Fundamentals of Financial ManagementX

118 Part 2 Fundamental Concepts in Financial Management

Trend Analysis 4.7 TREND ANALYSIS

An analysis of a firm’s It is important to analyze trends in ratios as well as their absolute levels, for
financial ratios over trends give clues as to whether a firm’s financial condition is likely to improve
time; used to estimate or to deteriorate. To do a trend analysis, simply plot a ratio over time, as shown
the likelihood of in Figure 4-1. This graph shows that Allied’s rate of return on common equity
improvement or deteri- has been declining since 2002, even though the industry average has been rela-
oration in its financial tively stable. All the other ratios could be analyzed similarly.
condition.
How is a trend analysis done?
What important information does a trend analysis provide?

4.8 TYING THE RATIOS TOGETHER:
THE DU PONT EQUATIONS

Basic Du Pont Table 4-2 summarizes Allied’s ratios. The profit margin times the total assets
turnover is called the basic Du Pont equation, and it gives the rate of return on
Equation assets (ROA):

A formula that shows ROA ϭ Profit margin ϫ Total assets turnover
that the rate of return
on assets can be found ϭ Net income ϫ Sales (4-1)
as the product of the Sales Total assets
profit margin times the
total assets turnover. ϭ 3.9% ϫ 1.5 ϭ 5.9%

Allied made 3.9 percent, or 3.9 cents, on each dollar of sales, and assets were
“turned over” 1.5 times during the year. Therefore, the company earned a return
of 5.9 percent on its assets.

F I G U R E 4 - 1 Rate of Return on Common Equity, 2001–2005

ROE Industry
(%) Allied
16

14

12

10

2001 2002 2003 2004 2005

Chapter 4 Analysis of Financial Statements 119

TABLE 4-2 Allied Food Products: Summary
of Financial Ratios (Millions of Dollars)
Ratio
Formula Calculation Ratio Industry Comment
Average

Liquidity Current assets $1,000 ϭ3.2ϫ 4.2ϫ Poor
Current Current liabilities $310 ϭ1.2ϫ 2.2ϫ Poor

Quick Current assets Ϫ Inventories $385
Current liabilities $310

Asset Management Sales $3,000 ϭ4.9ϫ 10.9ϫ Poor
Inventory turnover Inventories $615 ϭ46 days
Days sales outstanding (DSO) ϭ3.0ϫ 36 days Poor
Fixed assets turnover Receivables $375 ϭ1.5ϫ
Total assets turnover Annual sales>365 $8.2192 2.8ϫ OK

Sales $3,000 1.8ϫ Somewhat low
Net fixed assets $1,000

Sales $3,000
Total assets $2,000

Debt Management

Total debt to total assets Total debt $1,060 ϭ53.0% 40.0% High (risky)
Total assets $2,000 ϭ3.2ϫ 6.0ϫ Low (risky)
Times-interest- $283.8 ϭ3.0ϫ 4.3ϫ Low (risky)
earned 1TIE2 Earnings before interest and taxes 1EBIT 2
Interest charges $88

EBITDA coverage EBITDA ϩ Lease payments $411.8
Interest ϩ Principal payments ϩ Lease payments $136

Profitability Net income $117.5 ϭ3.9% 5.0% Poor
Sales $3,000 ϭ5.9% 9.0% Poor
Profit margin on sales ϭ14.2% 18.0% Poor
Net income $117.5 ϭ12.5% 15.0% Poor
Return on total Total assets $2,000
assets 1ROA 2
Earnings before interest and taxes 1EBIT2 $283.8
Basic earning Total assets $2,000
power 1BEP2
Net income $117.5
Return on common Common equity $940
equity 1ROE2

Market Value Price per share $23.00 ϭ9.8ϫ 11.3ϫ Low
Price/earnings (P/E) Earnings per share $2.35 ϭ5.3ϫ 5.4ϫ Low
Price/cash flow ϭ1.2ϫ 1.7ϫ Low
Market/book (M/B) Price per share $23.00
Cash flow per share $4.35

Market price per share $23.00
Book value per share $18.80

120 Part 2 Fundamental Concepts in Financial Management

If the company were financed only with common equity, the rate of return
on assets (ROA) and the return on equity (ROE) would be the same because
total assets would equal common equity:

ROA ϭ Net income ϭ Net income ϭ ROE
Total assets Common equity

This equality holds if and only if the company uses no debt. Allied does use
debt, so its common equity is less than its total assets. Therefore, the return to
the common stockholders (ROE) must be greater than the ROA of 5.9 percent.
Specifically, to go from the rate of return on assets (ROA) to the return on equity
(ROE) we multiply by the equity multiplier, which is the ratio of total assets to
common equity:

Equity multiplier ϭ Total assets
Common equity

Firms that use large amounts of debt (more leverage) will necessarily have a
high equity multiplier—the greater the debt, the less the equity, hence the higher
the equity multiplier. For example, if a firm has $1,000 of assets and finances
with $800, or 80 percent debt, then its equity will be $200 and its equity multi-
plier will be $1,000/$200 ϭ 5. Had it used only $200 of debt, its equity would
have been $800, and its equity multiplier would have been only $1,000/$800 ϭ
1.25.19

Allied’s return on equity (ROE) depends on its ROA and its use of
leverage:20

ROE ϭ ROA ϫ Equity multiplier (4-2)

ϭ Net income ϫ Total assets
Total assets Common equity

ϭ 5.9% ϫ $2,000/$940

ϭ 5.9% ϫ 2.13

ϭ 12.5%

When they are combined, Equations 4-1 and 4-2 form the extended Du Pont
equation, which shows how the profit margin, the total assets turnover ratio, and
the equity multiplier combine to determine the ROE:

ROE ϭ (Profit margin)(Total assets turnover)(Equity multiplier)

ϭ Net income ϫ Sales ϫ Total assets (4-3)
Sales Total assets Common equity

19 Expressed algebraically,

Debt ratio ϭ D ϭ AϪE ϭ A Ϫ E ϭ 1 Ϫ Equity 1
A A A A multiplier

Here D is debt, E is equity, A is total assets, and A/E is the equity multiplier. This equation ignores
preferred stock.
20 Note that we could also find the ROE by “grossing up” the ROA, that is, by dividing the ROA by
the common equity fraction: ROE ϭ ROA/Equity fraction ϭ 5.9%/0.47 ϭ 12.5%. The two proce-
dures are algebraically equivalent.

Chapter 4 Analysis of Financial Statements 121

For Allied, we have

ROE ϭ (3.9%)(1.5)(2.13)

ϭ 12.5%

The 12.5 percent rate of return could, of course, be calculated directly: both Sales
and Total assets cancel, leaving Net income/Common equity ϭ $117.5/$940 ϭ
12.5%. However, the extended Du Pont equation shows how the profit margin,
total assets turnover, and use of debt combine to determine the return on equity.

Allied’s management can use the extended Du Pont equation to analyze
ways of improving performance. Focusing on the profit margin, marketing peo-
ple can study the effects of raising sales prices (or lowering them to increase vol-
ume), of moving into new products or markets with higher margins, and so on.
Cost accountants can study various expense items and, working with engineers,
purchasing agents, and other operating personnel, seek ways to hold down costs.
Regarding the “turnover” term, the financial staff, working with both production
and marketing people, can investigate ways to reduce the investment in various
types of assets. Finance people can also analyze the effects of alternative financ-
ing strategies, seeking ways to hold down interest expense and the risk associ-
ated with debt while still using leverage to increase the return on equity.

As a result of such an analysis, Ellen Jackson, Allied’s president, recently
announced a series of moves that are expected to cut operating costs by more
than 20 percent per year. Jackson and Allied’s other executives have a strong
incentive for improving its financial performance because their compensation is
based to a large extent on how well the company does. Its executives receive a
salary that is sufficient to cover their living costs, but their compensation pack-
age also includes stock options that will be awarded if and only if Allied meets
or exceeds target levels for earnings and the stock price. These target levels are
based on its performance relative to other food companies. So, if it does well,
then Jackson and the other executives—and the stockholders—will also do well.
But if things deteriorate, Jackson could be looking for a new job.

Write out the equation for the basic Du Pont equation.

What is the equity multiplier?

How can management use the extended Du Pont equation to
analyze ways of improving the firm’s performance?

4.9 COMPARATIVE RATIOS A good site for compara-
tive ratios is http://
AND “BENCHMARKING” moneycentral.msn.com.
Here you can find stock
Ratio analysis almost always involves comparisons—a company’s ratios are quotes, detailed company
compared with industry average figures. However, like most firms, Allied’s reports, company ratios,
managers go one step further—they also compare their ratios with those of lead- and comparative ratios.
ing food companies. This technique is called benchmarking, and the companies
used for the comparison are called benchmark companies. Allied’s management Benchmarking
benchmarks against Campbell Soup, a leading manufacturer of canned soups; The process of com-
Dean Foods, a processor of canned and frozen vegetables; Del Monte Foods, a paring a particular
processor of fruits and vegetables; H. J. Heinz, which makes ketchup and other company with a group
products; Flowers Industries, a producer of bakery and snack-food goods; Sara of “benchmark”
Lee, a manufacturer of baked goods; and Hershey Foods Corp., a producer of companies.

