Critical Thinking

The to take a holistic view as well

The fact that there has been no sequential decline in the relevance of accounting earnings and that will boost the confidence of investors and other stakeholders on the quality of accounting information (Graham, Harvey, & Rajgopal, 2005).Another paper was done by (Wang, Fu, & Luo, 2013) to investigate the relationship between stock price and accounting information.  Correlation and regression analysis being done showed that accounting information had a significant impact on stock prices. The ratio analysis with respect to profitability, earning per share and rate of return on equity was found to be the most significant. Stock price alone though didn’t tell much regarding the progress being made by the company as it is dependent on numerous factors as well apart from an accounting information. Though results were highlighted by saying that China’s stock market was considered to be mature and novel which creates doubt with regard to the disclosure of information. So, it’s important to take a holistic view as well (Wang, Fu, & Luo, 2013).2.4 Theories on Stock Prices2.4.1 Efficient Market HypothesisThe efficient market hypothesis essentially explains that stock prices are truly representative of all the available information and any new information being readily reflective of the share price (Richard & Witt, 1979). Various tests of efficient market hypothesis are conducted on the assumption of zero transaction cost, no taxation, and free access to the availability of information for all parties involved in the process and contract between them regarding the ramification of information for security prices. It is not possible to test efficient market hypotheses directly as there would be a need to know market predicted net operational cash flows and predicted the average required rate of return for all the future time period. The researcher would need to know all the information available regarding the stock and the way information is reflected in stock price. A great deal of evidence supports the three forms i.e., weak, semi-strong and strong form. The weak form of the efficient market hypothesis states the extent to which stock prices can be used to predict future price pattern. A great degree of evidence suggests that such pattern cannot predict the future. Semi-strong form attempts to explore the extent to which share prices fully reflect all the publicly available information. This assumption has been supported by Fama, Fisher, Jensen and Roll. Investors predict and react to the publicly available information as to the stock price to get any deviation from equilibrium market values. Whereas strong form is designed to explore whether share prices are truly representative of all the information. The hypothesis is gain advocated by many researchers namely Friend, Brown, Herman etc. various other studies find that stock market professionals identified all the managers of unit trusts won’t be able to earn a return greater than the return expected at particular market risk. Though some evidence has also been found against specialists and corporate insiders which predicts that corporate insiders have exclusive access to the information which equips them to earn future returns (Richard & Witt, 1979).The following cases explain that in case of uncertain times, many financial economists and legal practitioners urge that directors are guided by efficient market hypothesis.A.Smith v. Van Gorkom (Trans Union)In the Trans Union, directors were found to be totally negligent to sell the company despite experiencing large premiums of approximately 47% over the pre-offer market price. The 3-2 majority based his decision on the BJR criteria as per their view, the directors didn’t base their decision according to the chairman’s role in forcing the sale of the company and in predicting the share price. But if the situation ought to be judged by efficient market hypothesis, Trans Union directors would have fared well since the price they agreed to was significantly higher than the price calculated according to the efficient market hypothesis (Margotta, 1995).B. Dynamics v. CTS (CTS) Dynamics corporation of America made a tender offer for 18% if the shares of CTS corporation which would have brought its holding to 27.5%. On the same day, it sued CTS from enforcing the recently adopted shareholder rights plan because its adoption violated fiduciary duties of management. The market price of the publicly traded stock reflects all the available information about the value of stock and anyone who offers a higher price offers an unequivocal benefit to the shareholders of the target firm which management should accept instead of opposing (Margotta, 1995).2.4.2 Fifty Percent PrincipleThis is a term that has been used frequently while conducting technical analysis of stock price movement and states that stock price will be corrected at around half and 2/3 of its previous movement before the observed trend continues. This technique takes into account Fibonacci () levels though there are many levels but fifty percent replacement level is deemed as well known among all of them. The correction for regarding which the principle is alluding is considered to be normal as it’s a natural trading intuition to purchase a stock when it rebounds as equal to as half especially for day traders.2.4.5 Prospect Theory (Loss-Aversion Theory)Prospect theory was presented by (Kahneman & Tversky, 1979) which takes into account that losses and gains are not valued the same way therefore investors make decisions based on the perceived gains instead of losses. This theory is also called loss aversion theory which states that being an investor if two choices are put forth before an investor, one regarding a potential gain and one pertaining to the potential loss, the choice entailing the potential gain would be chosen. Prospect theory relates to the behavioral economic subgroup which clarifies as to how investors make the choice decision when likelihood of different outcome is unknown. The underline methodology behind an individual behavior is that since different choices are mutually exclusive, the likelihood of every outcome is 50/50 rather than what has actually been predicted. Though according to this theory, the probability of gain is perceived to be much higher than any other option (Lui, Zhang, & Zhao, 2017).2.4.6 Rational