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Unformatted text preview: Ec 173A FINANCIAL MARKETS LECTURE NOTES Foster, UCSD 30-Aug-08 TOPIC 7 EFFICIENT MARKETS HYPOTHESIS A. Stock Analysis 1. Corporate Accounting in 5 Minutes: a) Accounting and financial ratios are taught in Ec 4 and Ec 173B, but we need some familiarity with them now. b) The Income (aka Profit and Loss) Statement -- = TR TC. 1) Records flows of revenues, costs and profits over a fiscal year. 2) Costs include materials, operating and overhead costs, depreciation, interest obligations on bonds, and corp profits taxes. 3) Earnings are Net (Net Income) after taxes and interest. 4) In the example above, the corporation has issued no preferred stock. c) The Balance Sheet -- Assets Liabilities = Equity. 1) Records assets, liabilities, and net worth (owner equity) at the end of a year. 2) Assets show value of what the company owns (cash, capital equipment, securities). 3) Liabilities show size of what the company owes ; the firm's debt obligations (par values of outstanding bonds, unpaid principal on bank loans). 4) Equity is the net value of what the owners own. It consists of the money they placed in the company when it started (paid-in capital = common shares IPO share price) plus accumulated retained earnings. Income Statement 20XX Revenue = TR Cost+Tax = TC 1,000 900 Net Earnings = 100 Preferred Dividends Earnings on Common Common Shares = N c EPS $0 $100k 25,000 $4 Balance Sheet (31 DEC 20XX) A SSETS L IABILITIES Current Assets Short Term Debt Long Term Debt Fixed Assets: Plant Equipment Structures Total = $400m C OMMON E QUITY Capital + Ret. Earn. Total = $500m Total = $100m Ec 173A EMH p. 2 d) Companies divide earnings on common between dividends distributed to shareholders and additions to retained earnings. Let D = annual dividend/share. Some ratios: 1) Earnings per share: EPS = EARNINGS ON COMMON/N c 2) Return on Equity: ROE = /COMMON EQUITY 3) Dividend Payout Ratio: d = D/EPS 4) Earnings Retention or Plowback Ratio: e = 1 d 5) Price-Earnings Ratio: P/E = P /EPS 2. Picking Winners and Losers: a) Stock analysts examine characteristics of stock prices and prospects for the corporations that issue the stock to try to determine the intrinsic value P . 1) If one can consistently pick winners, the return on investment will exceed the market average return r m , which would be the return on a broad based stock mutual fund that is representative of the total population of publicly traded common stocks. 2) We will see later that it is anywhere from difficult to impossible to beat the market average rate of return. 3) There are two basic approaches to stock analysis, technical and fundamental. b) Technical analysis (chartism)....
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