122 Part 2 Fundamental Concepts in Financial Management

chocolates, nonchocolate confectionary products, and pasta. Ratios are calculated
for each company, then listed in descending order as shown below for the profit
margin (the firms’ latest 12 months’ results reported by Yahoo!Finance as of Sep-
tember 15, 2005):

Company Profit Margin

Hershey Foods 11.9%
Campbell Soup 9.4
H. J. Heinz 7.9
Allied Food Products 3.9
Del Monte Foods 3.9
Sara Lee 3.7
Flowers Industries 3.6
Dean Foods 2.6

TABLE 4-3 Key Financial Ratios for Selected Industriesa

Industry Name Total Days Return Return
Assets on on
Current Inventory Turnover Debt Sales Profit
Ratio Turnoverb Ratioc Assets Equity
Outstandingd Margin

Aerospace/defense 1.1 9.3 0.9 70.8% 49.3 2.8% 2.6% 8.9%
Apparel stores 2.5 4.4 5.0 8.2 14.7
Auto manufacturing—major 1.8 8.2 1.6 44.2 12.7 2.6 1.6 10.9
Beverage (soft drink) 1.0 7.8 10.6 8.5 24.3
Education and training services 1.4 59.4 0.6 85.3 202.8 9.8 10.0 16.9
Electronics—diversified 2.6 4.7 5.7 4.0
Food processing 2.0 4.6 0.8 65.0 39.7 4.4 4.6 6.6
Food wholesalers 1.2 16.1 2.0 7.1 9.7
Grocery stores 1.1 11.0 1.1 40.8 38.4 0.5 1.2 19.8
Health services—specialized 1.5 27.5 4.3 6.5 4.6
Lodging 1.0 49.4 0.7 39.4 70.2 6.0 4.1 15.2
Metals and minerals—industrial 1.6 4.8 8.4 5.0 9.5
Newspapers 1.1 10.9 1.1 52.6 36.1 9.9 5.4 12.0
Paper and paper products 1.3 6.1 2.7 1.8 11.6
Railroad 0.8 13.2 3.6 64.1 18.1 8.7 3.1 5.8
Restaurant 0.9 30.3 5.7 6.2 8.8
Retail—department stores 1.7 3.6 2.4 73.9 9.1 3.8 4.8 13.8
Scientific and technical 13.9
2.6 3.2 1.6 57.2 47.4
instruments 2.0 3.6
Sporting goods 1.7 5.2 0.7 56.8 35.1
Steel and iron 2.2 7.7
Telecommunications equipment 2.1 3.9 0.6 58.3 42.9
Textile manufacturing 1.1 3.4
Tobacco (cigarettes) 0.5 53.4 57.0

0.7 69.0 71.6

0.4 64.8 29.2

1.1 55.1 11.2

1.3 65.5 32.6

0.8 41.1 76.0 5.4 4.3 7.3
1.1 51.9 53.7 3.4 3.8 7.9
1.0 61.9 46.2 3.9 3.7 9.7
0.7 50.0 86.9 0.2 0.2 0.4
1.1 51.6 49.3 2.8 3.1 6.4
0.8 77.6 32.3 6.2 5.0 22.3

Notes:
a The ratios presented are averages for each industry. Ratios for the individual companies are also available.
b The inventory turnover ratio in this table is calculated as the company’s latest 12 months of cost of sales divided by the average of

its inventory for the last quarter and the comparable year earlier quarter.
c The debt ratio in this table is calculated as 1 Ϫ (ROA/ROE).
d The days sales outstanding ratio in this table was calculated as 365/Receivable turnover. The receivable turnover is calculated as the

company’s latest 12 months of sales divided by the average of its receivables for the last quarter and the comparable year earlier
quarter.
Source: Data obtained from the Key Ratios section, http://moneycentral.msn.com, February 25, 2005.

Chapter 4 Analysis of Financial Statements 123

Looking for Warning Signs
within the Financial Statements

Enron’s decline spurred a renewed interest in finan- second quarter of 2001 (a few months before its
cial accounting, and analysts now scour companies’ problems began to unfold), Enron reported earn-
financial statements to see if trouble is lurking. This ings of $423 million versus a cash flow of minus
renewed interest has led to a list of “red flags” to $527 million.
consider when reviewing a company’s financial state-
ments. For example, after conferring with New York Along similar lines, after consulting with various pro-
University Accounting Professor Baruch Lev, Fortune fessionals, Ellen Simon of the Newark Star Ledger
magazine’s Shawn Tully identified the following warn- came up with her list of “red flags”:
ing signs:
• You wouldn’t buy the stock at today’s price.
• Year after year, a company reports restructuring • You don’t really understand the company’s finan-
charges and/or write-downs. This practice raises
concerns because companies can use write- cial statements.
downs to mask operating expenses and thus • The company is in a business that lends itself to
results in overstated earnings.
“creative accounting.”
• A company’s earnings have been propped up • The company keeps taking nonrecurring
through a series of acquisitions. Acquisitions can
increase earnings if the acquiring company has a charges.
higher P/E than the acquired firm, but such • Accounts receivable and inventory are increasing
“growth” cannot be sustained over the long run.
faster than sales revenue.
• A company depreciates its assets more slowly • The company’s insiders are selling their stock.
than the industry average. Lower depreciation • The company is making aggressive acquisitions,
boosts current earnings, but again, this cannot
be sustained because eventually depreciation especially in unrelated fields.
must be recognized.
There is some overlap between these two lists. Also,
• A company routinely has high earnings but low none of these items automatically means there is
cash flow. As Tully points out, this warning sign something wrong with the company—instead, the
would have exposed Enron’s problems. In the items should be viewed as warning signs that cause
you to take a closer look at the company’s perfor-
mance before making an investment.

The benchmarking setup makes it easy for Allied’s management to see exactly
where it stands relative to the competition. As the data show, Allied is in the
middle of its benchmark group relative to its profit margin, so it has lots of room
for improvement. Other ratios are analyzed similarly.

Comparative ratios are available from a number of sources, including the
MSN Money Web site, http://moneycentral.msn.com. Table 4-3 presents a list of
key ratios for a variety of industries covered by this site. Useful ratios are also
compiled by Value Line Investment Survey, Dun and Bradstreet (D&B), and
Robert Morris Associates, which is the national association of bank loan officers.
Also, financial statement data for thousands of publicly owned corporations are
available on other Internet sites, and as brokerage houses, banks, and other
financial institutions have access to these data, security analysts can and do gen-
erate comparative ratios tailored to their specific needs.

Each of the data-supplying organizations uses a somewhat different set of
ratios designed for its own purposes. For example, D&B deals mainly with small
firms, many of which are proprietorships, and it sells its services primarily to
banks and other lenders. Therefore, D&B is concerned largely with the creditor’s
viewpoint, and its ratios emphasize current assets and liabilities, not market

124 Part 2 Fundamental Concepts in Financial Management

To find quick information value ratios. So, when you select a comparative data source, you should be sure
about a company, link to that your emphasis is similar to that of the agency whose ratios you plan to use.
http://www.investor Additionally, there are often definitional differences in the ratios presented by
.reuters.com. Here you different sources, so before using a source, be sure to verify the exact definitions
can find company profiles of the ratios to ensure consistency with your own work.
and snapshots, stock price
quotes and share informa- Why is it useful to do comparative ratio analyses?
tion, key ratios, and com-
parative ratios. Differentiate between trend and comparative analyses.

“Window Dressing” What is benchmarking?
Techniques
Techniques employed 4.10 USES AND LIMITATIONS
by firms to make their OF RATIO ANALYSIS
financial statements
look better than they As noted earlier, ratio analysis is used by three main groups: (1) managers, who
really are. employ ratios to help analyze, control, and thus improve their firms’ operations;
(2) credit analysts, including bank loan officers and bond rating analysts, who
analyze ratios to help judge a company’s ability to pay its debts; and (3) stock
analysts, who are interested in a company’s efficiency, risk, and growth
prospects. In later chapters we will look more closely at the basic factors that
underlie each ratio, which will give you a better idea about how to interpret and
use ratios. Note, though, that while ratio analysis can provide useful information
concerning a company’s operations and financial condition, it does have
limitations that necessitate care and judgment. Some potential problems are
listed here:

1. Many large firms operate different divisions in different industries, and for
such companies it is difficult to develop a meaningful set of industry aver-
ages. Therefore, ratio analysis is more useful for small, narrowly focused
firms than for large, multidivisional ones.

2. Most firms want to be better than average, so merely attaining average per-
formance is not necessarily good. As a target for high-level performance, it is
best to focus on the industry leaders’ ratios. Benchmarking helps in this
regard.

3. Inflation has badly distorted many firms’ balance sheets—recorded values
are often substantially different from “true” values. Further, because inflation
affects both depreciation charges and inventory costs, profits are also
affected. Thus, a ratio analysis for one firm over time, or a comparative
analysis of firms of different ages, must be interpreted with judgment.

4. Seasonal factors can also distort a ratio analysis. For example, the inventory
turnover ratio for a food processor will be radically different if the balance
sheet figure used for inventory is the one just before versus just after the close
of the canning season. This problem can be minimized by using monthly
averages for inventory (and receivables) when calculating turnover ratios.

5. Firms can employ “window dressing” techniques to make their financial
statements look stronger. To illustrate, a Chicago builder borrowed on a two-
year basis on December 27, 2005, held the proceeds of the loan as cash for a
few days, and then paid off the loan ahead of time on January 2, 2006. This
improved his current and quick ratios, and made his year-end 2005 balance
sheet look good. However, the improvement was strictly window dressing; a
week later the balance sheet was back at the old level.