Expectations TheoryThe theory of Rational Expectations was first developed by (Muth, 1961). While describing different economic scenarios, the term was used to describe the likelihood of that particular outcome which people have come to believe. For example, the price of an agricultural product depends on the acres being farmed by the farmer which is dependent on the price famers expect at the time of reaping and selling the crops. Similarly, the rate at which any currency would be depreciated depend on the rate of depreciation that is expected. This is partly because people rush to sell the currency which they believe is going to go down in the future thereby contributing to the loss in its value. Likewise, the price of the bond and stock would be what is being expected by buyers and sellers going forward (Reddick, 2004).The use of economic theory is not new at all in the economics. (Keynes, 1924) referred to this as waves of optimism and pessimism that would define the level of economic activity. While making their mind, people predict as to what would happen in the future. Investors have a strong incentive to use forecasting rules as being seen in the case of stock market. Higher profits are generated by those who act on the basis of better understanding about the stock market. When you are asked to forecast the price of the stock again and again, its human tendency to adjust their price level according to the market scenario. Thus, there is a continual feedback from past events for the future likelihood of occurrences of various events. The concept of rational expectation assumes that outcomes do not differ in a predicted pattern from what people expect them to be. Abraham Lincoln (Lincoln & Willey, 2014) stated the similar fact long ago when he said that ‘anyone could fool some of the people all the time and all the people at different events but it would be difficult to repeat the pattern and fool all the people all the time. Analysts who believe in the Rational Expectations Theory base their opinion on the fact that people are guided to behave in the best interest in order to maximize their benefit (Reddick, 2004).2.4.3 Greater Fool TheoryIt’s a hypothesis that elaborates the existence of speculative bubbles which would inflate the price of assets such as stocks, real estate and commodities way beyond their intrinsic value (Santoni, 1987). The underline assessment is that people may realize that stock price no longer reflects intrinsic assessment of value but doesn’t take this into account because prices continue to soar as new players enter the market being lured by attractive returns. Asset bubbles generally get the media attention that attracts new investors. Investors may be hesitant at first but after experiencing positive returns they get encouraged and tend to get more aggressive. As a consequence, the market that goes up draws a considerable amount of investment as the world is propagated. This could make the price being risen more than their intrinsic value. Though in the given scenario, the speculative bubble may not crash until the new investment comes in. the investors typically experience large losses especially those who held on to their assets more than the prescribed period and those who bought in the end (Bruss, 1986).2.4.4 Odd Lot TheoryThe concept of odd-lot theory was first presented by Garfield A. Drew in 1940’s but it was furthered modified in research in (Drew, 1967).This theory states that an increase in odd lot activity is a buy signal in the market. An odd lot is a group of shares that is not a multiple of 100 as 100 shares are called round lot. Individual investors are most likely to hold an odd amount of shares therefore when the number of odd lot trade increases in the market, the analysts interpret this as an indication that individual investors are very active in the market. The theory suggests that these individual investors do not have sufficient knowledge and are always wrong. When the odd lot sales increases, institutional investors deem it as the time to sell. This theory doesn’t only determine the buy and sell process but also sheds light on the behavior of individual investors (Kewley & Stevenson, 1967).2.4.7 Short Interest TheoryThe concept of interest with regards to human actions was first discussed by (Fisher, 1930) which takes into account individual behavior in various aspects of life. With regards to stock price and as per Douglas W. Diamond and Robert E. Verrecchia, the theory takes into account the fact that security with a high degree of short interest would result in an increase in price. The theory mainly emphasizes on stocks with high short interest which is gauged in terms of shares sold either as a proportion of shares outstanding or in terms of shares being floated. The theory suggests that stocks with relative short positions may be the one with a significant increase in price as short sellers would buy the stocks to cover their short positions. The buying pressure being exerted supports a short squeeze and results in a surge in price that triggers more short covering. Though investors need to be careful as to not to rely on short interest theory more to identify stocks in which to invest. Sometimes it’s the case that short interest may have been the cause of deteriorating fundamentals and highly geared balance sheet. Even though the stock may rise dramatically if a positive development triggers the stock rise, there is also a chance that short sellers might be right in their assessment and stock price may be reduced significantly in the future (Diamond & Verrecchia, 1987).2.4.8 The Bottom LineBottom line refers to the company’s net earnings, income and earnings per share. The reference to the bottom line indicates the very position of company’s net income figure on the income statement. Companies generally have two options to improve the new earnings either via increasing the revenues or through cutting the costs. The bottom line essentially corresponds to the net income figure stated at the end of the income statement. Management has multiple options to increase the bottom line. This could be done by increasing production, lowering sales or via expanding the product line and prices. Other income such as rental, interest could also increase the total income of the company.2.5 Stock price valuation ModelsAccording to Richard M. Burns and Joe Walker, the existing literature