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Financial Institutions, Instruments and Markets

8th edition
Instructor's Resource Manual
Christopher Viney and Peter Phillips

Chapter 6
Investors in the share market
Learning objective 6.1: Consider the role of an investor in the share market, appreciate the wide
range of investment choices that are available, and understand risks associated with investments
in shares of listed corporations

Securities quoted on a stock exchange provide investors with an enormous range of investment

A corporation makes no promise of a return to ordinary shareholders, so the higher level of risk
attached to these securities creates an expectation in the investor of a higher level of return, on
average, over time.

A stock exchange brings buyers and sellers together to form an efficient, deep and liquid market
in securities.

A share in a listed company, in part, entitles an investor to receive a return on the investment in
the form of any dividends paid and any capital gain or loss accumulated on the current market
value of the share.

Risks associated with share investments are described as systematic and unsystematic.
Systematic risk exposures affect the price of most shares listed on a stock exchange, to a greater
or lesser extent. Unsystematic risk specifically impacts on the share price of individual stocks.

Portfolio theory demonstrates that, by holding a diversified share portfolio, unsystematic risk can
be substantially reduced. The remaining systematic risk is measured using a beta coefficient.
This is a statistical measure of the sensitivity of a share price relative to an average share listed
on a stock exchange.

Investors will consider the cash-flow and investment characteristics of a particular share. An
investor may adopt an active or a passive share investment approach.

The active approach might use fundamental analysis or technical analysis to structure a portfolio
to meet the investors personal risk and return preferences.

With a passive approach, an investor will seek to replicate the structure, and therefore the return,
of a specific share-market index.

Within a diversified share portfolio the investor will consider the correlation of risk and return
between shares.

Finally, the allocation of shares within the portfolio will be both strategic, in that it meets the
investors personal preferences, and tactical, in that it will be monitored and managed to take
account of new information that comes to the market.

Learning objective 6.2: Detail the process for buying and selling of shares

An investor buying or selling shares can take a direct investment approach or an indirect

With the direct approach an investor will select the shares to be included in a portfolio. The
transaction will usually be carried out through a stockbroker.

A stockbroker accepts buy or sell orders from investors and acts as the agent in placing the
orders into the stock exchanges trading system.

The share trading system used by the ASX is known as ASX Trade and the transfer and
settlement system is known as CHESS. Settlement occurs in T + 3 business days.

A broker may be a discount broker that executes transactions but does not provide investment
advice. A full-service broker will execute buy and sell orders, but will also provide investment
advice and some other financial services.

With the indirect investment approach, an investor does not select the stocks to be held in a
portfolio; rather the investor purchases units in a managed fund such as a public unit trust.

Learning objective 6.3: Understand the importance of taxation in the investment decision process

Taxation will impact on the net return received by an investor. Taxation regimes vary
considerably between countries. However, two major taxes that may be imposed on the return of
a shareholder are income tax and capital gains tax.

An investor needs to consider the level of income tax payable. For example, is income taxed at a

flat rate or a marginal rate? Are realised capital gains taxed or not, and at what rate?

For example, in Australia the marginal tax rate ranges up to 45 per cent,plusa1.50percent
Medicarelevy. Generally, fifty per cent of a realised capital gain is also taxed at the taxpayers
marginal income tax rate.

However, there is a tax benefit available to Australian shareholders known as dividend

imputation. The dividend imputation system enables corporations to pay franked dividends to
shareholders, whereby the company tax paid on profits can be passed as a franking credit to the
shareholder. This reduces the amount of tax payable by the shareholder.

Learning objective 6.4: Identify and describe various indicators of financial performance

When analysing a share investment opportunity, an investor should consider a range of financial
performance indicators.

Measures of a companys liquidity, such as the current and liquid ratios, provide an indication of
the companys ability to meet its short-term financial obligations.

The long-term financial viability of a company is indicated by the companys capital structure, as
measured by the debt-to-equity ratio or the proprietorship ratio.

Past profitability may be measured by different earnings ratios. These include the earnings before
interest and tax (EBIT) to total funds ratio, the EBIT to long-term funds ratio and the after-tax
earnings on shareholders funds ratio.