6. Different accounting practices can distort comparisons. As noted earlier,
inventory valuation and depreciation methods can affect financial statements

Chapter 4 Analysis of Financial Statements 125

and thus distort comparisons among firms. Also, if one firm leases a substan-
tial amount of its productive equipment, then its assets may appear low rela-
tive to sales because leased assets often do not appear on the balance sheet.
At the same time, the liability associated with the lease obligation may not
appear as debt. Therefore, leasing can artificially improve both the turnover
and the debt ratios. However, the accounting profession has taken steps to
reduce this problem.
7. It is difficult to generalize about whether a particular ratio is “good” or
“bad.” For example, a high current ratio may indicate a strong liquidity posi-
tion, which is good, or excessive cash, which is bad (because excess cash in
the bank is a nonearning asset). Similarly, a high fixed assets turnover ratio
may indicate either that the firm uses its assets efficiently or that it is short of
cash and cannot afford to make needed investments.
8. A firm may have some ratios that look “good” and others that look “bad,”
making it difficult to tell whether the company is, on balance, strong or
weak. However, statistical procedures can be used to analyze the net effects of
a set of ratios. Many banks and other lending organizations use such proce-
dures to analyze firms’ financial ratios, and then to classify them according
to their probability of getting into financial trouble.21

Ratio analysis is useful, but analysts should be aware of these problems and
make adjustments as necessary. Ratio analysis conducted in a mechanical,
unthinking manner is dangerous, but used intelligently and with good judg-
ment, it can provide useful insights into a firm’s operations. Your judgment in
interpreting a set of ratios is bound to be weak at this point, but it will improve
as you read the remaining chapters of this book.

List three types of users of ratio analysis. Would the different users
emphasize the same or different types of ratios? Explain.

List several potential problems with ratio analysis.

4.11 PROBLEMS WITH ROE

In Chapter 1 we said that managers should strive to maximize shareholder
wealth. If a firm takes steps to improve its ROE, does it mean that shareholder
wealth will also increase? Not necessarily, for despite its widespread use and the
fact that ROE and shareholder wealth are often highly correlated, serious prob-
lems can arise if a firm uses ROE as its sole performance measure.

First, ROE does not consider risk. While shareholders clearly care about
returns, they also care about risk. To illustrate this point, consider two divisions
within the same firm. Division S has stable cash flows and a predictable 15 percent
ROE. Division R, on the other hand, has a 16 percent expected ROE, but its cash
flows are quite risky, so the expected ROE may not materialize. If managers were
compensated solely on the basis of ROE, and if the expected ROEs were actually
achieved, then Division R’s manager would receive a higher bonus than S’s, even
though S might actually be creating more value for shareholders as a result of its
lower risk. Also, as we discussed earlier, financial leverage can increase expected
ROE but at the cost of higher risk, so raising ROE through greater use of leverage
may not be good.

21 The technique used is discriminant analysis. The seminal work on this subject was by Edward I.
Altman, “Financial Ratios, Discriminant Analysis, and the Prediction of Corporate Bankruptcy,”
Journal of Finance, September 1968, pp. 589–609.

126 Part 2 Fundamental Concepts in Financial Management

EVA and ROE

To better understand the idea behind EVA and how Now what is Keller’s EVA? The basic formula for
it is connected to ROE, let’s look at Keller Electron- EVA is
ics. Keller has $100,000 in investor-supplied operat-
ing capital, which, in turn, consists of $50,000 of EVA ϭ EBIT (1 Ϫ Corporate tax rate) Ϫ (Total
long-term debt and $50,000 of common equity. The investor-supplied operating capital)
company has no preferred stock or notes payable. ϫ (After-tax percentage cost of capital)
The long-term debt has a 10 percent interest rate.
However, since the company is in the 40 percent tax ϭ $20,000(1 Ϫ 0.40) Ϫ ($100,000)(0.10)
bracket and interest expense is tax deductible, the
after-tax cost of debt is only 6 percent. On the basis ϭ $2,000
of their assessment of the company’s risk, sharehold-
ers require a 14 percent return. This 14 percent This $2,000 EVA indicates that Keller provided its
return is what shareholders could expect to earn if shareholders with $2,000 more than they could have
they were to take their money elsewhere and invest earned elsewhere by investing in other stocks with the
in stocks that have the same risk as Keller. Keller’s same risk as Keller’s stock. To see where this $2,000
overall cost of capital is a weighted average of the comes from, let’s trace what happens to the money:
cost of debt and equity, and it is 10 percent, found
as 0.50(6%) ϩ 0.50(14%) ϭ 10%. The total dollar cost • The firm generates $20,000 in operating income.
of capital per year is 0.10($100,000) ϭ $10,000. • $6,000 goes to the government to pay taxes,

Now let’s look at Keller’s income statement. Its leaving $14,000.
operating income, EBIT, is $20,000, and its interest • $5,000 goes to the bondholders in the form of
expense is 0.10($50,000) ϭ $5,000. Therefore, its
taxable income is $20,000 Ϫ $5,000 ϭ $15,000. interest payments, thus leaving $9,000.
Taxes equal 40 percent of taxable income, or • $7,000 is what Keller’s shareholders expected to
0.4($15,000) ϭ $6,000, so the firm’s net income is
$9,000, and its return on equity, ROE, is earn: (0.14)($50,000) ϭ $7,000. Note that this
$9,000/$50,000 ϭ 18%. $7,000 payment is not a requirement to stay in
business—companies can stay in business as
long as they pay their bills and their taxes. How-
ever, this $7,000 is what shareholders expected
to earn, and it is the amount the firm must earn
if it is to avoid reducing shareholder wealth.

Second, ROE does not consider the amount of invested capital. To illustrate,
consider a large company that has $100 invested in Project A, which has an ROE
of 50 percent, and $1,000,000 invested in Project B, which has a 40 percent ROE.
The projects are equally risky, and the two returns are both well above the com-
pany’s cost of the capital invested in the projects. In this example, Project A has a
higher ROE, but because it is so small, it does little to enhance shareholder
wealth. Project B, on the other hand, has the lower ROE, but it adds much more
to shareholder value.

Consider one last problem with ROE. Assume that you manage a division of
a large firm. The firm uses ROE as the sole performance measure, and it deter-
mines bonuses on the basis of ROE. Toward the end of the year, your division’s
ROE is an impressive 45 percent. Now you have an opportunity to invest in a
large, low-risk project that has an estimated ROE of 35 percent, which is well
above the firm’s cost of capital. Even though this project is profitable, you might
be reluctant to make the investment because it would reduce your division’s
average ROE, and therefore reduce the size of your year-end bonus.

These three examples suggest that a project’s return must be combined with
its risk and size to determine its effect on shareholder value:

Chapter 4 Analysis of Financial Statements 127

• What’s left over, the $2,000, is EVA. In this case, equity. Indeed, using the simple example above, we
Keller’s management created wealth because it could also express EVA as net income minus the dol-
provided shareholders with a return greater than lar cost of equity:
what they presumably would have earned on
alternative investments with the same risk as EVA ϭ Net Income Ϫ [(Equity capital)
Keller’s stock. ϫ (Cost of equity capital)]

Some Additional Points ϭ $9,000 Ϫ [($50,000)(0.14)]

• In practice, it is often necessary to make several ϭ $2,000
adjustments in order to arrive at a “better” mea-
sure of EVA. The adjustments deal with leased Note that this is the same number we calculated
assets, depreciation, and other accounting details. before when we used the other formula for calculat-
ing EVA. Note also that the expression above could
• Shareholders may not immediately receive the be rewritten as follows:
$9,000 that Keller made for them this year (the
$7,000 that shareholders expected plus the EVA ϭ (Equity capital)[Net income/Equity capital
$2,000 of EVA). Keller can either pay its earnings Ϫ Cost of equity capital]
out as dividends or keep them in the firm as
retained earnings. In either event, the $9,000 is or simply as
shareholders’ money. The factors influencing the
dividend payout decision are discussed in the EVA ϭ (Equity capital)(ROE Ϫ Cost of equity capital)
chapter on dividend policy.
This last expression implies that EVA depends on
The Connection between ROE and EVA three factors: rate of return, as reflected in ROE; risk,
which affects the cost of equity; and size, which is
EVA is different from the traditional accounting mea- measured by the equity employed. Recall that earlier
sure of profit because EVA explicitly considers not in this chapter we said that shareholder value
just the interest cost of debt but also the cost of depends on risk, return, and capital invested. This
final equation illustrates this point.

Value ϭ f(ROE, Risk, Size)

ROE is only one dimension of the value equation, and because actions that
increase expected ROE may also affect the other two factors, steps designed to
increase expected ROE may in some cases be inconsistent with increasing share-
holder wealth. Note that we say “expected ROE,” not simply ROE. All manage-
ment decisions are designed to do something in the future, hence to affect future
outcomes.

With all this in mind, academics, practitioners, and consultants have devel-
oped alternative measures that attempt to overcome ROE’s potential problems
when it is used to gauge performance. One such measure is Economic Value
Added (EVA), which was mentioned in Chapter 3 where we calculated EVA. For
a discussion of the connection between ROE and EVA, see the accompanying
box, “EVA and ROE.”

