reflected from the stock prices (Harder, p.5). Efficiency of stock prices can be termed as semi-strong when apart from the previous information of the past events of the market; the stock prices also undergo instantaneous fluctuation to reflect any new market information. Stock price efficiency is said to be strong when the stock prices additionally reflect any internal or hidden information instantly. Appraisal of relevant peer-reviewed academic literature on stock market efficiency Following the efficient market hypothesis, stock price efficiency assures that all publicly available information of the past is represented correctly from the price of a stock and at the same time the information on related events of the company’s performance that are expected to happen in future could be correctly predicted from the stock prices. The guaranteed returns in excess of the average market returns, however, could not be assured by stock market efficiency as the stock investments are done taking into account the information available at the point of investment. It was after the global financial crisis that the performance of major economies of the world became necessary to be evaluated. The economy of UK could be considered in this aspect. An appraisal on the UK stock market efficiency could help us to understand the degree of resilience of UK’s economy after the global financial crisis (Dimson, p.43). In the stock market of UK, FTSE 100 represents an index which records stock trading and related aspects of risk, volatility, etc for a set of selected major companies in the UK stock market. These form the benchmark for other smaller companies in UK stock market. The UK stock market could be termed as myopic because of the fact that a large section of the investors is inclined to the investments that offer short term returns. The government securities and the treasury bills are traded for a short term of not more than 1 year at a minimum discounted face value. UK stock markets have been recorded to produce an average return of 9.2%. The return of FTSE 100 recorded over the last five years has been given below with the help of a graphical representation (ADEBAYO, p.1). It can be seen from the graphical representation that the returns of stock of FTSE 100 over the period of time resemble a stationary character. The stock prices over the period of time shows a constant mean as well as a constant variance. A higher weight-age is placed by the UK stock market investors on the recent dividends in comparison to their interest over future dividends (Lumby, p.323). This does not fall in line with the proposals of the theory on efficient market hypothesis. It is thus required for the investors of UK stock market to distribute the weight-age given by them to the recent dividend as well as expectation on future dividends as a part of their consideration for deciding on the investment in the stocks (CEPR, p.1). The investors also need to consider other factors like volatility of the stock, market risk and factors related specific to the entity whose stocks are under consideration or investment. The weakness observed in the stock markets of UK may be due to the competition on currency exchanges in Europe, regulation on transparency of financial disclosures throughout the world, lack of equity exchange between the US and European nations, the impact of stamp duty, etc (Barnes, p.45). Thus it would be prudent for the investors of UK stock market to interpret available information from the current market price and then compare the same with the fair or actual value of the stock in order to understand whether the stock prices are overvalued or undervalued with respect to the current market conditions (Bruetsch, p.5). Any investment in stocks which are undervalued would produce capital gains in future whereas investment in stocks which are overvalued is likely to incur losses in future. The fair or intrinsic value of stocks is determined by discounting the future stock value to its present market value (Radia, p.5). Critical analysis and evaluation of share price movements and information flows to the market The share price movements in the UK stock market can be evaluated by using the concept of standard deviation. Standard deviation represents the volatility of the stock prices. Higher standard deviation indicates higher deviation of the individual values of UK stocks from the mean value of the stocks (Eckett, p106). Thus a measure of the volatility of the UK stock market could be understood. Flow of information to the market happens due to the fluctuation of the stock prices. The volatility of share prices in FTSE 100 is more as compared to the treasury bills in 2011-12 which can be observed from the figure given below. Hence due to the flow of information to the market the risk-averse investor would behave in such a way that he would incline to invest more in the government treasury