doesn’t provide most clear and unequivocal guidance regarding the most appropriate method of project evaluation. Capital budgeting entails the entire process of planning expenses when returns are calculated for more than one year. The easiest example being of land, building, equipment. A survey was mailed to the chief financial officers on the Fortune 500 companies list. The internal rate of return and net present value has been widely used because of the emphasis being put on the time value of money and cash flow measures. Though NPV was stood out categorically (Burns & Walker, 1997).2.5.2 Residual income valuation modelThe idea of how the business income should be measured and concept explaining residual income was first presented by (Edwards & Bell, 1961) in which they have discussed various techniques about how management can accurately and effectively work towards maximizing shareholder equity (Edwards & Bell, 1961). Residual income is calculated as the income being earned minus the cost that has been incurred for generating that income for the shareholders (Dechow, Hutton, & Sloan, 1999).  According to (Soffer, 2003)  its primarily used to gauge the internal company performance. It’s also employed to assess the intrinsic value of common stock. The conventional financial statements are prepared to exhibit earnings available to the owners. While calculating net income, dividend and other charges are not deducted in with regard to the equity being issued to generate the net income. Conventional accounting techniques leave the room to judge whether or not income earned by a company adequately covers the cost of equity capital. Whereas the fundamental concept of residual income incorporates the expenses being incurred for raising equity (Soffer, 2003).According to (Bell III, 1998) residual income could also be termed as economic profit since it portrays the economic profit of the company by deducting the cost of equity and debt. As described by (Sinnadurai, 2016) the phrase abnormal earnings have also been used to describe residual income. It is called on the assumption that the company is expected to earn its profit over the long run from various sources of income so income that will be earned over the cost of capital after covering all the expenses that were incurred to create the opportunity for that income would be called abnormal earnings (Sinnadurai, 2016). (Biddle, Bowen, & Wallace, 1998) said that traditional example of residual income concept is called Economic value added. which is calculated as follows:  EVA = NOPAT – Invested capital * WACCNOPAT= Net operating profit after taxWACC = Weighted average cost of capital (Dechow, Hutton, & Sloan, 1999) remarked that in the residual income valuation model, the intrinsic value of an enterprise has two major components:1)    The current book value of equity.2)    The value of the future residual income considering time value of money (Dechow, Hutton, & Sloan, 1999).As highlighted by (Schultze, 2005) the residual income has also been used to assess goodwill impairment. Goodwill is defined as an intangible asset that appears on the balance sheet when another firm is purchased. The higher residual income is the better the financial situation of any firm would be and it also implies greater management compensation (Schultze, 2005).  (Wallace, 1997) in his study argued that if the income surpasses the return being earned by management on his or her investment then the residual income will be positive and if the earnings are less, the residual income will be negative. The major advantage of the residual income model is that it uses the readily available accounting data (Wallace, 1997). 2.5.3 Use of CAPM model to classify risk characteristics of stockThe first work on the model was done by (Treynor, 1961). According to (Galagedera, 2007), one of the most important tasks of being the financial analysts is to identify the cost of equity capital. The capital asset pricing model is the most useful tool to analyze securities and afterwards determine the estimated return on investment. The method provides a way to measure risk quantitatively and translating that risk to determine the estimated return on equity. The principle advantage of Capital asset pricing model is the unbiased nature of calculated cost of equity that model attempts to calculate. CAPM cannot be used in isolation as managers use it in conjunction with other methods and base their results according to their own judgment (Galagedera, 2007).(Lee & Upneja, 2008)  in their study discussed that CAPM is the simplified application of financial market pattern and is generally employed to calculate the cost of equity capital. Regardless of the limitations, the model provides a useful tool to the financial manager to assess the behavior of any stock (Lee & Upneja, 2008). As discussed by (Laubscher, 2002) the recent financial theory is based on the two assumptions i.e., securities market is competitive by nature and highly efficient which essentially implies that relevant information about the stock of any company is readily accessible and financial markets are composed of investors who try to do everything to maximize their return from the money being injected by them. The first assumption takes into account the fact that financial market consists of well-aware traders and the second assumption sheds light on the behavior of investors as to their willingness to earn more and more profit and bear less risk. Moreover, practical investors demand a premium in the form of higher return for the risk being borne by them. Although all these assumptions form the basis of modern financial management, the CAPM model considers other assumptions as well. The most important of all is the frictionless markets without stable conditions such as transaction cost, taxes and limitation on the extent to which you borrow. The model also considers the statistical nature of the stock return and investor preferences. Many researchers have dug further into the problem so as to soften these assumptions but they resulted in deriving more complications (Laubscher, 2002). As (Lawson & Pike, 1979) narrated that CAPM deals with the risk and return of the stock and focuses on defining it perfectly. Even though investors buy any particular stock under the assumption of getting the expected return, the fluctuation in the market causes the result to move up and down