If a firm takes steps that increase its expected future ROE, does this
mean that shareholder wealth will also increase? Explain.

128 Part 2 Fundamental Concepts in Financial Management

Students might want to 4.12 LOOKING BEYOND THE NUMBERS
refer to AAII’s educational
Web site at http://www Hopefully, working through this chapter has increased your ability to understand
.aaii.com. The site pro- and interpret financial statements. This is critically important for anyone making
vides information on business decisions, evaluating performance, or forecasting likely future develop-
investing basics, financial ments. Moreover, sound financial analysis involves more than just calculating
planning, portfolio man- numbers—good analysis requires that certain qualitative factors be considered
agement, and the like, so when evaluating a company. These factors, as summarized by the American
individuals can manage Association of Individual Investors (AAII), include the following:
their own assets more
effectively. 1. Are the company’s revenues tied to one key customer? If so, the company’s
performance may decline dramatically if the customer goes elsewhere. On
the other hand, if the relationship is firmly entrenched, this might actually
stabilize sales.

2. To what extent are the company’s revenues tied to one key product? Companies that
focus on a single product may be more efficient, but this lack of diversification
also increases risk. If revenues come from several different products, the over-
all bottom line will be less affected by an event that leads to a drop in the
demand for one of the products.

3. To what extent does the company rely on a single supplier? Depending on a single
supplier may lead to unanticipated shortages, which investors and potential
creditors should consider.

4. What percentage of the company’s business is generated overseas? Companies with
a large percentage of overseas business are often able to realize higher
growth and larger profit margins. However, firms with large overseas opera-
tions may be exposed to regional stability problems, and cash flows from
their various operations also depend on the values of different currencies.

5. Competition. Increases in competition tend to lower prices and profit margins.
In forecasting future performance, it is important to assess both the likely
actions of the current competitors and the entry by new competitors.

6. Future products. Is it necessary for the company to invest heavily in research
and development? If so, its future prospects will depend critically on the suc-
cess of new products in the pipeline. For example, the market’s assessment
of Boeing’s and Airbus’s future profits depends on how their next genera-
tions of planes are shaping up. Likewise, investors in pharmaceutical compa-
nies are interested in knowing whether the company has a strong pipeline of
potential blockbuster drugs, and that those products are doing well in the
required tests.

7. Legal and regulatory environment. Changes in laws and regulations have
important implications for many industries. For example, when forecasting
the future of tobacco companies, it is crucial to factor in the effects of pro-
posed regulations and pending or likely lawsuits. Likewise, when assessing
banks, telecommunications firms, and electric utilities, analysts need to fore-
cast both the extent to which these industries will be regulated in the future
and the ability of individual firms to respond to changes in regulation.

What are some qualitative factors analysts should consider when
evaluating a company’s likely future financial performance?

Chapter 4 Analysis of Financial Statements 129

Tying It All Together

The primary purpose of this chapter was to discuss techniques investors
and managers use to analyze financial statements. The five main categories
of ratios were discussed using data for Allied Foods, and we explained how
trend analysis and benchmarking are used. It is important to realize ratio
analysis is useful, but it must be done intelligently and with good judgment
if it is to provide useful insights into firms’ operations.

SELF-TEST QUESTIONS AND PROBLEMS
(Solutions Appear in Appendix A)

ST-1 Key terms Define each of the following terms:

ST-2 a. Liquidity ratios: current ratio; quick ratio
ST-3 b. Asset management ratios: inventory turnover ratio; days sales outstanding (DSO);

fixed assets turnover ratio; total assets turnover ratio
c. Financial leverage: debt ratio; times-interest-earned (TIE) ratio; EBITDA coverage

ratio
d. Profitability ratios: profit margin on sales; basic earning power (BEP) ratio; return

on total assets (ROA); return on common equity (ROE)
e. Market value ratios: price/earnings (P/E) ratio; price/cash flow ratio; market/

book (M/B) ratio
f. Trend analysis; comparative ratio analysis; benchmarking
g. Basic and extended Du Pont equations; book value per share
h. “Window dressing”; seasonal effects on ratios

Debt ratio Last year, K. Billingsworth & Co. had earnings per share of $4 and dividends
per share of $2. Total retained earnings increased by $12 million during the year, while
book value per share at year-end was $40. Billingsworth has no preferred stock, and
no new common stock was issued during the year. If its year-end total debt was $120
million, what was the company’s year-end debt/assets ratio?

Ratio analysis The following data apply to A.L. Kaiser & Company (millions of dollars):

Cash and equivalents $100.00
Fixed assets $283.50
Sales $1,000.00
Net income
Current liabilities $50.00
Current ratio $105.50
DSOa
ROE 3.0ϫ
40.55 days

12%

a This calculation is based on a 365-day year.

Kaiser has no preferred stock—only common equity, current liabilities, and long-term
debt.
a. Find Kaiser’s (1) accounts receivable, (2) current assets, (3) total assets, (4) ROA,

(5) common equity, (6) quick ratio, and (7) long-term debt.

130 Part 2 Fundamental Concepts in Financial Management

b. In part a, you should have found Kaiser’s accounts receivable (A/R) ϭ $111.1
million. If Kaiser could reduce its DSO from 40.55 days to 30.4 days while holding
other things constant, how much cash would it generate? If this cash were used to
buy back common stock (at book value), thus reducing common equity, how would
this affect (1) the ROE, (2) the ROA, and (3) the total debt/total assets ratio?

QUESTIONS

4-1 Financial ratio analysis is conducted by four groups of analysts: short-term lenders, long-
4-2 term lenders, stockholders, and managers. What is the primary emphasis of each group,
4-3 and how would that affect the ratios they focus on?

4-4 Why would the inventory turnover ratio be more important for someone analyzing a
4-5 grocery store chain than an insurance company?
4-6
4-7 Over the past year, M. D. Ryngaert & Co. had an increase in its current ratio and a
4-8 decline in its total assets turnover ratio. However, the company’s sales, cash and equiva-
4-9 lents, DSO, and its fixed assets turnover ratio remained constant. What balance sheet
accounts must have changed to produce the indicated changes?
4-10
Profit margins and turnover ratios vary from one industry to another. What differences
would you expect to find between the turnover ratios, profit margins, and Du Pont
equations for a grocery chain and a steel company?

How does inflation distort ratio analysis comparisons, both for one company over time
(trend analysis) and when different companies are being compared? Are only balance
sheet items or both balance sheet and income statement items affected?

If a firm’s ROE is low and management wants to improve it, explain how using more
debt might help.

Give some examples that illustrate how (a) seasonal factors and (b) different growth
rates might distort a comparative ratio analysis. How might these problems be
alleviated?

Why is it sometimes misleading to compare a company’s financial ratios with those of
other firms that operate in the same industry?

Suppose you were comparing a discount merchandiser with a high-end merchandiser.
Suppose further that both companies had identical ROEs. If you applied the extended
Du Pont equation to both firms, would you expect the three components to be the same
for each company? If not, explain what balance sheet and income statement items might
lead to the component differences.

Indicate the effects of the transactions listed in the following table on total current assets,
current ratio, and net income. Use (ϩ) to indicate an increase, (Ϫ) to indicate a decrease,
and (0) to indicate either no effect or an indeterminate effect. Be prepared to state any
necessary assumptions, and assume an initial current ratio of more than 1.0. (Note: A
good accounting background is necessary to answer some of these questions; if yours is
not strong, just answer the questions you can handle.)

Total Effect

Current Current on Net

Assets Ratio Income

a. Cash is acquired through issuance of additional _____ _____ _____
common stock. _____ _____ _____
_____ _____ _____
b. Merchandise is sold for cash. _____ _____ _____
c. Federal income tax due for the previous year is paid. _____ _____ _____
d. A fixed asset is sold for less than book value. _____ _____ _____
e. A fixed asset is sold for more than book value.
f. Merchandise is sold on credit. _____ _____ _____
g. Payment is made to trade creditors for previous _____ _____ _____

purchases.
h. A cash dividend is declared and paid.

Chapter 4 Analysis of Financial Statements 131

Total Effect

Current Current on Net

Assets Ratio Income

i. Cash is obtained through short-term bank loans. _____ _____ _____
j. Short-term notes receivable are sold at a discount. _____ _____ _____
k. Marketable securities are sold below cost. _____ _____ _____
l. Advances are made to employees. _____ _____ _____
m. Current operating expenses are paid. _____ _____ _____
n. Short-term promissory notes are issued to trade
_____ _____ _____
creditors in exchange for past due accounts payable.
o. Ten-year notes are issued to pay off accounts _____ _____ _____
_____ _____ _____
payable. _____ _____ _____
p. A fully depreciated asset is retired. _____ _____ _____
q. Accounts receivable are collected. _____ _____ _____
r. Equipment is purchased with short-term notes. _____ _____ _____
s. Merchandise is purchased on credit.
t. The estimated taxes payable are increased.

PROBLEMS

Easy 4-1 Days sales outstanding Baker Brothers has a DSO of 40 days, and its annual sales are
Problems 1–6 4-2 $7,300,000. What is its accounts receivable balance? Assume it uses a 365-day year.
4-3
Debt ratio Bartley Barstools has an equity multiplier of 2.4, and its assets are financed
with some combination of long-term debt and common equity. What is its debt ratio?