bills (Mendelsohn, p.15). The volatility in share prices of FTSE 100 is much more and hence more risk would be associated in those investments. Assuming similar returns offered by two stocks with different standard deviation, a comparison of the stocks in UK market could be carried out. The flow of information to the market would occur in such a way that the market investors would incline towards investment on the stock which has a lesser standard deviation. Lesser standard deviation indicates that the share price of the stock would be subject to lesser variation or less volatile in the stock market as compared to the other stock. For obvious reasons, the opportunity cost to the investor for holding a stock with less volatility would be more in comparison to the other stock as due to less risk involved in that stock, the investor would expect comparatively higher returns (Davis, p.246). Thus the movements in share price generate flow of information to the market in such a fashion that reflects the risk-averse nature of the investors. The share price movements can also be analysed and evaluated with the help of Random walk theory which reflects information evolving out of instantaneous fluctuation in the price of shares. Random walk theory considers the effect of past information available, any drift in the parameters of performance and also takes into account any hidden or internal event (Sutcliffe, p.4). The change in the price of share from Y(t-1) to Y(t) could be described as: Y(t)= Y(t-1) + β + u(t), where β is the drift factor due to which changes in the share price have occurred and u(t) denoted the hidden part due to which the change in share price have occurred. Flow of information to the market varies with the change in share price thereby giving an idea to the users of information about the reason for change in the share price. The information also helps the investor to predict the future prices of the share. Critical evaluation of the market price of the WH Smith Plc. security using standard value assessment methods By analysing the nature of information flow to the market, the current market price of WH Smith Plc. can be evaluated. The flow of information to the market varies according to the fluctuation of the share price of WH Smith Plc. and comparing it with the intrinsic or fair value of WH Smith Plc. The intrinsic or fair value of share of WH Smith Plc. can be evaluated with the help of standard method of assessment as shown below (Friedentag, p.12). The table shown below uses the Free-cash flow from equity method for determining the fair value of stock of WH Smith Plc (WH Smith PLC, p.1). The current market price for WH Smith Plc. is found to be £757.5 as on 02.04.2013. The fair or intrinsic value of WH Smith Plc’s has been calculated by taking into consideration the future free cash flows from equity and the expected future values. By discounting the future cash flows from equity with the cost of equity of WH Smith Plc., the present value of equity has been calculated (Porter, p.9). The expected future values of the free cash flows from equity have been calculated by assuming that the cash flows from equity would continue to grow in the same growth rate for the subsequent years. The terminal value of the future cash flows is determined with the help of a terminal growth rate (Jones, p.16). The terminal growth rate depends on the growth rates of GDP and inflation of UK. £m FY12 FY13E FY14E FY15E FY16E FY17E Terminal value Net profit 84             Depreciation 28             Capital Expenditure -32             Change in non-cash working capital -8             Net debt taken 0                             Free Cash Flow from equity (FCFE) 72 83 96 111 128 147 1688 Present value (PV)   61 70 81 93 108 609 Total equity value 1022             Shares Outstanding 1,383,879             Intrinsic / Fair value 738.4959998                             Terminal growth rate 9.0%   Current market price(£) on 2.4.13 757.5       Cost of equity (Ke) 18.52%   Dividend per share (£) 23.6                                                     Growth rate of WH Smith Plc. 15.4%                             Capital expenditure= Beg. Fixed Assets - Ending Fixed Assets – Depreciation Non-cash Working Capital = Receivable + inventory - Prepaid Expense – Payables The growth of WH Smith Plc. is 15.4% and the terminal growth rate of WH Smith Plc. is 9%. This terminal growth rate is determined on the basis of growth rate of GDP rates of inflation (Baker and Powell, p.105). The cost of equity of WH Smith Plc. is 18.52%. The present value of equity of WH Smith Plc. is calculated by discounting the future cash flows by the cost of equity of WH Smith Plc. The cost of equity is obtained by adding the growth rate of the company with the proportion of dividend as a percentage of the current market price of WH Smith Plc. stock. The actual share price of WH Smith Plc. has been