Another important indicator is the companys ability to ensure its solvency by being able to meet
its short-term financing commitments. This is frequently measured through the ratio of debt to
gross cash flows, or through the ratio of EBIT to total interest.

An investor may also rank companies on the basis of the markets current valuation of the
business and its prospective earnings stream. Indicators of market valuation are obtained through
the price to earnings (P/E) ratio and the ratio of share price to net tangible assets.

Learning objective 6.5: Apply quantitative methods to the pricing of shares

Investors are interested in estimating the current market price of a share. The price may be said
to be a function of the supply and demand for a stock. This is influenced by future earnings

The price of a share is theoretically the present value of its future dividend streams. New
information that changes future earnings forecasts will also change the share price.

The future dividend payments of a corporation may be constant over time; in this case, the

dividend payment is simply divided by the required rate of return to estimate the share price.

Alternatively, a dividend payment may increase over time. It is assumed that that increase will be
at a constant growth rate. To calculate the share price, the last dividend is multiplied by the
constant growth rate; this is then divided by the required rate of return less the growth rate.

There are other more mechanical issues that affect a companys share price. These include the
price adjustments that occur when a share trades ex-dividend. All other things being equal, a
cum-dividend share price should fall by the amount of a dividend that is paid.

If a company makes a bonus issue to shareholders, where no new capital is raised, the share price
will theoretically fall by the relative proportion of new shares issued.

A similar price adjustment expectation will occur with a share split. A share split changes the
number of shares issued by a corporation, again without raising additional capital.

Another reason for an adjustment in a shares price is that, if it has been trading with an
entitlement to participate in a rights issue, the theoretical ex-rights price will be lower than the
cum-rights price.

A renounceable right has a value in that it can be sold before the rights issue exercise date.

Learning objective 6.6: Analyse the functions and importance of share-market indices and
interpret published share-market information

A stock-market index is a measure of the price performance of a specific sector of a share


S&PIndices provides specialist index management services to international stock markets and
compiles a range of different market and industry sector indices.

The global industry classification standard (GICS) comprises 10 industry sectors (energy,

An index may be a share price index or an accumulation index.

There is a wealth of share-market information that is published daily. Investors need to

understand and interpret this information.

Essay questions


1. Portfoliomanagementdrawsonsomewellknownstatisticalconcepts,includingaverages,
Theexpectedreturnonaportfoliomaybeestimatedbytheaverageofits pastreturns.The
The variance of portfolio is a function of the variance of the variance of each individual
provide an indication of the soundness of the diversification strategy. If many pairs of

2. MsBrownhasaninvestmentportfoliocomprisingAustralianshares.Atameetingwithher


In its basic form, risk comprises components of probability, variance, volatility and uncertainty.
Probability is a statistical estimate of a variance in an expected outcome. Volatility relates to the
degrees of change that historically have occurred in outcomes over time and uncertainty is the
possibility that an unexpected outcome might occur.

Systematic risk is exposures of a share portfolio to changes in the environment that have the
effect of impacting the majority of shares listed on a stock exchange. For example, changes in
interest rates, exchange rates or economic activity.

Unsystematic risk relates to exposures that specifically affect the share price of a particular
corporation. For example, loss of key personnel or systems, or a downgrade of performance

(b) Why should an investor not expect to be rewarded for the unsystematic risk element in a
share portfolio?

An investor is able to minimise unsystematic risk by holding a diversified investment portfolio;

for example, a portfolio of shares, property and fixed interest investments. Within the share
portfolio the investor can hold shares in a number of companies, a range of industry sectors, and
across different countries.

Therefore, as investors are able to hold diversified investment portfolios, prices will not
incorporate a significant risk component for unsystematic risk.

3. An investor holds the following shares in an investment portfolio:

JB Hi Fi


beta 1.20



beta 0.95

ANZ Bank


beta 1.05

(a) What does each beta coefficient imply about the volatility of each companys shares relative
to the overall market?

Beta is the amount of systematic risk that is present in a particular share relative to the share
market as a whole.

The market has a beta of 1.0.