Du Pont analysis Doublewide Dealers has an ROA of 10 percent, a 2 percent profit
margin, and an ROE of 15 percent. What is its total assets turnover? What is its equity
multiplier?

4-4 Market/book ratio Jaster Jets has $10 billion in total assets. Its balance sheet shows $1
billion in current liabilities, $3 billion in long-term debt, and $6 billion in common equity.
It has 800 million shares of common stock outstanding, and its stock price is $32 per
share. What is Jaster’s market/book ratio?

4-5 Price/earnings ratio A company has an EPS of $2.00, a cash flow per share of $3.00, and
a price/cash flow ratio of 8.0ϫ. What is its P/E ratio?
4-6
Du Pont and ROE A firm has a profit margin of 2 percent and an equity multiplier of
Intermediate 4-7 2.0. Its sales are $100 million and it has total assets of $50 million. What is its ROE?
Problems 7–19
Du Pont and net income Ebersoll Mining has $6 million in sales; its ROE is 12 percent;
4-8 and its total assets turnover is 3.2ϫ. The company is 50 percent equity financed. What is
its net income?

Basic earning power Duval Manufacturing recently reported the following information:

Net income $600,000
ROA 8%
Interest expense
$225,000

Its tax rate is 35 percent. What is its basic earning power (BEP)?

4-9 M/B and share price You are given the following information: Stockholders’ equity ϭ
4-10 $3.75 billion; price/earnings ratio ϭ 3.5; common shares outstanding ϭ 50 million; and
market/book ratio ϭ 1.9. Calculate the price of a share of the company’s common stock.

Ratio calculations Assume you are given the following relationships for the Brauer Corp.:

Sales/total assets 1.5ϫ
Return on assets (ROA) 3%
Return on equity (ROE) 5%

Calculate Brauer’s profit margin and debt ratio.

4-11 EBITDA coverage ratio Willis Publishing has $30 billion in total assets. Its basic earning
power (BEP) ratio is 20 percent, and its times-interest-earned ratio is 8.0. Willis’ deprecia-
tion and amortization expense totals $3.2 billion. It has $2 billion in lease payments, and

132 Part 2 Fundamental Concepts in Financial Management

$1 billion must go toward principal payments on outstanding loans and long-term debt.
What is Willis’s EBITDA coverage ratio?

4-12 Ratio calculations Graser Trucking has $12 billion in assets, and its tax rate is 40 percent.
4-13 Its basic earning power (BEP) ratio is 15 percent, and its return on assets (ROA) is 5 per-
4-14 cent. What is its times-interest-earned (TIE) ratio?
4-15
Times-interest-earned ratio The H.R. Pickett Corp. has $500,000 of debt outstanding, and
4-16 it pays an annual interest rate of 10 percent. Its annual sales are $2 million, its average
4-17 tax rate is 30 percent, and its net profit margin on sales is 5 percent. What is its TIE ratio?

4-18 Return on equity Midwest Packaging’s ROE last year was only 3 percent, but its man-
4-19 agement has developed a new operating plan that calls for a total debt ratio of 60 per-
4-20 cent, which will result in annual interest charges of $300,000. Management projects an
EBIT of $1,000,000 on sales of $10,000,000, and it expects to have a total assets turnover
ratio of 2.0. Under these conditions, the tax rate will be 34 percent. If the changes are
made, what will be its return on equity?

Return on equity and quick ratio Lloyd Inc. has sales of $200,000, a net income of
$15,000, and the following balance sheet:

Cash $ 10,000 Accounts payable $ 30,000
Receivables 50,000 Other current liabilities 20,000
Inventories Long-term debt 50,000
Net fixed assets 150,000 Common equity
Total assets 90,000 Total liabilities and equity 200,000
$300,000
$300,000

The new owner thinks that inventories are excessive and can be lowered to the point
where the current ratio is equal to the industry average, 2.5ϫ, without affecting either
sales or net income. If inventories are sold off and not replaced thus reducing the current
ratio to 2.5ϫ, if the funds generated are used to reduce common equity (stock can be
repurchased at book value), and if no other changes occur, by how much will the ROE
change? What will be the firm’s new quick ratio?

Return on equity Central City Construction (CCC) needs $1 million of assets to get
started, and it expects to have a basic earning power ratio of 20 percent. CCC will own
no securities, so all of its income will be operating income. If it chooses to, CCC can
finance up to 50 percent of its assets with debt, which will have an 8 percent interest
rate. Assuming a 40 percent tax rate on all taxable income, what is the difference between
its expected ROE if CCC finances with 50 percent debt versus its expected ROE if it
finances entirely with common stock?

Conceptual: Return on equity Which of the following statements is most correct? (Hint:
Work Problem 4-16 before answering 4-17, and consider the solution setup for 4-16, as
you think about 4-17.)

a. If a firm’s expected basic earning power (BEP) is constant for all of its assets and
exceeds the interest rate on its debt, then adding assets and financing them with
debt will raise the firm’s expected return on common equity (ROE).

b. The higher its tax rate, the lower a firm’s BEP ratio will be, other things held constant.
c. The higher the interest rate on its debt, the lower a firm’s BEP ratio will be, other

things held constant.
d. The higher its debt ratio, the lower a firm’s BEP ratio will be, other things held

constant.
e. Statement a is false, but statements b, c, and d are all true.

TIE ratio AEI Incorporated has $5 billion in assets, and its tax rate is 40 percent. Its basic
earning power (BEP) ratio is 10 percent, and its return on assets (ROA) is 5 percent.
What is AEI’s times-interest-earned (TIE) ratio?

Current ratio The Petry Company has $1,312,500 in current assets and $525,000 in cur-
rent liabilities. Its initial inventory level is $375,000, and it will raise funds as additional
notes payable and use them to increase inventory. How much can its short-term debt
(notes payable) increase without pushing its current ratio below 2.0?

Challenging DSO and accounts receivable Harrelson Inc. currently has $750,000 in accounts receiv-
Problems 20–24 able, and its days sales outstanding (DSO) is 55 days. It wants to reduce its DSO to 35
days by pressuring more of its customers to pay their bills on time. If this policy is
adopted the company’s average sales will fall by 15 percent. What will be the level of
accounts receivable following the change? Assume a 365-day year.

Chapter 4 Analysis of Financial Statements 133

4-21 P/E and stock price Fontaine Inc. recently reported net income of $2 million. It has
4-22 500,000 shares of common stock, which currently trades at $40 a share. Fontaine continues
to expand and anticipates that 1 year from now its net income will be $3.25 million. Over
4-23 the next year it also anticipates issuing an additional 150,000 shares of stock, so that 1
year from now it will have 650,000 shares of common stock. Assuming its price/earnings
ratio remains at its current level, what will be its stock price 1 year from now?

Balance sheet analysis Complete the balance sheet and sales information that follows
using the following financial data:

Debt ratio: 50%
Current ratio: 1.8ϫ
Total assets turnover: 1.5ϫ
Days sales outstanding: 36.5 daysa
Gross profit margin on sales: (Sales Ϫ Cost of goods sold)/Sales ϭ 25%
Inventory turnover ratio: 5ϫ

a Calculation is based on a 365-day year.

Balance Sheet Accounts payable 60,000
Cash Long-term debt 97,500
Accounts receivable Common stock
Inventories $300,000 Retained earnings
Fixed assets Total liabilities and equity
Total assets Cost of goods sold
Sales

Ratio analysis Data for Barry Computer Co. and its industry averages follow.

a. Calculate the indicated ratios for Barry.
b. Construct the extended Du Pont equation for both Barry and the industry.
c. Outline Barry’s strengths and weaknesses as revealed by your analysis.
d. Suppose Barry had doubled its sales as well as its inventories, accounts receivable,

and common equity during 2005. How would that information affect the validity of
your ratio analysis? (Hint: Think about averages and the effects of rapid growth on
ratios if averages are not used. No calculations are needed.)

Barry Computer Company: Balance Sheet as of
December 31, 2005 (In Thousands)

Cash $ 77,500 Accounts payable $129,000
Receivables 336,000 Notes payable 84,000
Inventories 241,500 Other current liabilities
117,000
Total current assets $655,000 Total current liabilities $330,000
Long-term debt
Net fixed assets 292,500 Common equity 256,500
Total assets $947,500 Total liabilities and equity 361,000
$947,500
Barry Computer Company: Income Statement for $717,000
Year Ended December 31, 2005 (In Thousands) 453,000 $1,607,500
68,000
Sales 113,000 1,392,500
Cost of goods sold 41,500 $ 215,000

Materials 115,000
Labor 30,000
Heat, light, and power
Indirect labor $ 70,000
Depreciation 24,500

Gross profit $ 45,500
Selling expenses 18,200
General and administrative expenses
$ 27,300
Earnings before interest and taxes (EBIT)
Interest expense

Earnings before taxes (EBT)
Federal and state income taxes (40 percent)

Net income

134 Part 2 Fundamental Concepts in Financial Management

Ratio Barry Industry Average

Current _____ 2.0ϫ
Quick _____ 1.3ϫ
Days sales outstandinga _____ 35 days
Inventory turnover _____ 6.7ϫ
Total assets turnover _____ 3.0ϫ
Net profit margin _____ 1.2%
ROA _____ 3.6%
ROE _____ 9.0%
Total debt/total assets _____ 60.0%

a Calculation is based on a 365-day year.

