Taxation

Pre-dividend imputation (prior to 1987)

Dividends were taxed twicefirst at company level (as profits) and then
at the investors marginal rate

Dividend imputation (since 1987)

Removed the double taxation of dividends
Investors receive franking credit for the tax a company pays on a
franked dividend

Taxation

Capital gains tax on shares purchased

Prior to 19/9/1985 tax free
19/9/198521/9/1999
Taxpayers marginal tax rate applied if held less than 12 months
Taxpayers marginal tax rate applied to indexed capital gain if held
over 12 months
Since 21/9/1999
50% discounted gain if held at least 12 months; or
indexed capital gain or 50% discounted gain if purchased
19/9/198521/9/1999

Financial performance indicators

Potential investors are concerned with the future level of a companys

performance

Companys performance affects both the profitability of the company and the
variability of the cash flows

Indicators of company performance

Capital structure
Liquidity
Debt servicing
Profitability
Share price
Risk

Financial performance indicators

Capital structure

Proportion of company assets (funding) obtained through debt and equity

Usually measured by debt to equity ratio (D/E)
Higher debt levels increase financial risk; i.e. firm may not be able to
meet interest payments
Also measured by proprietorship ratio, which is the ratio of shareholders
funds to total assets
Indicates firms longer term financial viability/stability; a higher ratio
indicates less reliance on external funding

Financial performance indicators

Liquidity
The ability of a company to meet its short-term financial obligations

Measured by current ratio

Fails to consider the not very liquid nature of certain current assets,
such as inventory

Current ratio current assets (maturing within one year)

current liabilities (due within one year)

Financial performance indicators

Liquidity (cont.)
Measured by liquid ratio
The higher the current and liquid ratios, the better the liquidity position of a
firm

Liquid ratio current assets - inventory (stock on hand)

current liabilities - bank overdraft

Financial performance indicators

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

Measured by interest coverage ratio

Interest cover earnings before finance lease charges, interest and tax
finance lease charges and interest

Financial performance indicators

Profitability

Wide variation in the measurement of profitability

Earnings before interest and tax (EBIT) to total funds ratio
Earnings per share (EPS)

EBIT to total funds ratio

EBIT
total funds employed (shareholders' funds and borrowings)

Financial performance indicators

Profitability (cont.)

Wide variation in the measurement of profitability (cont.)

EBIT to long-term funds ratio

EBIT to long- term funds ratio

EBIT
long- term funds (i.e. total funds less short - term debt)

Financial performance indicators

Profitability (cont.)

Wide variation in the measurement of profitability (cont.)

Return on equity (net income/equity)
Higher ratios indicate greater profitability

Return on equity

net income
equity (shareholders' funds)

Financial performance indicators

Share price
Represents investors view of the present value of future net cash flows of a
firm

Share price performance indicators

Price to earnings ratio (P/E)
Share price divided by earnings per share
A higher P/E indicates more growth in future net cash flows
Share price to net tangible assets ratio (P/NTA)
Measures the theoretical premium or discount at which a firms
share price is trading relative to its NTA

Learning objectives

Evaluate and apply bottom-up and top-down approaches to fundamental

analysis

Describe and apply technical analysis techniques

Examine the role of program trading

Explain the theoretical concepts and implications of the random walk and
efficient market hypotheses when forecasting share price movements

Share price
Share price is determined by supply and demand of a companys
shares
Expectation of bad company performance causes investors to sell
their shares, increasing supply and reducing the price
Expectation of good company performance increases demand and
leads to an increase in share price

What causes the shifts in demand and

supply of a companys securities on the
secondary market?

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Share price

Three approaches to answering this question

1.

Fundamental analysis: top-down

2.

Fundamental analysis: bottom-up

3.