In the above portfolio, JB Hi Fi and ANZ have betas greater than 1.00. As such, they are more
volatile than the market. When the S&P/ASX 200 increases (decreases) by 10 per cent, JB Hi
Fis price will increase (decrease) by 12 per cent or 1.20 times as much. Following the same
market movement, ANZ shares will increase (decrease) in price by 1.05 times as much or, in this
case, by 10.50 per cent. Because Telstra has a beta of 0.95, it will move less than proportionally
with the market.

(b) What is the portfolios beta?

The weighted average beta of the portfolio is:










Telstra $8 600




ANZ $7 900




Weighted average beta =



(c) If the investor added to the portfolio with the purchase of $5000 worth of shares in Myer
(beta 1.60), what impact would that purchase have on the risk structure of the portfolio? (LO

If the investment in Myer is added to the portfolio the weighted average beta
of the portfolio becomes:





Myer $5 000




JB Hi Fi

$6 500



Telstra $8 600






ANZ $7 900




Weightedaveragebeta= 1.1523

By adding the risky investment in Myer, the investor has increased the
volatility of the portfolio. This is reflected in the increased systematic risk.

That is, the average weighted beta is now quite a bit higher than the market

4. Asaninvestment adviser foramanagedfundthatinvestsinAustralianresourcesshares,

youmustadviseclientsonthefundsstrategyofpassiveinvestment.Analyse and explain the
concept of passive investment to your client, and describe how the fund manager uses an index
fund to achieve a specific performance outcome. (LO 6.1)

Passive investment involves the selection of shares in an investment portfolio based on shares
included in a published stock market index, that is, a managed fund share portfolio is structured
to replicate a specific share market index.

An index is a grouping of shares listed on a stock exchange that shows changes in the overall
prices of those shares day to day.

Each stock market has its own set of indices. Well known international indices include the Dow
Jones Industrial Average (USA), FTSE (UK), Nikkei 225 (Japan), and Hang Seng (Hong Kong).

If a passive investor wishes to obtain returns on a share portfolio equal to the return achieved by
the Dow Jones then the investor will purchase the thirty stocks included in that index.

Another investor may replicate a sector index such as the telecommunications sector, or the
industrials sector.

A number of managed funds are index funds. Index funds use a range of sophisticated techniques
to replicate or track the share market, including full or partial replication of a specified stock
market index.

Full replication occurs when a funds manager purchases all the stocks included in an index.
However, with a large index such as the S&P500, the funds manager may only hold a percentage
of the 500 stocks, so long as sufficient stocks are held to ensure the portfolio fundamentally
tracks the index.

The funds manager buys and sells shares in order to maintain the replication of the index over

5. Jack and Jill have recently married and have decided to start buying shares for an
(a) Explain the role of a stockbroker in the direct investment approach to share investments.

A stockbroker has access to the trading and settlement systems of a stock exchange.

A stockbroker acts as an agent for a buyer or seller of securities listed on a stock exchange.

Brokers add to the efficiency and integrity of the stock markets in that they must gain minimum
education and training standards, and abide by the rules of the stock exchange and the nationstates Corporation Law.

Development of electronic trading and settlement systems and greater investor access to the
internet has radically changed how stockbrokers function.

Combined with this has been increased investor knowledge, a more affluent aging population
preparing for retirement, globalisation of the investment markets, investor demand for higher
performance outcomes, and significantly increased competition for the provision of broker

(b) Within the context of services provided by a stockbroker, discuss the two main types of
stockbrokers that an investor may choose to use. Differentiate between the services provided
by these brokers.

Stockbrokers may be categorised as discount non-advisory brokers or full service advisory


Discount non-advisory brokers:

only accepts buy or sell orders from clients

provides no advice or recommendations to the client in relation to investment alternatives

orders are initiated by the client either phoning the discount broker, or more likely, entering an
instruction to buy or sell electronically via the internet

brokerage fees of a discount broker will be lower than the fees of a full service broker, for
example, in Australia, discount brokers fees generally range around $29 to $39 per transaction
for transactions up to $10 000 in value and a percentage fee (ranging from 0.31 per cent) above
that amount.