4-24 Du Pont analysis A firm has been experiencing low profitability in recent years. Perform
an analysis of the firm’s financial position using the extended Du Pont equation. The
firm has no lease payments, but has a $2 million sinking fund payment on its debt. The
most recent industry average ratios and the firm’s financial statements are as follows:

Industry Average Ratios

Current ratio 2ϫ Fixed assets turnover 6ϫ
Debt/total assets 30% Total assets turnover 3ϫ
Times interest earned Profit margin on sales 3%
EBITDA coverage 7ϫ Return on total assets 9%
Inventory turnover 9ϫ Return on common equity 12.9%
Days sales outstandinga 10ϫ
24 days

a Calculation is based on a 365-day year.

Balance Sheet as of December 31, 2005 (Millions of Dollars)

Cash and equivalents $ 78 Accounts payable $ 45
Net receivables 66 Notes payable 45
Inventories Other current liabilities 21
159
$ 111
Total current assets $303 Total current liabilities 24
Long-term debt
$ 135
Gross fixed assets 225 Total liabilities
Less depreciation 78 114
Common stock 201
Net fixed assets $147 Retained earnings $ 315
$ 450
Total stockholders’ equity

Total assets $450 Total liabilities and equity

Income Statement for Year Ended December 31, 2005 $795.0
(Millions of Dollars) 660.0

Net sales $135.0
Cost of goods sold 73.5

Gross profit $ 61.5
Selling expenses 12.0

EBITDA $ 49.5
Depreciation expense 4.5

Earnings before interest and taxes (EBIT) $ 45.0
Interest expense 18.0

Earnings before taxes (EBT) $ 27.0
Taxes (40%)

Net income

Chapter 4 Analysis of Financial Statements 135

a. Calculate those ratios that you think would be useful in this analysis.
b. Construct an extended Du Pont equation, and compare the company’s ratios to the

industry average ratios.
c. Do the balance sheet accounts or the income statement figures seem to be primarily

responsible for the low profits?
d. Which specific accounts seem to be most out of line relative to other firms in the

industry?
e. If the firm had a pronounced seasonal sales pattern, or if it grew rapidly during the

year, how might that affect the validity of your ratio analysis? How might you cor-
rect for such potential problems?

COMPREHENSIVE/SPREADSHEET
PROBLEM

4-25 Ratio analysis The Corrigan Corporation’s 2004 and 2005 financial statements follow,
along with some industry average ratios.

a. Assess Corrigan’s liquidity position, and determine how it compares with peers and
how the liquidity position has changed over time.

b. Assess Corrigan’s asset management position, and determine how it compares with
peers and how its asset management efficiency has changed over time.

c. Assess Corrigan’s debt management position, and determine how it compares with
peers and how its debt management has changed over time.

d. Assess Corrigan’s profitability ratios, and determine how they compare with peers
and how the profitability position has changed over time.

e. Assess Corrigan’s market value ratios, and determine how their valuation compares
with peers and how it has changed over time.

f. Calculate Corrigan’s ROE, as well as the industry average ROE, using the extended
Du Pont equation. From this analysis, how does Corrigan’s financial position com-
pare with the industry average numbers?

g. What do you think would happen to its ratios if the company initiated cost-cutting
measures that allowed it to hold lower levels of inventory and substantially
decreased the cost of goods sold? No calculations are necessary. Think about which
ratios would be affected by changes in these two accounts.

Corrigan Corporation: Balance Sheets as of December 31

2005 2004

Cash $ 72,000 $ 65,000
Accounts receivable 439,000 328,000
Inventories 894,000 813,000

Total current assets $1,405,000 $1,206,000
Land and building 238,000 271,000
Machinery 132,000 133,000
Other fixed assets 61,000 57,000

Total assets $1,836,000 $1,667,000

Accounts and notes payable $ 432,000 $ 409,500
Accrued liabilities 170,000 162,000

Total current liabilities $ 602,000 $ 571,500
Long-term debt 404,290 258,898
Common stock 575,000 575,000
Retained earnings 254,710 261,602

Total liabilities and equity $1,836,000 $1,667,000

136 Part 2 Fundamental Concepts in Financial Management

Corrigan Corporation: Income Statements for
Years Ending December 31

2005 2004

Sales $4,240,000 $3,635,000
Cost of goods sold 3,680,000 2,980,000

Gross operating profit $ 560,000 $ 655,000
General administrative and selling expenses 236,320 213,550
Depreciation 159,000 154,500
Miscellaneous 134,000 127,000

Earnings before taxes (EBT) $ 30,680 $ 159,950
Taxes (40%) 12,272 63,980

Net income $ 18,408 $ 95,970

Per-Share Data 2005 2004

EPS $0.80 $4.17
Cash dividends $1.10 $0.95
Market price (average) $12.34 $23.57
P/E ratio 15.4ϫ 5.65ϫ
Number of shares outstanding 23,000 23,000

Industry Financial Ratiosa 2.7ϫ
7.0ϫ
Current ratio 32 days
Inventory turnoverb 13.0ϫ
Days sales outstandingc 2.6ϫ
Fixed assets turnoverb 9.1%
Total assets turnoverb 18.2%
Return on assets 50.0%
Return on equity 3.5%
Debt ratio 6.0ϫ
Profit margin on sales 3.5ϫ
P/E ratio
Price/cash flow ratio

a Industry average ratios have been constant for the past 4 years.
b Based on year-end balance sheet figures.
c Calculation is based on a 365-day year.

Integrated Case

D’Leon Inc., Part II

4-26 Financial statement analysis Part I of this case, presented in Chapter 3, discussed the situation that D’Leon
Inc., a regional snack-foods producer, was in after an expansion program. D’Leon had increased plant capac-
ity and undertaken a major marketing campaign in an attempt to “go national.” Thus far, sales have not been
up to the forecasted level, costs have been higher than were projected, and a large loss occurred in 2005 rather
than the expected profit. As a result, its managers, directors, and investors are concerned about the firm’s
survival.

Donna Jamison was brought in as assistant to Fred Campo, D’Leon’s chairman, who had the task of get-
ting the company back into a sound financial position. D’Leon’s 2004 and 2005 balance sheets and income
statements, together with projections for 2006, are given in Tables IC4-1 and IC4-2. In addition, Table IC4-3
gives the company’s 2004 and 2005 financial ratios, together with industry average data. The 2006 projected
financial statement data represent Jamison’s and Campo’s best guess for 2006 results, assuming that some
new financing is arranged to get the company “over the hump.”

Chapter 4 Analysis of Financial Statements 137

Jamison examined monthly data for 2005 (not given in the case), and she detected an improving pattern
during the year. Monthly sales were rising, costs were falling, and large losses in the early months had turned
to a small profit by December. Thus, the annual data look somewhat worse than final monthly data. Also, it
appears to be taking longer for the advertising program to get the message across, for the new sales offices to
generate sales, and for the new manufacturing facilities to operate efficiently. In other words, the lags between
spending money and deriving benefits were longer than D’Leon’s managers had anticipated. For these rea-
sons, Jamison and Campo see hope for the company—provided it can survive in the short run.

Jamison must prepare an analysis of where the company is now, what it must do to regain its financial
health, and what actions should be taken. Your assignment is to help her answer the following questions. Pro-
vide clear explanations, not yes or no answers.

a. Why are ratios useful? What are the five major categories of ratios?
b. Calculate D’Leon’s 2006 current and quick ratios based on the projected balance sheet and income state-

ment data. What can you say about the company’s liquidity positions in 2004, 2005, and as projected for
2006? We often think of ratios as being useful (1) to managers to help run the business, (2) to bankers for
credit analysis, and (3) to stockholders for stock valuation. Would these different types of analysts have
an equal interest in these liquidity ratios?
c. Calculate the 2006 inventory turnover, days sales outstanding (DSO), fixed assets turnover, and total
assets turnover. How does D’Leon’s utilization of assets stack up against other firms in its industry?
d. Calculate the 2006 debt, times-interest-earned, and EBITDA coverage ratios. How does D’Leon compare
with the industry with respect to financial leverage? What can you conclude from these ratios?
e. Calculate the 2006 profit margin, basic earning power (BEP), return on assets (ROA), and return on equity
(ROE). What can you say about these ratios?
f. Calculate the 2006 price/earnings ratio, price/cash flow ratio, and market/book ratio. Do these ratios
indicate that investors are expected to have a high or low opinion of the company?
g. Use the extended Du Pont equation to provide a summary and overview of D’Leon’s financial condition
as projected for 2006. What are the firm’s major strengths and weaknesses?
h. Use the following simplified 2006 balance sheet to show, in general terms, how an improvement in the
DSO would tend to affect the stock price. For example, if the company could improve its collection proce-
dures and thereby lower its DSO from 45.6 days to the 32-day industry average without affecting sales,
how would that change “ripple through” the financial statements (shown in thousands below) and influ-
ence the stock price?

