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Part I: An Introduction

1. An Overview


Having read Corporate Valuation and Takeover (2011) or any other texts from the author's bookboon series referenced at the end of this Chapter, you should have a critical understanding of how financial securities and companies are valued. In this free compendium of Exercises we shall reinforce the theory and application of stock market analysis as a guide to further reading.

Armed with the Corporate Valuation and Takeover companion text (CVT henceforth) you should have no conceptual problems with the following material. But remember the concepts need to be applied and we live in extremely difficult times where more than ever, past performance may be no guide to the future.

Since the millennium crash, every year has been dramatic for stock market participants. After a five year "bull" run followed by global banking meltdown in 2007-8, economic recession has seen a number of Western governments (including America) unable to repay their debts and their credit status downgraded.

The subsequent eurozone credit crisis saw the departure of four European prime ministers in late 2011 (Greece, Italy, Ireland and Spain) and the credit rating of Portugal reduced to "junk" status in early 2012. With tighter stock market regulation, increased International Monetary Fund (IMF) and central banking intervention, investors (institutional or otherwise) continue to make provision for massive losses, which imposes a huge restriction on stock market liquidity worldwide.

To reflect these events, we will consider a number of worst case scenarios where appropriate. The Exercises will also compare ideal investment decisions with those to be avoided. But remember these are only hypothetical examples.

A Guide to Further Study

To keep up to speed with real world events as they unfold, I suggest that you acquire informed comment from quality newspapers, financial websites, corporate and analyst reports, plus any topical material that you come across as you trawl the Internet during your studies. Do read share price listings looking for trends based on the stock market ratios explained in CVT and summarized in the Appendix to this text (price, yield, cover and the price-earnings ratio).

Focus on a few companies of your choice. Look back over a number of years to get a feel for how they have moved within the context of the market. Pay particular attention to company profit warnings, analyst downgrades, director share dealings, takeover activity and rumour. This research need not be too formidable, particularly if you are studying with friends and have CVT for reference.

Modern Finance: A Review

Part One of CVT explains why contemporary financial analysis is not an exact science and the theories upon which it is based may even be "bad" science. The fundamental problem is that economic decisions are characterized by hypothetical human behavior in a real world of uncertainty. Thus, theoretical financial models may be logically conceived. But all too often, they are based on hypotheses underpinned by simple assumptions that rationalize the complex world we inhabit with little empirical support. At best they may support your conclusions. But at worst they may invalidate your analysis.

Yet as we observed, most modern theorists, academics and analysts still cling to the simplistic normative objective of shareholder wealth maximization based on "rational" investment decisions, premised on NPV maximization techniques designed to deliver the highest absolute profit. Underpinned by the Separation Theory of Fisher (1930) that assumes perfect capital markets, characterized by freedom of information and no barriers to trade:

Shares are always correctly priced by the market at their true intrinsic value. The consumption (dividend) preferences of all shareholders are satisfied by the rational managerial investment policies of the company that they own, based on the agency principle formalized by Jenson and Meckling (1976).

Even when modern financial theory moves from a risk-free world to one of uncertainty, Fisherian analysis remains the bedrock of rational investment. Statistically, it defines how much return you can expect for a given level of risk, assuming project or stock market returns are linear random variables that conform to a "normal" distribution. For every level of risk, there is an investment with the highest expected return. For every return there is an investment with the lowest expected risk. Using mean-variance analysis, the standard deviation calibrates these risk-return trade-offs. Corporate wealth maximization equals the maximization of investor utility using certainty equivalence associated with the expected NPV (ENPV) maximization of all a firm's projects.

According to Modern Portfolio Theory (MPT) based on the pioneering work of Markovitz (1952), Tobin (1958) and Sharpe (1963) if different investments are combined into a portfolio, management (or any investor) with the expertise can also plot an "efficiency frontier" to select any investment's trade-off according to their desired risk-return profile (utility curve) relative to the market as a whole.

So far so good, but what if capital markets are imperfect, information is not freely available and there are barriers to trade? Moreover, what if corporate management and financial institutions pursue their own agenda characterized by short-term goals at the expense of long-run shareholder wealth maximization, as the previous decade's catastrophic events suggest? Are shares still correctly priced and are financial resources still allocated to the most profitable investment opportunities, irrespective of shareholder consumption preferences. In other words, are markets efficient once the agency principle breaks down?

Like all my other texts in the bookboon series, CVT suggests they are not. Post-modern theorists with their cutting-edge mathematical expositions of speculative bubbles, catastrophe theory and market incoherence, believe that investment returns and prices may be non- random variables and that markets have a memory. They take a non-linear view of society and dispense with the assumption that we can maximize anything. Unfortunately, their models are not yet sufficiently refined to provide the investment community with alternative guidance in their quest for greater wealth.

Nevertheless, post-modernism serves a dual purpose. First, it justifies why the foundations of traditional finance may indeed be "bad science" by which we mean that theoretical investment and financing decisions are all too often based on simplifying assumptions without any empirical support. Second, it explains why the investment community still works with imperfect theories. As a consequence, it reveals why they should always interpret their results with caution and not be surprised if subsequent events invalidate their conclusions.

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