Full service advisory broker offers advice and recommendations to clients on investment choices and
strategies. Their range of services includes:

buying and selling shares on the instruction of clients

providing investment advice on securities listed on a stock exchange, including shares, fixed
interest securities, derivatives and listed trusts

giving advice on other non-listed investment opportunities, such as cash management trusts,
property and equity trusts

making recommendations, establishing and monitoring financial plans for clients;

preparing retirement plans for clients, including superannuation

conducting research, forecasting and disseminating information on investment opportunities to


feestypically charge either a flat fee ranging up to $120 or a percentage of the transaction,
ranging from 2.5% for smaller value transactions, usually less than $5 000, down to 1.0% for
larger transactions over $50 000.

6. CondorLimitedislistedontheASXandearnspartofitsincomeinAustralia,andpart
(a) Explain the dividend imputation process.

With the Australian dividend imputation system, dividends on which the company has already
paid Australian company tax are referred to as franked dividends.

A company is able to pass the benefit of the Australian tax paid on profits to its shareholders.

For personal taxation purposes, the franked dividend received by the shareholder is grossed-up
by the franking credit and the total amount is included in assessable income.

Franking credit

franked dividend

x company tax rate

1company tax rate

The individual shareholder is entitled to receive a franking rebate up to the amount of the
franking credit.

(b) Why might a dividend be only partly franked?

If a company derives part of its profits overseas and does not pay Australian company tax on
those profits then it is unable to pass on a tax credit on associated dividend payments.

The company may only pay a partly franked dividend based on the tax paid on profits on which
Australian company tax has been paid.

(c) Calculate the income tax payable by the investor.

Calculation of tax payable:

dividend received (70% partly franked)

$12 700.00

plus franking credit [($12700 x 0.7) x 0.3/0.7]

$3 810.00

income included in tax return

$16 510.00

tax liability ($16510 x 39%)

$6 438.90

less franking credit paid by company

$3 810.00

Tax payable

$2 628.90

7. (a) Explain what is meant by the liquidity of a company. Define two common accounting
measures of liquidity. (LO 6.4)

The liquidity of a company relates to its ability to have access to sufficient cash to meet its
current commitments, such as, pay variable costs including electricity, rates and creditors, and
take advantage of future trading opportunities, that is, conduct existing and new business

Two common accounting ratios used to measure the level of liquidity of a company are the
current ratio and the liquid ratio.

Current ratio =

current assets (maturing within one year)

current liabilities (due within one year)


Liquid ratio =

current assetsinventory (stock on hand)

current liabilitiesbank overdraft

The liquid ratio provides a more realistic view of a companys liquidity position because in a
liquidity crisis a company may not be able to sell its inventory.

(b) Why is liquidity an important indicator that an investor should consider when analysing
share investment opportunities?

A company with a higher liquidity ratio has a healthier liquidity position.

Current liquidity levels should be compared with historic levels having regard for changes to its
business operations over that period.

Liquidity ratios will vary between companies depending on their reputation and access to sources
of funds, and particularly between industry groupings.

Liquidity ratios are an indicator of whether a company has the capacity to meet its on-going
commitments and take advantage of trading opportunities.

Need to maintain a balance between liquidity and investment return trade-offs.

Compare the liquidity ratios of a company with those of similar well-performed companies in the

Understanding the liquidity of a company is one measure of the level of risk associated with an
investment in that company.

8. Define the commonly used measures of the profitability of a firm. Which measure do you
consider to be most informative in comparing the profitability of firms across different
industry sectors? (LO 6.4)

The profitability of a company may be represented by a range of different accounting ratios.

A ratio that allows for comparisons to be made between companies with different capital
structures is:
EBIT to total funds ratio =

total funds employed
(shareholders funds and borrowings)

A variation of the above ratio is to exclude short-term funding. This eliminates the effects of
seasonal fluctuations in the amount of short-term debt used by some companies:
EBIT to long-term funds ratio =

long-term funds
(total fundsshort-term debt)

A further measure of profitability is the return on shareholders funds:

After-tax earnings on shareholders funds =

profit after tax

shareholders funds

Each measure of profitability provides valuable information on company performance.

It is important to compare the current performance measure with the past equivalent measure for
that company.

There is a need to consider the performance of other companies in the same industry.

Variations of earnings on shareholders funds between industry sectors indicates that factors
other than profitability must be considered, including level of risk, cycle of an industry sector
and timing of an investment opportunity.

