Equity Markets II: Equity and Investors

Equity and Investors

Investors in The Share Market

Investors

• Investors purchase shares to gain returns through dividends and capital gains or losses.

• Debt vs. Equity:

  • Cash Flow: Debt involves coupon payments, while equity involves dividends.

  • Return: Debt has fixed returns, while equity has variable returns.

  • Maturity: Debt has a fixed maturity, while equity is indefinite.

  • Redemption: Debt is redeemed, while equity is not.

  • Claim on Income and Assets: Debt has priority, while equity has a residual claim.

  • Management Influence: Debt has usually little influence, while equity varies.

  • Tax Consequences: Debt is tax-deductible, while equity is non-deductible.

Share Markets

• Wide Range of Security Types:

  • Shares

  • A-REITS (Australian Real Estate Investment Trusts)

  • Exchange Traded Products (ETFs, ETMFS, etc.)

  • Listed Investment Companies & Trusts (LICs, LITs)

  • MFunds

  • Hybrids

  • Bonds

  • ASX Options Knowledge Hub

  • Warrants

  • Investing in Futures

  • Indices

Equity Funding Alternatives

• Available to established companies with solid track records:

  • Rights Issue

  • Placements

  • Dividend Reinvestment Schemes

  • Preference Shares

  • Convertible Notes

ASX Sectors

• Securities are categorized into industry groups, providing investors with choices across various economic sectors.

• The Australian share market consists of 11 sectors, 24 industry groups, 68 industries, and 157 sub-industries.

• Companies are classified based on their primary business activity, following the Global Industry Classification Standard (GICS).

• Australia’s 11 GICS sectors each have a benchmark index that tracks the performance of ASX-listed companies in that sector.

• The constituents of the ASX sector indices are selected from the S&P/ASX 200.

Share Market Indices

• A share market index tracks the performance of a group of stocks, providing a snapshot of market trends and investor sentiment, and assisting with investment strategies.

• Examples include S&P/ASX 200 indices for various sectors (e.g., Financials, Materials, Health Care, etc.).

• Weighting Method: Float-adjusted market cap weighted.

• Rebalancing Frequency: Quarterly in March, June, September, and December.

• Calculation Frequency: Real time.

• Calculation Currencies: AUD.

• Launch Date: April 3, 2000.

Share Market Investment

• Returns can be generated through dividends and/or capital gains (or losses).

• Two Types of Risk:

  • Systematic Risk: Factors that broadly affect share prices in the market.

  • Unsystematic Risk: Factors that specifically impact a corporation's share price.

Diversification and Risk

• A diversified portfolio reduces unsystematic risk.

• Systematic risk, measured by beta, reflects an asset's price sensitivity relative to the market.

• Expected portfolio return is the weighted average of individual share returns.

• Portfolio risk depends on the correlation between pairs of securities.

Active vs. Passive Investing

• Active Investment: Portfolio structure is based on share analysis and risk-return preferences.

• Passive Investment: Portfolio structure replicates a specific share market index.

• Other Factors to Consider:

  • Risk versus return

  • Investment time horizon

  • Income vs. capital growth

  • Domestic and international shares

Buying and Selling Shares

• Direct Investment: Buying and selling shares through a stockbroker (discount or full-service).

• Indirect Investment: Purchasing units in a unit trust or managed fund.

Taxation

Taxation Systems

1. Classical Tax System (pre-1987):

   • Companies pay corporate tax on their income.

   • Shareholders pay personal income tax on dividends.

2. Imputation Tax System (post-1987):

   • Companies pay corporate tax.

   • Dividends are paid with franking credits, representing company tax already paid.

   • Shareholders pay tax on the sum of the cash dividend and franking credits (grossed-up dividend).

Classical vs. Imputation Example

| Item | Classical | Imputation | $</p><table style="min-width: 75px"><colgroup><col style="min-width: 25px"><col style="min-width: 25px"><col style="min-width: 25px"></colgroup><tbody><tr><th colspan="1" rowspan="1"><p>Taxable Income$

$100$

$100$

$</p></td><td colspan="1" rowspan="1"><p></p></td><td colspan="1" rowspan="1"><p></p></td></tr><tr><td colspan="1" rowspan="1"><p>Company Tax (30$

30

30

$</p></td><td colspan="1" rowspan="1"><p></p></td><td colspan="1" rowspan="1"><p></p></td></tr><tr><td colspan="1" rowspan="1"><p>Net Profit After Tax$

70

70

$</p></td><td colspan="1" rowspan="1"><p></p></td><td colspan="1" rowspan="1"><p></p></td></tr><tr><td colspan="1" rowspan="1"><p>Cash Dividend$

$70$

$70$

$</p></td><td colspan="1" rowspan="1"><p></p></td><td colspan="1" rowspan="1"><p></p></td></tr><tr><td colspan="1" rowspan="1"><p>Taxable Income$

$70$

$100$

$Personal Tax Liability (45$

$31.50$

$45$

$</p></td><td colspan="1" rowspan="1"><p></p></td><td colspan="1" rowspan="1"><p></p></td></tr><tr><td colspan="1" rowspan="1"><p>Franking Credit$

$30$

$</p></td><td colspan="1" rowspan="1"><p></p></td><td colspan="1" rowspan="1"><p></p></td></tr><tr><td colspan="1" rowspan="1"><p>Personal Tax Paid$

$31.50$

$15$

$</p></td><td colspan="1" rowspan="1"><p></p></td><td colspan="1" rowspan="1"><p></p></td></tr><tr><td colspan="1" rowspan="1"><p>After-Tax Income$

$38.50$

$55$

Capital Gains Tax

• Payable on shares sold at a profit.

