FEATURE
PAPER
The
Usefullness of Ratio Analysis in Predicting Stock Market Returns
The
following paper was presented at the 2006 Allied Academies Conference.
It was written by Jonathan E. Miller and Frank W. Bacon of Longwood
University.
Background
There
is much debate over the ability of firms to earn an above-normal
return using either rules of investing or ratio analysis. If
the capital markets are weak-form efficient then the market will
already have reacted to the past information embodied in financial
ratios. Theoretically, if the average investor responds irrationally
to past information, arbitrageurs would short those stocks
that are over-priced and buy those that are undervalued pushing over-priced
shares down and under-priced shares up. Therefore, if capital markets
are always weak-form efficient, one should not be able to predict return
or change in stock price using financial ratios, because the price of
a stock should already reflect the information in those ratio's. If the
stock returns can be predicted using financial ratios, investors could
use that information to make greater profit than the market as a whole.
Research
Problem
Though some
researchers believe that the markets are efficient enough to
render ratio analysis useless, there is some evidence that markets
may not always be efficient and that ratio’s can help predict
returns. The set of ratio’s that may be useful for this
purpose include B/M (book to market), P/E (price to earnings),
and DY(dividend yield). It would be valuable to any investor
to
determine to what extent the market is inefficient and, therefore, whether
one can out-think the market and earn above normal returns. Presumably,
if the market is efficient, then, holding growth constant, neither B/M
nor market capitalization should effect the average firm’s return
over any period. Dividend Yield should have already been incorporated
in stock prices after holding growth constant, therefore, over the time-period
of the study, it should not have a statistically significant effect on
return assuming the truth of the EMH.
Read the Entire Paper...
TIP
OF THE WEEK
How
Much Should You Pay?
Even if you don't plan to buy an existing business, the methods
of evaluating one are useful in appraising the success of any firm.
When you make a substantial financial investment in a business,
you should expect to receive personal satisfaction as well as an
adequate living. A business bought at the wrong price, at the wrong
time, or in the wrong place can cost you and your family more than
the dollars invested and lost. After you have thoroughly investigated
the business, weighted the information collected, and decided that
the business will satisfy your expectations, a price must be agreed
on.
Determining the purchase price for a business involves analyzing
several important factors: (1) valuation of the firm's tangible
net assets; (2) valuation of the firm's intangible assets, especially
any goodwill that has been built up; (3) expected future earnings;
(4) the market demand for the particular type of business; and
(5) the general condition of the business (including completeness
and accuracy of its records, employee esprit de corps, and physical
condition of facilities).
A beginning point (not a finely tuned ending point) for business
valuation is the multiple method. This approach is based on a formula
that applies a weighting factor to the previous year(s) Owner Benefit
to arrive at a possible purchase price. The Owner Benefit is a
combination of several factors:
Pretax Profit + Owner's Salary + Additional Owner Perks + Interest
+ Depreciation
Most small business will sell for a one to three
times multiple of this figure. Granted, this is a wide range,
so how do you determine
which multiple to apply? Use a one-time multiple for those business
where the seller is "the business" - such as consulting
businesses, professional practices, and one-person businesses.
Three-times multiples are more appropriate for business that have
been existence for several years, have demonstrated sustainable
growth, boast a solid base of clients, own assets that will not
have to be replaced in the immediate future, and are involved in
growth industries, among other things. A study of hundreds of businesses
sold in a recent year in the state of Florida indicated that the
average multiple was 2.1 times the Owner Benefit.
Approaches to valuing a business that focus on the value of the
business's assets are called balance sheet methods of valuation.
They are most appropriate for businesses that generate earnings
primarily from their assets, rather than from the contributions
of their employees. Approaches that focus more on the profits or
cash flows that a business generates are called income
statement methods of valuation.
As methodology, discounted cash flow (an income statement method)
is often considered the preferred toll with which to value businesses.
What sets this approach apart from the other approaches is that
it is based on future operating results than on historical operating
results. As a result, companies can be valued based on their future
cash flows, which may be somewhat different than the historical
results, especially if the buyer expects to operate aspects of
the businesses differently.
Discounted cash-flow analysis consists of projecting future cash
flows (generally for five years) before debts are subtracted and
after taxes are paid. A discount rate (expressed as a percentage
that represents the risk associated with the investment) is then
derived and applied to the future cash flows and terminal value
( a current value for a company's long-term future cash flows).
This detailed analysis depends on accurate financial projections
and specific discount rate assumptions.
| Timothy
S. Hatten. Small
Business Management - Entrepreneurship & Beyond. Houghton
Mifflin Company. Boston. 2006. Pages 172& 173. |
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CONFERENCES
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| Who: |
The
National District Export Council Conference
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Adversity
and the Benefits of International Trade
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| Where: |
New
Orleans, USA |
| When: |
October
30 - November 1, 2006 |
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ALLIED
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Allied
Academies
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2006 Fall International Conference
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Atlantis Casino Resort & Spa,
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October 19-21, 2006 |
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CEE
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Consortium
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| What: |
24th Annual Entrepreneurship Education
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Phoenix,
Arizona, USA |
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November 4-7, 2006 |
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CHAOS
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Center
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The 2006 Chaos Conference
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Austin, Texas, USA |
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November 17-18, 2006 |
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NVC
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New
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New
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Embassy Suites - Portland, Oregon, USA |
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April, 12, 2007 |
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Social
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Second
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July
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AIMS4
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Fourth
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Indian
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December
28-31, 2006 |
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ICSM
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ICSM
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2007
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April 19-20, 2007 |
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ASBBS
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American
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| What: |
14h
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and
Behavioral Sciences
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Imperial
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| When: |
February
22-25, 2007 |
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Hawaii
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7th
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Waikiki
Beach Marriott Resort & Spa, Honolulu Hawaii, USA |
| When: |
May
24-27, 2007 |
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