9. (a) Define two measures of a companys debt-servicing capacity. (LO 6.4)

A companys capacity to generate liquidity to meet its day-to-day cash flow commitments and to
ensure its solvency is of critical importance.

A measure of a companys solvency, or its capacity to service debt, is the debt to gross cash flow
ratio. This ratio compares the amount of debt outstanding with the gross cash flow (where gross
cash flow is defined as net profit after tax, plus non-cash charges, e.g. depreciation). This ratio
provides an indication of the number of years required, based on current cash flows, to repay the
total debt of the company.

Another measure is the interest cover ratio. This ratio represents the number of times a
companys interest charge is covered by its earnings before finance lease charges, interest and
tax. The higher the ratio, the greater is the companys ability to cover its interest commitments.

(b) Explain why it is not appropriate to compare, on the basis of the identified measures,
companies in different industry classifications.

It is not appropriate to compare ratios between different industry classifications without

analysing the debt-servicing practices and capital structures adopted within various industries;
for example, some industries will normally maintain higher levels of debt to equity ratios which
in turn will impact upon their debt-servicing ratios. Other industries may normally hold lower


levels of debt, while others may hold mainly short-term debt. Depreciation levels may also vary
substantially between industry sectors.
10. A corporations price to earnings ratio (P/E) is a commonly used measure in the analysis of
share investments. An investor who is analysing two retail sector corporations notes their P/E
ratios for the past three years:



JB Hi-Fi








(a) Define thecalculationanddiscussthemeaningandpurposeofa P/E ratio.

The price to earnings ratio (P/E) is the market price of a company's shares divided by its earnings
per share.

The P/E ratio is an indicator of investors' evaluation of the future earnings prospects of a firm,
rather than an indicator of its past performance.

If good earnings growth is expected the P/E ratio will rise, but where there is less optimism
about the future prospects the P/E ratio will fall.

Variations will be evident between companies within the same industry sector and between
sectors. This implies that the prices have adjusted to reflect anticipated changes in future

The P/E ratio is conceptually simple, but difficult to calculate and interpret. The ratio for a
company can vary from one published source to another, depending on the earnings figure used
in the calculation.

The ratio should use expected future earnings, however, there are likely to be as many estimates
of future earnings figure as there are investment analysts.

When interpreting P/E ratios published in the financial press, keep in mind that they will have
been calculated using the immediate past earnings figures.

(b) Analyse and interpret the data in the table. (LO 6.4)

The P/E ratios of both companies increased between 2012 and 2014.


This could indicate either an increase in the price of the shares relative to earnings or a decline in
earnings relative to the share price.

In the case of Woolworths, the share price increased over this period from about $30 to about
$36. Simultaneously, there was a small decline in earnings per share during 20122013.

In the case of JB Hi-Fi, the share price has increased from about $12 to about $20. Unlike
Woolworths, however, there was an increase in earnings per share during 20122013.

The P/E ratio for the market as a whole also increased over this period from 13 to 16. This
indicates a general increase in share prices over the period.

Given that both companies experienced increases in share prices over the period, it seems that
both are benefiting from a general improvement in market conditions that probably reflects
investors beliefs in an improving economic environment.

Investors are hoping that future earnings increase enough to justify the higher prices being paid
for these shares at present.

11. Gazal Limited pays a constant dividend of $0.18 cents per share. A fund manager is
considering purchasing the shares as part of an investment portfolio. The fund manager
requires a return of 14 per cent on the investment. Calculate the price that the fund manager
would be willing to pay for the shares. (LO 6.5)

If dividend payments are expected to remain constant, such that D0 = D1 = D2 = . Dn, the share
price can be calculated based on a perpetuity.

