Importance of financial reporting to share purchasing - Free Essay Example

Nowadays, most of the people have invested in the capital market. For example, stock, bond, options, foreign currencies, etc. They all want to gain the profit what they want. Everyone is different. However, how can they predict the share price for purchasing or sale decision? Are there any influences of financial information to them for making decision? Before answering these questions, lets discuss what market efficiency is first. The term of capital market efficiency is used to describe the way in which the market absorbs information. An efficient capital market is that the information relating to a company is processed quickly and accurately and reflected in the share price. So, the shares will be fairly priced. Some new information such as profit warning, dividend announcements, new contracts have been signed, which alters the expectations of investors about the future prospects of the company, we should expect an instantaneous and unbiased reaction from the market in the form of a revised share price. (Dr Peter Atrill, ACCA, What every financial manager needs to know about market efficiency, 24 Feb 2002) There are three type of efficiency: Operational efficiency, this refers to cost, speed and reliability of transactions in securities on the exchange. We can achieve by creating as much competition between market makers and brokers as possible so that they earn not very high profit. Allocational efficiency, stock markets help in the process of allocating societys resources between competing real investments. For example, a large amount of funds is provided for the growth industries but small for slow-growth industries. Pricing efficiency, in a pricing efficient market the investor can expect to earn merely a risk-adjusted return from an investment as prices move instantaneously and in an unbiased manner to any news. Efficient market hypothesis (EMH) applies to this form of efficiency only. (Glen Arnold, Corporate Financial Management, 3rd ed., Financial Times) EMH (Fama 1964) is a theory that can predict the future prices of securities. It is assumed that the price of a security reflects all of the information available and everyone has some degree of access to the information. Famas theory breaks EMH into three forms. They are weak, semi-strong and strong. Weak form: All information contained in past price movements are fully reflected in share price. It is pointless basing trading rules on share price history as the future cannot be predicted in this way. Semi-strong form: Share prices fully reflect all the relevant publicly available information. Because of the market has already absorbed the information. So, there is no advantage in analyzing after is has been released. Strong form: All relevant information, including private information, is reflected in the share price. Even insiders are unable to make abnormal profits. (Glen Arnold, Corporate Financial Management, 3rd ed., Financial Times) However, EMH has been criticized by many authors and philosophers. EMH assumes that the investors have similar expectations, but if all of them had the same expectations, it would not be possible for security markets and security trading to emerge. Assuming all participants gave equal access to information is quite controversial. EMH gives the impression that security markets have no connection with real life, but the investments made in the market are used in the operations of companies in the real world. Behavioral Finance (BF) is a concept that has become widely popular in recent years. It focuses on how investors interpret their knowledge then makes decisions based on information and how they act with their investment decisions. It has developed as a result of increasing interest of psychologists in economics. (Murat Kiyiar, Okan Acar. Annales Universitatis Apulensis: Series Oeconomica. Behavioural finance and the study of the irrational financial choice of credit card isers, Alb a lulia: 2009. Vol.11) Emotion, one of the most important factors, affects the investors decisions. BF approach investigates the influence of emotions on investment decisions. In converse to the EMH, BF is based on the investor behavior in the market. And also, BF states that markets are not effective, overreaction or lack of reaction has been shown the proof to us. Technical analysis: For those shortsighted investors, they may use this analysis to make the profit in a short time. Evaluate securities by studying the statistics generated by market activity on those securities. Using charts of stock performance, identify past patterns and trends and then to determine the future stock price. (William Ainson, Financial Planning, New York: Mar 2011. Vol. 41, Iss.3) Fundamental analysis: In my viewpoint, I think this analysis is only suitable on longsighted investors, not for the day traders. It is because research is required to determine the securitys intrinsic value. Investors rely on the companys annual report, competitive environment facing by the company, or any current news relating to the companys operations, to analyze its future growth, business prospect, financial strength and management skills, in order to determine whether the share price is overvalued or undervalued. Investors normally will focus on the following ratios by using the income statement and balance sheet which are inside the annual report. Such ratios are earning per shares, P/E ratio, Return on Equity, etc. Both technicians and fundamentalists have developed certain techniques to predict prices from financial information. Such financial information includes the company financial statements, company announcements. Let me show you some example that companys announcement affect its share price. The first