• 50% discount if held for at least 12 months.

• Capital losses can offset capital gains.

Financial Performance Indicators

Indicators

1. Capital structure

2. Liquidity

3. Debt servicing

4. Profitability

5. Share price

6. Risk

1. Capital Structure

• Proportion of funding from debt and equity.

• Debt-to-Equity Ratio (D/E):

  • D/E = \rac{Total Debt}{Shareholders' Equity}

  • Higher debt increases financial risk.

• Proprietorship Ratio:

  • \rac{Shareholders' Funds}{Total Assets}

  • Indicates long-term financial viability.

  • A higher ratio indicates less reliance on external funding.

2. Liquidity

• Company's ability to meet short-term obligations.

• Current Ratio:

  • $Current Ratio = \frac{Current Assets}{Current Liabilities}$

  • May not reflect illiquid assets like inventory.

• Liquid Ratio:

  • $Liquid Ratio = \frac{Current Assets - Inventory}{Current Liabilities}$

  • Higher ratios indicate better liquidity.

3. Debt Servicing

• Ability to meet debt-related obligations.

• Debt to Gross Cash Flow Ratio:

  • Indicates years of cash flow needed to repay debt.

• Interest Coverage Ratio:

  • $Interest Cover = \frac{Earnings Before Finance Lease Charges, Interest and Tax}{Finance Lease Charges and Interest}$

4. Profitability

• Measured by:

  • Earnings Before Interest and Tax (EBIT) to Total Funds Ratio

  • Earnings Before Interest and Tax (EBIT) to Long-Term Funds Ratio

  • Return on Equity (ROE):

    • $ROE = \frac{Operating Profit After Tax}{Shareholders' Equity}$

5. Share Price

• Reflects investors' view of future net cash flows.

• Price to Earnings Ratio (P/E):

  • $P/E = \frac{Current Share Price}{Earnings Per Share}$

  • Higher P/E suggests more growth in future cash flows.

• Share Price to Net Tangible Assets Ratio (P/NTA)

6. Risk

• Variability of share price.

  • Systematic Risk: Market-wide factors (calculated using beta).

  • Non-Systematic Risk: Firm-specific factors (can be diversified away).

Share Price Movements

Pricing of Shares

• Driven by supply and demand, influenced by information.

• Share price is the present value of expected future dividend payments:

  • $P<em>0 = \sum</em>{t=1}^{\infty} \frac{Div_t}{(1+r)^t}$

Valuing Shares

• Constant Dividend:

  • $P<em>0 = \frac{Div}{r</em>e}$

• Constant Dividend Growth:

  • $P<em>0 = \frac{Div</em>1}{r_e - g}$

• New information affecting expected dividends changes the share price.

Other Factors Influencing Share Pricing

• Cum-Dividend and Ex-Dividend Shares:

  • Share price falls on the ex-dividend date by the dividend size.

• Bonus Share Issues:

  • Downward price adjustment when shares go ex-bonus.

• Share Splits:

  • Price falls proportionally to the split.

• Pro-Rata Rights Issue:

  • Price falls based on the number of shares issued and discount size.

Share Price Movements (Chapter 7)

1a. Fundamental Analysis: Top-Down Approach

• Share price results from supply and demand.

• Based on supply and demand of shares.

• Bad performance expectations increase selling, decreasing price.

• Good performance expectations increase buying, increasing price.

• Considers macro and micro factors impacting cash flows and future prices.

1b. Fundamental Analysis: Bottom-Up Approach

• Identifies best companies using ratios and financial performance measures.

• Accounting ratios for capital structure, liquidity, debt servicing, profitability, share price, and risk.

• Considers Management changes, corporate governance and strategic direction

2. Technical Analysis

• Forecasts price movements using past price behavior.

• Charts of historical prices forecast future trends.

• Assumes non-random trends exploitable for profits.

• Uses indicators like moving averages and chart patterns.

• Assumes markets are dominated by mass psychology, creating regular patterns.

The Random Walk Hypothesis

• Price changes respond to new information in a random fashion.

• Each price point is independent of the previous one.

• Equal probability of price moving up, down, or unchanged.

The Efficient Market Hypothesis (EMH)

• Markets are information efficient; prices adjust immediately to new information.

• Fama's Three Levels of Market Efficiency:

  • Weak Form

  • Semi-Strong Form

  • Strong Form

Levels of Market Efficiency

• Weak Form:

  • Prices reflect past prices and volumes.

• Semi-Strong Form:

  • Prices reflect all publicly available information.

  • Must also be weak form efficient.

• Strong Form:

  • Prices reflect all available information (public and private).

  • Must also be semi-strong and weak form efficient.

The Behavioral Finance Hypothesis

• Do market prices deviate from EMH expectations due to irrational investors?

• Investors may not process information correctly or make suboptimal decisions.

• Based on psychological principles of investor behavior.

  • Prospect theory, overconfidence, loss aversion, framing, representativeness, cognitive dissonance, reference point dependence.