The present value of a perpetuity is the cash flow divided by the relevant discount rate:
P 0 = D 0 / rs

Gazal Limited is expected to pay a constant dividend of $0.18 cents per share, and the funds
managers required rate of return is 14%, therefore:
P0 = 0.18 / 0.14
= $1.28

12. The last dividend paid to shareholders by AMP Limited was $0.23 per share. Assume that
the board of directors of the company plans to maintain a constant dividend growth policy of
4.00 per cent. An investor, in evaluating an investment in the company, has determined that
she would require a 17 per cent rate of return from this type of investment. If the current price

of AMP shares in the stock market is $5.22, should the investor purchase the shares? (Show
your calculations.) (LO 6.5)

AMP is planning to maintain constant dividend growth. Therefore, the next dividend paid will be
the last dividend multiplied by the growth rate:
P0 = D0 (1 + g) / (rsg)
= 0.23 (1.04) / (0.17 0.04)
= $1.84

At a current market price of $5.22 the investor should not consider buying the shares based on
this simple analysis. Rather, to justify a purchase at $5.22, the required rate of return must be
lower or the growth rate of the dividends must be higher.

13. AGL Energy Limited has declared a $0.33 cents per share dividend, payable in one month.
At the same time the company has decided to capitalise reserves through a one-for-three bonus
issue. The current share price at the close of business on the final cum-dividend date is $16.15.
(LO 6.5)
(a) Explain the strategy adopted by the company. In your answer define the terms cumdividend and ex-dividend.

The company wishes to restructure its balance sheet by converting reserves into ordinary shares
through the provision of bonus shares to existing shareholders.
o assumption: dividend is not payable on bonus share issue
o cum-dividendthe situation when a share price incorporates an entitlement to receive a
declared dividend
o ex-dividendthe share price after a declared dividend has been paid in cash to shareholders.

(b) Calculate the theoretical price of the share after the bonus issue and the dividend payment
have occurred.

Calculate the theoretical share price:

cum-dividend share price


dividend paid


ex-dividend price



cum-bonus/ex-dividend price


market value of 3 cum-bonus shares


market value of 4 ex-bonus shares


theoretical value of ex-dividend/ex-bonus share


14. Myer Holdings Limited has a share price of $2.82. The company has made a renounceable
rights issue offer to shareholders. The offer is a three-for-ten pro-rata issue of ordinary shares
at $2.60 per share. (LO 6.5)
(a) Explain the effect of the offer being renounceable.

Rights issuethe issue of additional ordinary shares to existing shareholders on a pro-rata basis
relative to their existing shareholding

Renounceablethe right is listed on the stock exchange and the shareholder is entitled to sell the
right to a third party rather than accepting the offer.

(b) What is the price of the right?

value of right

N (cum rights price - subscription price)

N 1

where N is the number of shares required to obtain the rights issue share, and the subscription price
is the discounted price of the additional share. Therefore:
3.3333($2.82 $2.60)


Value of right

(c) Calculate the theoretical ex-rights share price.

cum-rights share price
Market value of 10 cum-rights shares
new cash introduced through take-up of 3 for 10 issue
market value of 13 ex-rights shares
theoretical ex-rights share price



(d) Explain why an actual ex-rights price of a share may at times differ from the calculated
theoretical price. (LO 6.5)

The ex-rights price may not fall to its theoretical value because of the informational content of
the rights issue. The increased equity base may indicate increased growth and profitability thus
allowing the company to maintain its current dividend rate.


S&P Indices manages a global industry classification standard (GICS) for share-market

industry sector indices. The standard comprises 10 international industry sector indices. (LO
(a) What is the purpose of share-market indices?

A stock market index provides a quantitative measure of the performance of a share market, or
an industry sector within the market.

Changes in an index over time reflects the mood of the marketbull market or a bear market.

(b) How does the existence of standard international industry sector indices facilitate global

Passive funds managers in local and international markets will replicate a selected index for an
investment portfolio in order to obtain a return equal to stocks incorporated in that index.

(c) Identify and briefly explain the structure of the GICS indices.

Global industry classification standard (GICS) comprises 10 standard international industry


consumer discretionary
consumer staples
health care
information technology
telecommunication services

In addition, a country may add further sectors that recognise particular strengths within that
market; for example, Australia has further sector classifications for financial excluding property
trusts, and property trusts.


In Chapter 6 we discussed some widely used indicators of market value, especially the P/E or
price-to-earnings ratio. The P/E ratio has been used for decades as an indicator that promises
to allow investors to gain some insights into whether shares are cheap or expensive. When the
average P/E ratios for particular sectors or the share market as a whole are tracking lower
than their historical averages there is an indication that the market is not overvalued and
might even be undervalued (and vice versa).