Technical analysis

Fundamental analysis
Considers macro and micro factors that impact upon cash flows and
future share prices of various industry sectors and firms
Macro factors include interest rates, economic growth, business
investment
Micro factors are firm-specific and relate to managements
impact on company performance

15

Top-down approach
Considers macro factors
Economic growth of international economies
Exchange rates
Interest rates
Domestic economy
Growth rate
Balance of payments
Inflation
Wage and productivity growth
Government responses to changes in the above factors

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Economic growth
The higher the growth rate in the rest of the world, the greater the
demand for Australian exports
Sectors benefitting from international growth determined by source of
the growth
Growth can be driven by:
increased consumer demand
increased business investment in equipment

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Flip side of growth

Generally, greater domestic growth leads to increased profitability of
firms
But high growth can lead to any of the following factors that can
reduce firm profitability:
Deterioration in balance of payments
Increase in inflationary pressures
Pressure on wages
Depreciation of the exchange rate
Rise in interest rates

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Currency
Affect the domestic currency profit of exporters that quote their
products in foreign currency prices
A strengthening Australian dollar (AUD) makes these firms worse
off because the AUD value of their exports is lower
The strength of the AUD over the past few years has led to calls
for assistance from the manufacturing industry, for example
Exchange rates also affect firms indirectly
E.g. devaluation of currency increases cost of imports, thereby
increasing inflation

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Interest rates
Have both a direct and indirect impact on a firms value
Direct effect on profitability
Represents the cost of debt finance for borrowers and the
return for finance providers
Indirect effect on profitability
Rise in interest rates may indicate a slowing of economic
activity
Future reduction in profitability
A strong relationship exists between interest rates and exchange
rates

20

Balance of payments
If current account is in deficit (i.e. total international payments exceed
total international receipts):
some export income is diverted to service debt
need to borrow foreign currency to service debt
Indirect effect on firms profitability
Government may increase interest rates to slow economic
growth and control the debt

21

Inflation
Effect of inflation on firms real profit
Tax treatment of inflation
Makes historical-based depreciation allowances inappropriate
Combined with higher replacement costs, leads to an
overstatement of after-tax profit
Inventory
Inflated selling price of inventory creates an illusion of inventory
profits

22

Bottom-up approach
Following identification of 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
Bottom-up approach considers micro factors using ratios and other
measures of a firms financial characteristics and performance
Considers factors such as:
Accounting ratios that assess a companys capital structure,
liquidity, debt servicing, profitability, share price and risk (see
Chapter 6), observing the trend and making comparisons with
firms in the same industry
Additional information on key management changes, corporate
governance and strategic direction

23

Comparing companies

24

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
Two main forecasting models

Moving averages (MA)

Charting

25

Moving averages
Smooth out a series facilitating the identification of trends in the series
Calculation of MA
Assuming a five-day moving average, the MA is calculated by
taking the average of the price series for the preceding five days
Trading rules
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
Sell when the MA is in decline and the price series cuts or touches
the MA from below for only a few observations
26

Charting
Investigating patterns in price charts
Several techniques
Trend lines
Support and resistance lines
Continuation patterns
Reversal patterns

27

Trend lines
Trends are regular movements in share prices
Two types of trends
1.

Uptrend lineconnecting the lower points of rising price series

2.

Downtrend lineconnecting the higher points of falling price

series

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

channel
Critical issue is to determine when the trend line is going
to change

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Support and resistance lines

Support levelswhere there is sufficient demand to halt further price

falls

Resistance levelswhere there is sufficient supply to halt further

price increases

Strong levelshistorical support and resistance

Weak levelssupport and resistance based on more recent activity

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Continuation patterns
Sideways share trading that does not normally signal a change in trend
Two types
1.

Trianglescomposed of a series of price fluctuations, each

smaller than its predecessor

Symmetrical triangle (no change in trend); ascending triangle

(uptrend); descending triangle (downtrend)
2.

Pennants and flagsformed during a sharp rise in prices (the

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

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Reversal patterns
Occur after a major market move
Result in a head and shoulders pattern
Three successive rallies and reactions, the second rally being
stronger than the first and third rallies
i.

Left shoulderformed by volume-strong rally on uptrend,

followed by reduced-volume reaction

ii. Headsecond rally increases price before reaction moves

price back to previous low
iii. Right shoulderfinal rally marked by reduced volume
indicating price weakness

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Validity of technical analysis

Even where techniques have no apparent underlying validity, if they

are followed by enough participants they may impact on share price
behaviour at times

More likely to forecast successfully when share prices move out of a

range explained by economic and financial fundamentals

32