Accounts receivable $ 878 Debt $1,545
Other current assets 1,802
Net fixed assets 817 Equity 1,952
Liabilities plus equity $3,497
Total assets $3,497

i. Does it appear that inventories could be adjusted, and, if so, how should that adjustment affect D’Leon’s
profitability and stock price?

j. In 2005, the company paid its suppliers much later than the due dates, and it was not maintaining finan-
cial ratios at levels called for in its bank loan agreements. Therefore, suppliers could cut the company off,
and its bank could refuse to renew the loan when it comes due in 90 days. On the basis of data provided,
would you, as a credit manager, continue to sell to D’Leon on credit? (You could demand cash on
delivery—that is, sell on terms of COD—but that might cause D’Leon to stop buying from your
company.) Similarly, if you were the bank loan officer, would you recommend renewing the loan or
demand its repayment? Would your actions be influenced if, in early 2006, D’Leon showed you its 2006
projections plus proof that it was going to raise more than $1.2 million of new equity?

k. In hindsight, what should D’Leon have done back in 2004?
l. What are some potential problems and limitations of financial ratio analysis?
m. What are some qualitative factors analysts should consider when evaluating a company’s likely future

financial performance?

138 Part 2 Fundamental Concepts in Financial Management

TA B L E I C 4 - 1 Balance Sheets

Assets 2006E 2005 2004
Cash
Accounts receivable $ 85,632 $ 7,282 $ 57,600
Inventories 878,000 632,160 351,200
715,200
Total current assets 1,716,480 1,287,360
Gross fixed assets $2,680,112 $1,926,802 $1,124,000
Less accumulated depreciation 491,000
1,197,160 1,202,950 146,200
Net fixed assets 380,120 263,160
$ 344,800
Total assets $ 817,040 $ 939,790 $1,468,800
$3,497,152 $2,866,592
Liabilities and Equity $ 145,600
Accounts payable $ 436,800 $ 524,160 200,000
Notes payable 300,000 636,808 136,000
Accruals 408,000 489,600
$ 481,600
Total current liabilities $1,144,800 $1,650,568 323,432
Long-term debt 400,000 723,432 460,000
Common stock 460,000 203,768
Retained earnings 1,721,176 32,592
231,176 $ 663,768
Total equity $ 492,592 $1,468,800
$1,952,352 $2,866,592
Total liabilities and equity $3,497,152

Note: “E” indicates estimated. The 2006 data are forecasts.

TA B L E I C 4 - 2 Income Statements

Sales 2006E 2005 2004
Cost of goods sold
Other expenses $7,035,600 $6,034,000 $3,432,000
Total operating costs excluding 5,875,992 5,528,000 2,864,000
550,000 519,988 358,672
depreciation
EBITDA $6,425,992 $6,047,988 $3,222,672
Depreciation $ 609,608 ($ 13,988) $ 209,328

EBIT 116,960 116,960 18,900
Interest expense $ 492,648 ($ 130,948) $ 190,428

EBT 70,008 136,012 43,828
Taxes (40%) $ 422,640 ($ 266,960) $ 146,600
( 106,784)a
Net income 169,056 ($ 160,176) 58,640
$ 253,584 $ 87,960
($1.602)
EPS $1.014 $0.110 $0.880
DPS $0.220 $4.926 $0.220
Book value per share $7.809 $2.25 $6.638
Stock price $12.17
Shares outstanding 250,000 100,000 $8.50
Tax rate 40.00% 40.00% 100,000
Lease payments 40,000 40,000 40.00%
Sinking fund payments
0 0 40,000
0

Note: “E” indicates estimated. The 2006 data are forecasts.
a The firm had sufficient taxable income in 2003 and 2004 to obtain its full tax refund in 2005.

Chapter 4 Analysis of Financial Statements 139

TA B L E I C 4 - 3 Ratio Analysis

2006E 2005 2004 Industry
Average
Current 1.2ϫ 2.3ϫ
Quick 0.4ϫ 0.8ϫ 2.7ϫ
Inventory turnover 4.7ϫ 4.8ϫ 1.0ϫ
Days sales outstanding (DSO)a 38.2 37.4 6.1ϫ
Fixed assets turnover 6.4ϫ 10.0ϫ 32.0
Total assets turnover 2.1ϫ 2.3ϫ 7.0ϫ
Debt ratio 82.8% 54.8% 2.6ϫ
TIE Ϫ1.0ϫ 4.3ϫ 50.0%
EBITDA coverage 0.1ϫ 3.0ϫ 6.2ϫ
Profit margin Ϫ2.7% 2.6% 8.0ϫ
Basic earning power Ϫ4.6% 13.0% 3.5%
ROA Ϫ5.6% 6.0% 19.1%
ROE Ϫ32.5% 13.3% 9.1%
Price/earnings Ϫ1.4ϫ 9.7ϫ 18.2%
Price/cash flow Ϫ5.2ϫ 8.0ϫ 14.2ϫ
Market/book 0.5ϫ 1.3ϫ 11.0ϫ
Book value per share $4.93 $6.64 2.4ϫ

n.a.

Note: “E” indicates estimated. The 2006 data are forecasts.
a Calculation is based on a 365-day year.

Please go to the ThomsonNOW Web site to access the
Cyberproblems.

140 Part 2 Fundamental Concepts in Financial Management

Access the Thomson ONE problems though the ThomsonNOW Web site. Use the Thomson
ONE—Business School Edition online database to work this chapter’s questions.

Conducting a Financial Ratio Analysis on Ford Motor Company

In Chapter 3, we took a look at Starbucks’ financial statements. Now we use Thomson
One to analyze Ford Motor Company.

Enter Ford’s ticker symbol (F) and select “GO.” If we select the tab at the top labeled
“Financials,” we can find Ford’s key financial statements for the past several years. At the
“Financials” screen on the second line of tabs, select the “Fundamental Ratios” tab. If
you then select the SEC Database Ratios from the pull-down menu, you can select either
annual or quarterly ratios.

Under annual ratios, there is an in-depth summary of Ford’s various ratios over the
past 3 years. This information enables you to evaluate Ford’s performance over time for
each of the ratio categories that we mention in the text (liquidity, asset management,
debt management, profitability, and market-based ratios).

The text mentions that financial statement analysis has two major components: a
trend analysis, where we evaluate changes in the key ratios over time, and a peer analy-
sis, where we compare financial ratios with firms that are in the same industry and/or line
of business. We have already used Thomson One to conduct a trend analysis—next we
use this tool to conduct a peer analysis. If we click on the “Peers” tab (on the first line of
tabs) near the top of the screen, some summary financial information for Ford and a few
of its peers will be presented. If you click on the “Peer Sets” tab (second line of tabs),
you can modify the list of peer firms. The default setup is “Peers set by SIC Code.” To
obtain a comparison of many of the key ratios presented in the text, just click on “Finan-
cials” (second line of tabs) and select “Key Financial Ratios” from the drop-down menu.

Discussion Questions

1. What has happened to Ford’s liquidity position over the past 3 years? How does
Ford’s liquidity compare with its peers? (Hint: You may use both the peer key financial
ratios and liquidity comparison to answer this question.)

2. Take a look at Ford’s inventory turnover ratio. How does this ratio compare with its
peers? Have there been any interesting changes over time in this measure? Do you
consider Ford’s inventory management to be a strength or a weakness?

3. Construct a simple Du Pont analysis for Ford and its peers. What are Ford’s strengths
and weaknesses relative to its competitors?

© JOHN GRESS/REUTERS/CORBIS HAPTER

C 5

FINANCIAL MARKETS

AND INSTITUTIONS

A Strong Financial System Is Necessary for a Growing
and Prosperous Economy

Financial managers and investors don’t operate in a vacuum—they make deci-
sions within a large and complex financial environment. This environment
includes financial markets and institutions, tax and regulatory policies, and the
state of the economy. The environment both determines the available financial
alternatives and affects the outcomes of various decisions. Thus, it is crucial that
investors and financial managers have a good understanding of the environ-
ment in which they operate.

History shows that a strong financial system is a necessary ingredient for a
growing and prosperous economy. Companies raising capital to finance capital
expenditures as well as investors saving to accumulate funds for future use
require well-functioning financial markets and institutions.

Over the past few decades, changing technology and improving communi-
cations have increased cross-border transactions and expanded the scope and
efficiency of the global financial system. Companies routinely raise funds
throughout the world to finance projects all around the globe. Likewise, with
the click of a mouse an individual investor in Nebraska can deposit funds in a
European bank or purchase a mutual fund that invests in Chinese securities.

It is important to recognize that at the most fundamental level well-functioning
markets and institutions are based heavily on trust. An investor who deposits
money in a bank, buys stock through an online brokerage account, or contacts
her broker to buy a mutual fund places her money and trust in the hands of the
financial institutions that provide her with advice and transaction services. Simi-
larly, when businesses approach commercial or investment banks to raise capi-
tal, they are relying on these institutions to provide them with funds under the
best possible terms, and with sound, objective advice.

While changing technology and globalization have made it possible for
more and more types of financial transactions to take place, a series of scan-
dals in recent years have rocked the financial industry and have led many to

142 Part 2 Fundamental Concepts in Financial Management

question whether some of our institutions are serving their own or their clients’
interests.