In recent years, the classical P/E ratio has been surpassed in popularity by Shillers
cyclically adjusted P/E ratio (CAPE), or simply, the Shiller P/E named after Robert Shiller
from Yale University (more will be said about him in Chapter 7). This ratio is now widely
reported. Several years after the global financial crisis, with American market indexes posting
record highs, debate ensued regarding the validity of the Shiller P/E as it indicated that
markets were significantly overvalued. The following article discusses the Shiller P/E and
outlines some criticisms of it. It is important for finance students to be familiar with the
Shiller P/E and its use, particularly, in the North American financial markets.

The Shiller price/earnings ratio has become the go-to method for valuing stock markets, but its
flaws are drawing more attention as markets hit new highs. David Bianco, chief investment
strategist at Deutsche Bank, has been one of the more vocal critics, detailing the ratios pitfalls
in two recent notes.

His main beef centres on its approach to estimating normalized earnings and the
corresponding cyclically adjusted price/earnings ratio. The Shiller P/E ratio, which is named
after well-known Yale professor Robert Shiller, uses the annual earnings of S&P 500
companies over the past 10 years and then adjusts past earnings for inflation using the
consumer price index.

This makes it a more stable market valuation indicator than a simple P/E ratio, because it

eliminates the variation of profit margins during business cycles. But Mr. Bianco believes the
ratio is not sufficient, largely because it does not adjust for EPS growth that should come from
retained earnings.

'This is a major pitfall because dividend payout ratios have declined tremendously since 19001950, from over two-thirds to less than a third the last decade,' he said. 'Not adjusting past EPS
for growth that should come from retained earnings is a major distortion that compounds with

It also means, he added, that the EPS underlying the Shiller ratio significantly underestimates
todays normal EPS. 'This makes the observed Shiller PE unreliable in both absolute terms and
relative to history,' Mr. Bianco said.
His solutionaka the Bianco ratiois to raise past earnings per share by the nominal cost of
equity less the dividend yield. Its heady stuff, for sure, but whats important for investors is the
striking difference in results between the two valuation methods.

The Shiller ratio is currently near 25, well above its historical average back to 1910 of 16.3,
while the Bianco ratio has the S&P 500 trading at 16.5, just slightly above its average of 13.9
over the same period. That suggests the key U.S. equity benchmark may not be as expensive as
many investors think, but the debate doesnt end there.

The current Shiller ratio is usually compared to its 113-year average, but Mr. Bianco believes a
better comparison is the average from 1960 onwards as the S&P 500 didnt exist until 1957. In
this case, the historical average for the Shiller is 19.6 while its 15.6 for the Bianco. '[The
historical average from 1910] includes the WWI EPS cycle, when companies benefited
tremendously from supplying Europe,' the Deutsche Bank strategist noted.

'Profits tripled from 1914 to 1916, and then fell to less than a fifth during the 1921 post war
recession. This exceptional profit swing distorts the long-term average 10yr PE a full point.'

James Paulsen, chief investment strategist at Wells Capital Management, also recently
questioned the historic valuation range used for the Shiller and most other popular valuation

metrics. He said there are actually two distinct valuation rangesone prior to 1990 and a
noticeably higher range since 1990with the Shiller experiencing the most profound change
over the past 23 years.

'The mean Shiller PE has been almost double its old historical average (about 26 times since
1990 versus about 14 times prior to 1990) and since 1990 has ranged almost persistently
beyond one standard deviation above the old mean PE prior to 1990,' he told clients in a note

There could be a number of reasons for the shift, Mr. Paulsen said, including broader stock
market participation, aging demographics and the technology boom and bust of the late 1990s
and early 2000s.

Whatever the case, he believes the new valuation range, which suggests a reasonably priced
S&P 500 at the moment, has persisted too long to ignore. At the same time, hes not willing to
dismiss the old and presently more pessimistic valuation range altogether.

'Perhaps investors are best served by heeding both,' he said.

