FM201 - Financial Institutions & Markets

Tutorial 6 Solutions

Chapter 7
1. Evans and Partners is an investment advisory firm that provides specialist investment advice
to its private clients. As part of the investment decision process, the senior investment
analysts at the firm apply the bottom-up approach to the fundamental analysis of share
prices. This approach focuses on the analysis of accounting ratios and other performance
measures.

a. Explain why Evans and Partners will use this type of analysis.

 Fundamental analysis considers macro and micro fundamentals that impact upon
future changes in share prices; includes the bottom-up approach and the top-down
approach.

 The bottom-up approach analyses the performance of specific corporations using

accounting ratios and other organisation specific information.

 Accounting ratios focus on measures of a company’s financial and management

performance, strength and efficiency over specific periods.

 An investor will calculate and compare the ratios of companies in the same industry.

 The investor will consider selecting the shares of companies with the strongest ratios
for inclusion in an investment portfolio.

 An investor should consider the bottom-up approach within the context of the top-
down approach.

b. Identify and discuss six different accounting ratios that should be included in a bottom-up
approach model.

 Current ratio—ratio of current assets to current liabilities

 Liquid ratio—ratio of current assets, less inventory, to current liabilities, less bank overdraft
 Interest cover ratio—the number of times a firm’s financial commitments are covered by
earnings
 EBIT to total funds ratio—the profits of a firm before allowing for interest expense and tax
payments divided by shareholders’ funds and borrowings
 EBIT to long-term funds ratio—EBIT divided by total funds less short-term debt
 FM201 - Financial Institutions & Markets
Tutorial 6 Solutions

 Return on equity—net income of a firm as a percentage of shareholders’ funds.

c. Identify and discuss three other performance measures that may be used.

 Earnings per share ratio—earnings attributable to an ordinary share

 Price earnings ratio—the current share price divided by the earnings per share
 Price to net tangible assets ratio—the current share price relative to the firm’s net tangible
assets.
2. Listed below are the close-of-business share prices for the Fortescue Metals over the last 10
trading days:

5.28 | 5.29 | 5.41 | 5.54 | 5.59 | 5.46 | 5.45 | 5.39 | 5.46 | 5.31

a. Calculate a five-day moving average.

Day Price Delete old Add new Sum of Moving

$ day 1 day 5 days 1 - 5 average
1 5.28
2 5.29
3 5.41
4 5.54
5 5.59 27.11 5.422
6 5.46 5.28 5.46 27.29 5.458
7 5.45 5.29 5.45 27.45 5.49
8 5.39 5.41 5.39 27.43 5.486
9 5.46 5.54 5.46 27.35 5.47
10 5.31 5.59 5.31 27.07 5.414

b. Why might a technical analyst seek to plot moving averages?

 The analyst is creating a price series showing price changes over time
 The technical analyst will seek to interpret the information that is evident within a price series
 FM201 - Financial Institutions & Markets
Tutorial 6 Solutions

 Construction of a moving average seeks to smooth out erratic price movements and reveal
clear price trends in the series
 From this data the technical analyst will employ buy or sell decision rules
 Buy when the actual 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, but then moves back above the MA after a few observations
 Sell when the MA flattens or declines after a steady rise, and the price series cuts the MA
from above
 Sell when the MA series is in decline and the price series cuts or touches the MA from below,
but then moves back beneath the MA after a few observations.

3. The random walk hypothesis is analogous to the Brownian motion model from physics, which
describes how microscopic particles bombarded by water molecules, for example, trace a
random haphazard pattern over time. Outline the main features of the random walk model
and discuss the appropriateness of the analogy between share price movements and the
random movements of physical particles.

 The random walk hypothesis contends that each observation in a time series such as share prices
is independent of the previous observation.
 If a share price rises in period one, there is an equal probability that in period two the price will
rise, fall or remain unchanged.
 Once the result for period two is observed, again there is an equal probability that in period three
the price will rise, fall or remain unchanged.
 Each share is assumed to have an intrinsic value that is based on investors' expectations about
the present value of the firm's future net cash flows.
 The price of the share is based on the latest information available and relevant to the company's
current state and its future prospects.
 Variations in the price of the share through time should only be in response to changes in the
relevant information that comes to the attention of the market concerning the company.
 FM201 - Financial Institutions & Markets
Tutorial 6 Solutions

 The analogy is only somewhat appropriate. In the short term, asset prices are not able to be
forecast and may be thought of as being random.
 However, asset prices cannot be purely random or they could drift ever higher or ever lower.
There must be some attachment to the fundamentals.
 More advanced models of the financial markets have improved significantly upon the basic
random walk hypothesis.
4. Briefly outline the main contentions of the efficient market hypothesis. In your answer,
discuss the contentions of the efficient market hypothesis within the context of technical
analysis and fundamental analysis. How can the hypothesis be tested? In your response,
distinguish between the weak, semi-strong and strong forms of efficiency.

 Efficient market hypothesis contends that markets are information-efficient and that share
prices reflect all available information.
 If this is the case extra profits cannot be made from superior information.
 This suggests that the two fundamental analysis approaches will not achieve higher results.
However, there is a need to consider the ability of market participants to understand, evaluate
and interpret that information.
 The efficient market hypothesis also argues that technical analysis is of no value as it relies the
repetition of past price patterns.
 Share markets are generally information-efficient and prices generally follow the random walk
process and reflect the current available information.
 Above-normal profits are unlikely to be made by using current information since it is likely to
already be reflected in the price of the share.
 Nevertheless, for some skilled analysts, and for those able to uncover not-yet-public information,
above-average rates of return may be available.
 The strength of the efficient market hypothesis is related to the level of efficiency of the markets;
that is, how quickly is information absorbed by the market and reflected in the share price
 There are three measures or levels of efficiency
 Weak form efficiency—share prices changes are independent and not based on historic data
 FM201 - Financial Institutions & Markets
Tutorial 6 Solutions

 Semi-strong form efficiency—all publicly available information is fully reflected in a share price
 Strong form efficiency—all publicly available information and private research is fully
reflected in a share price.