example is Asia Energy Logistics Group Limited, which is listed in HK, stock code is 351. The company followed the HK Listing Rule 13.09 (1) issue an Announcement. This was a profit warning Announcement because the company expected to record a substantial loss for the year ended 31 December 2010 compared with last year. The company wanted to inform shareholders and potential investors should exercise caution when dealing the shares or other securities. The Announcement was announced on 25 March 2011 at 8 p.m. Due to this Announcement is the bad news to the company. So, we may expect that this information will reflect on 28 March 2011 trading hours. The truth was that the closing price of the company on 25 March is $0.171. The company recorded a maximum 18.1% decrease at 28 March. And the closing price is $0.150. A decrease of 12.3% compared with the last closed price. Another example is Li Fung Limited, one of the constituent of Hang Seng Index, stock code is 494. The company issued its final result of 2010 on 24 March 2011 after the trading hours. The sales were increase 19% to HK$124 billion and the profit attributable to shareholders was increased 27% to HK$4,278 million. However, on the next day, the share price of the company decreased from $42.95 to 39.05. On 28 March, the closing price fell to $37.55. You may ask the performance is better than the last year, why the share price would fall? It is because the company cant meet the targets which were set in the annual report of 2007. Referring to the report, the targets were that the sales of 2010 were expected to US$200 billion and the net profit of core business was US$1 billion. Explained by that company the reasons are that due to the unexpected onset of the global financial crisis and economic downturn of 2008 and 2009 resulted in soft consumer markets in the US and Europe that compromis ed the companys ability to achieve these targets. So, although the performance of the company is better than the last year, the share price was also fall because of the company can not meet the target. By looking at these two cases, we can proof that financial information issued by the company will affect the performance of the share price. And also this information can predict the share price. In order to derive a summary measure to predict the direction of future earnings changes of companies, Ou and Penman (1989) performed an extensive analysis. They assigned the companies to long and short positions on the basis of calculated summary measure and the profitability of investing in a hedged portfolio was examined. Their version of fundamental analysis involved the reduction of a large array of financial statement information into a scalar measure called Pr. The main aim of the study was to asses whether the Pv measure captured information that was not reflected in prices. The descriptors should have the ability to forecast stock returns if the prices did not reflect the information about future earnings and later gravitated towards fundamentals. (Ou, J.A. and Penamn, S.H. (1989b), Financial statement analysis and the prediction of stock returns, Journal of Accounting and Economics, Vol. 11) Holthausen and Larcker (1992) predicted stock returns from accounting data. They also analyzed specifications for measuring excess returns such as market adjusted returns, computed using CAPM and size adjusted returns in order to investigate whether their fundings were influenced by the method of excess return calculation. (Holthaisen, R. W. and Larcher, D.F. (1992), The prediction of stock returns using financial stetment information, Journal of Accounting and Economics, Vol. 15) Therefore, investors could use both current and historical earnings data to predict the share price response to future earnings announcements. As Mr. Right agree the EMH and said the information contained in the annual reports is already included in share prices before the information is published. The report cant help us for making share purchasing or sale decisions. However, I dont agree with his opinion because I think EMH is a perfect theory. In the stock market, the information is not perfect efficient, insider dealing must be contained in the market. Some people may know the companys news before they issue to the public. And all some analysis needs cost to analyze. So, not every people can obtain these kinds of information. So, the share price can not reflect the company value accurately. Investors are irrational, if something happens that will make them afraid, they will follow the other peoples action. For example, people were afraid that the radiation would be released from Japan. They heard that salt can prevent radiation. So, everyone go to buy salt. The price becomes increase from $2 per bag to $10. It is not a reasonable price. However, they also buy it quickly. It can also apply to the stock market. Subject to this case, we can see that people are irrational. So, I suggest that investors should use financial information to evaluate their decisions. (1,607 words) REFERENCE: Dr Peter Atrill, ACCA, What every financial manager needs to know about market efficiency, 24 Feb 2002 Glen Arnold, Corporate Financial Management, 3rd ed., Financial Times Murat Kiyiar, Okan Acar. Annales Universitatis Apulensis: Series Oeconomica. Behavioural finance and the study of the irrational financial choice of credit card isers, Alba lulia: 2009. Vol.11 William Ainson, Financial Planning, New York: Mar 2011. Vol. 41, Iss.3 Ou, J.A. and Penamn, S.H. (1989b), Financial statement analysis and the prediction of stock returns, Journal of Accounting and Economics, Vol. 11 Holthaisen, R. W. and Larcher, D.F. (1992), The prediction of stock returns using financial stetment information, Journal of Accounting and Economics, Vol. 15