SOURCE: Pett, D. 2013, The Trouble With P/E Values, The Financial Post, 12th November 2013,


Outline the difference between the Shiller P/E and the ordinary P/E ratio.
An ordinary P/E ratio is computed by simply taking the ratio of the current market price
to the current earnings per share. The Shiller P/E ratio uses 10-year inflation-adjusted
earnings per share in order to remove (or smooth) the influence of the business cycle on
company earnings.

Explain how biases in underlying data, such as those introduced by earnings

volatility or changes in accounting standards over time, may undermine a conclusion
based on a comparison between the current Shiller P/E and its long term historical

In order to reach some conclusion about whether market values are too high or too low,
the current Shiller P/E ratio is compared against its historical average. However, because
of secular changes in the economy over the longer term, the average can be quite
different depending on which periods are excluded or included in the analysis.

The Shiller P/E is computed on the basis of the past 10 years of earnings adjusted by
inflation. Explain why this approach is supposed to make the Shiller P/E a more
stable indicator of value than the traditional approach of computing the P/E ratio
for a company or market on the basis of one year of earnings.
The one-year approach will be subject to short-term fluctuations in earnings due to
temporary economic conditions or extraordinary earnings events. Computing earnings
over the longer term minimises the influence of these factors.

In an interview with the New York Times in 2013, James Stack of InvesTech
Research commented: 'Normalised earnings are fine to use if the periods youre
looking at are going to be more normal. But anyone looking at 10-year P/Es today
has to realise that the past decade has been anything but normal.' Discuss the
implications of this statement with reference to the applicability of the Shiller P/E
ratio as an indicator of market value after the global financial crisis.
As mentioned above, the analysis depends on the time periods that are chosen when
computing both the P/E ratio and the benchmark against which it will be compared. When
those periods are extraordinary in some way, arguments against the generality of the
conclusions that can be drawn will always surface.

True/False questions

F Fixed interest securities are more volatile and, as such, will generate higher average returns

than shares in publicly listed corporations.


F Systematic risk refers to the risk that derives from factors unique to a particular company.


T Portfolio theory contends that the imperfect correlation characterising the returns of

different securities is the basis for an investment strategy that can reduce the total risk of a portfolio.

T A share that has a beta of 0.50 is half as risky as an average share listed on a stock market.


F If new economic information comes to the market, shares that demonstrate a zero price

correlation will tend to move in opposite directions.



T With dividend imputation, a shareholder with a marginal tax rate that is lower than the

company tax rate will pay no tax on a fully franked dividend received, and the excess credit can be
applied against other assessable income.

T A companys liquidity, that is, its ability to meet its short-term financial obligations, may

be measured using the current ratio and the liquid ratio. Of the two ratios, the latter is the more
stringent measure.

F It can be safely inferred that a company with a low current ratio is a riskier investment than

a company with a high current ratio.


T In comparing the profitability of different companies that have quite different financial

structures, the use of the EBIT to total funds employed ratio would be more suitable than the EBIT
to shareholders funds ratio.

F Given that the banking sector consistently displays a higher debt-to-equity ratio than do

other sectors of the market, it can be reasonably concluded that there is a greater level of risk
associated with investments in this sector.

T A price to net tangible assets ratio of less than 1 indicates that the book value of the

companys assets exceeds the markets valuation of the company.


T A share with a constant dividend of $1.00, discounted at a rate of 20 per cent, should trade

at a price of $5.00.

F A company announces the payment of an interim dividend of 65 cents per share. The cum-

dividend shares are trading at $12.60. The theoretical ex-dividend price will be $13.25.

T The issue of bonus shares merely changes the composition of the firms equity as bonus

issues do not add to the firms capital.


T In a one-for-nine bonus issue, if the cum-bonus price of the share was $10, then the

theoretical ex-bonus price would be $9.


F A pro-rata rights issue that has a 100 per cent take-up rate simply increases the number of

shares issued and has no effect on the companys capital.


T If a rights issue is renounceable, the right may be sold by a shareholder to another party

before the exercise date.


T In a one-for-five rights issue, priced at $2 a share, and with the shares valued at $2.40 cum-

rights, the theoretical ex-rights price of the share would be $2.33, and the value of the right would be

F The global industry classification standard (GICS) is a measure of the liquidity in major

stock market indices around the world.



F A share price accumulation index measures changes over time in the price of shares