found to be £738.49 as compared to its current market price of £757.5. The actual share price of WH Smith Plc. has been obtained by dividing the present value of the total equity of WH Smith Plc. by the total number of outstanding shares of the company. Thus the market price of WH Smith Plc. security has been evaluated as slightly overvalued. Justifications regarding pricing of WH Smith Plc. security The fair value of stock price of WH Smith Plc. has been calculated as £738.49 which is slightly lower than its current market price of £757.5. Thus WH Smith Plc.’s stock is being traded above its face value which indicates that its performance seem to follow an increasing trend either due to market information on net profits or dividend per share for subsequent years or because of market speculations on the stock of WH Smith Plc (Bodie, p.238). Thus, the securities of WH Smith Plc. showed signs of overvaluation and is thus selling at a premium over its fair value. Since the overvaluation of WH Smith Plc. stock is marginal as compared to its fair value, it would be prudent for the shareholders if they decide to hold the shares and securities of WH Smith Plc. Identification of limitations: Strategic solutions to corporate financial management The limitations on pricing of security of WH Smith Plc. is that the evaluation of intrinsic price of stock of WH Smith Plc. is done with the method of estimating expected future free cash flows from equity over a period of time. The terminal growth rate has been used to find the terminal value of the future cash flow of WH Smith Plc. This terminal growth rate is dependent on the GDP growth rates of UK and rate of inflation (Garg, p.253). Thus there is a limitation because of the inability to include all factors affecting growth rate of GDP and inflation in UK. This may result in a variation in the terminal growth rate. Application of moving-average method to calculate the present value of future cash flows would be a strategic solution to the corporate financial management which would help n overcoming the limitation and would help in the correct prediction of the fair value of security of WH Smith Plc (Vishwanath, p.19). Conclusions The evaluation of security of WH Smith Plc. has been done using standard assessment method with the help of discounted cash flow technique and thus finding the present value of expected future cash flows discounted by WH Smith Plc.’s cost of equity. This valuation of an indicative stock like WH Smith Plc. provides us with an understanding of the efficiency of stock markets in UK. The investors of stock market in UK should take into consideration the information related to past, present as well as anticipation of future related events that is indicated from prices of the stock. The fair or intrinsic value of stock is determined on the basis of present value of share prices which is obtained by discounting the future values of share prices. The stock price of UK stock market companies vary widely on due to their performance in the past, taking recent drifts into consideration due to present market conditions and the results of the company as anticipated in future. UK stock market can be termed as efficient only when the UK stock market prices reflect the relevant publicly available information of the past, present information emerging out of the recent fluctuation in prices and the related events anticipated in the future. Importance to interests over the recent dividend per share as well as the dividend per share expected from the companies in future should be fairly distributed by the investors in UK stock market. References ADEBAYO, Q. A. Capital Market Efficiency: An Analysis Of The Weak - Form Efficiency Of The U.K Stock Market. 2013. 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Delhi: Global India Publications, 2009. Print. Harder, S. The Efficient Market Hypothesis and Its Application to Stock Markets. Germany: GRIN Verlag, 2010. Print. Jones, C. P. Investments: Analysis And Management, 9Th Ed. Noida: John Wiley & Sons, 2007. Print. Lumby, S. Investment Appraisal and Financing Decisions. Hong Kong: Taylor & Francis, 1988. Print. Mendelsohn, L. B. Trend Forecasting with Intermarket Analysis: Predicting Global Markets with Technical Analysis. New Jersey: John Wiley & Sons, 2012. Print. Porter, G. A. and Norton, C. L. Financial Accounting: The Impact on Decision Makers. USA: Cengage Learning, 2010. Print. Radia, N. Testing for UK Stock Market Efficiency Under Conservative and Labour Governments 1951-1970. England: University of Sheffield, 2003. Print. Sutcliffe, C. M. S. Stock Index Futures. England: Ashgate Publishing, Ltd., 2006. Print. Vishwanath, S. R. and Krishnamurti, C. Investment Management. Hiedelberg: Springer, 2009. Print. WH Smith PLC. WH Smith PLC Annual Reports. 2012. Web. 02 April. 2013. < http://www.whsmithplc.co.uk/investors/company_reports/annual_reports>. Read More