Many of these questionable practices have come to light because of the
efforts of a single man: the Attorney General of New York, Eliot Spitzer. In 2001,
Spitzer exposed conflicts of interest within investment banking firms regarding
dealings between their underwriters, who help companies issue new securities,
and their analysts, who make recommendations to individual investors to pur-
chase these securities. Allegations were made that to attract the business of firms
planning to issue new securities, investment banks leaned on their analysts to
write glowing, overly optimistic research reports on these firms. While such prac-
tices helped produce large underwriting fees for the investment banks, they com-
promised their ability to provide the objective, independent research on which
their clients depended. A few years later, Spitzer turned his attention to the
mutual fund industry, where he exposed unethical fee structures and trading prac-
tices of some of the leading funds. More recently, Spitzer has questioned whether
some insurance brokers have compromised their clients’ interests in order to steer
business toward insurers, who provide the broker with rebates of different types.1

While some have criticized Spitzer for being overly zealous and politically
ambitious, his efforts have appropriately brought to light many questionable
practices. Hopefully, this spotlight will put pressure on the institutions to estab-
lish practices that will restore the public’s trust and lead to a better financial
system in the long run.

Putting Things In Perspective

In earlier chapters, we discussed financial statements and showed how
financial managers and others analyze them to evaluate a firm’s operations
and financial position—past, current, and future. To make good decisions,
financial managers must understand the environment and markets within
which businesses operate. Therefore, in this chapter we describe the mar-
kets where capital is raised, securities are traded, and stock prices are
established, as well as the institutions that operate in these markets.
Because the overall objective of financial managers is to maximize share-
holder value, we also take a closer look at how the stock market operates,
and we discuss the concept of market efficiency.

1 For example, some insurance companies allowed brokers to keep premiums for as much as a year
before remitting them to the insurance companies. The brokers invested these premiums and earned
interest on them, and this gave them an incentive to steer business to these companies rather than
to insurance companies whose policies might be better for the brokers’ clients.

Chapter 5 Financial Markets and Institutions 143

5.1 AN OVERVIEW OF THE CAPITAL

ALLOCATION PROCESS

Businesses, individuals, and governments often need to raise capital. For exam-
ple, suppose Carolina Power & Light (CP&L) forecasts an increase in the
demand for electricity in North Carolina, and the company decides to build a
new power plant. Because CP&L almost certainly will not have the $1 billion or
so necessary to pay for the plant, the company will have to raise this capital in
the financial markets. Or suppose Mr. Fong, the proprietor of a San Francisco
hardware store, decides to expand into appliances. Where will he get the money
to buy the initial inventory of TV sets, washers, and freezers? Similarly, if the
Johnson family wants to buy a home that costs $200,000, but they have only
$40,000 in savings, how can they raise the additional $160,000? And if the city of
New York wants to borrow $200 million to finance a new sewer plant, or the
federal government needs money to meet its needs, they too need access to the
capital markets.

On the other hand, some individuals and firms have incomes that are greater
than their current expenditures, so they have funds available to invest. For exam-
ple, Carol Hawk has an income of $36,000, but her expenses are only $30,000,
and as of December 31, 2004, Ford Motor Company had accumulated roughly
$23.5 billion of cash and equivalents, which it has available for future investments.

People and organizations with surplus funds are saving today in order to
accumulate funds for future use. A household might save to pay for future
expenses such as their children’s education or their retirement, while a business
might save to fund future investments. Those with surplus funds expect to earn
a positive return on their investments. People and organizations who need
money today borrow to fund their current expenditures. They understand that
there is a cost to this capital, and this cost is essentially the return that the
investors with surplus funds expect to earn on those funds.

In a well-functioning economy, capital will flow efficiently from those who
supply capital to those who demand it. This transfer of capital can take place in
the three different ways described in Figure 5-1:

1. Direct transfers of money and securities, as shown in the top section, occur
when a business sells its stocks or bonds directly to savers, without going
through any type of financial institution. The business delivers its securities
to savers, who in turn give the firm the money it needs.

2. As shown in the middle section, transfers may also go through an investment
banking house such as Merrill Lynch, which underwrites the issue. An under-
writer serves as a middleman and facilitates the issuance of securities. The
company sells its stocks or bonds to the investment bank, which in turn sells
these same securities to savers. The businesses’ securities and the savers’
money merely “pass through” the investment banking house. However, the
investment bank does buy and hold the securities for a period of time, so it is
taking a risk—it may not be able to resell them to savers for as much as it
paid. Because new securities are involved and the corporation receives the
proceeds of the sale, this is called a primary market transaction.

3. Transfers can also be made through a financial intermediary such as a bank or
mutual fund. Here the intermediary obtains funds from savers in exchange
for its own securities. The intermediary uses this money to buy and hold
businesses’ securities. For example, a saver might deposit dollars in a bank,
receiving from it a certificate of deposit, and then the bank might lend the
money to a small business as a mortgage loan. Thus, intermediaries literally
create new forms of capital—in this case, certificates of deposit, which are
both safer and more liquid than mortgages and thus are better for most

144 Part 2 Fundamental Concepts in Financial Management

F I G U R E 5 - 1 Diagram of the Capital Formation Process

1. Direct Transfers Securities (Stocks or Bonds) Savers
Business Dollars

2. Indirect Transfers through Investment Bankers

Securities Securities
Dollars
Business Investment Banking Savers
Houses Savers

Dollars

3. Indirect Transfers through a Financial Intermediary

Business’s Intermediary’s
Securities Securities

Business Dollars Financial Dollars
Intermediary

savers to hold. The existence of intermediaries greatly increases the efficiency
of money and capital markets.

Often the entity needing capital is a business, and specifically a corporation,
but it is easy to visualize the demander of capital being a home purchaser, a
small business, a government unit, and so on. For example, if your uncle lends
you money to help fund a new business after you graduate, this would be a
direct transfer of funds. Alternatively, if your family borrows money to purchase
a home, you will probably raise the funds through a financial intermediary such
as your local commercial bank or mortgage banker, which in turn may acquire
its funds from a national institution, such as Fannie Mae.

In a global context, economic development is highly correlated with the
level and efficiency of financial markets and institutions.2 It is difficult, if not
impossible, for an economy to reach its full potential if it doesn’t have access to a
well-functioning financial system. For this reason, policy makers often promote
the globalization of financial markets.

In a well-developed economy like that of the United States, an extensive set
of markets and institutions has evolved over time to facilitate the efficient alloca-
tion of capital. To raise capital efficiently, managers must understand how these
markets and institutions work.

Identify three different ways capital is transferred between savers
and borrowers.

Why do policy makers promote the globalization of financial markets?

2 For a detailed review of the evidence linking financial development to economic growth, see Ross
Levine, “Finance and Growth: Theory and Evidence,” NBER Working Paper no. w10766, September
2004.

Chapter 5 Financial Markets and Institutions 145

5.2 FINANCIAL MARKETS Spot Markets
The markets in which
People and organizations wanting to borrow money are brought together with assets are bought or
those having surplus funds in the financial markets. Note that “markets” is plural; sold for “on-the-spot”
there are a great many different financial markets in a developed economy such delivery.
as ours. We briefly describe the different types of financial markets and some
recent trends in these markets. Futures Markets
The markets in which
Types of Markets participants agree
today to buy or sell an
Different financial markets serve different types of customers or different parts asset at some future
of the country. Financial markets also vary depending on the maturity of the date.
securities being traded and the types of assets used to back the securities.
For these reasons it is often useful to classify markets along the following Money Markets
dimensions: The financial markets in
which funds are bor-
1. Physical asset versus financial asset markets. Physical asset markets (also called rowed or loaned for
“tangible” or “real” asset markets) are those for products such as wheat, short periods (less than
autos, real estate, computers, and machinery. Financial asset markets, on the one year).
other hand, deal with stocks, bonds, notes, mortgages, and other claims on
real assets, as well as with derivative securities whose values are derived from Capital Markets
changes in the prices of other assets. A share of Ford stock is a “pure finan- The financial markets
cial asset,” while an option to buy Ford shares is a derivative security whose for stocks and for
value depends on the price of Ford stock. intermediate- or long-
term debt (one year
2. Spot versus futures markets. Spot markets are markets in which assets are or longer).
bought or sold for “on-the-spot” delivery (literally, within a few days).
Futures markets are markets in which participants agree today to buy or Primary Markets
sell an asset at some future date. For example, a farmer may enter into a Markets in which
futures contract in which he agrees today to sell 5,000 bushels of soybeans corporations raise
six months from now at a price of $5 a bushel. On the other side, an inter- capital by issuing new
national food producer looking to buy soybeans in the future may enter securities.
into a futures contract in which it agrees to buy soybeans six months from
now. Secondary Markets
Markets in which secu-
3. Money versus capital markets. Money markets are the markets for short-term, rities and other finan-
highly liquid debt securities. The New York, London, and Tokyo money mar- cial assets are traded
kets are among the world’s largest. Capital markets are the markets for among investors after
intermediate- or long-term debt and corporate stocks. The New York Stock they have been issued
Exchange, where the stocks of the largest U.S. corporations are traded, is a by corporations.
prime example of a capital market. There is no hard and fast rule on this, but
when describing debt markets, “short term” generally means less than 1 year,
“intermediate term” means 1 to 10 years, and “long term” means more than
10 years.

4. Primary versus secondary markets. Primary markets are the markets in which
corporations raise new capital. If GE were to sell a new issue of common
stock to raise capital, this would be a primary market transaction. The corpo-
ration selling the newly created stock receives the proceeds from the sale in a
primary market transaction. Secondary markets are markets in which exist-
ing, already outstanding, securities are traded among investors. Thus, if Jane
Doe decided to buy 1,000 shares of GE stock, the purchase would occur in
the secondary market. The New York Stock Exchange is a secondary market
because it deals in outstanding, as opposed to newly issued, stocks and
bonds. Secondary markets also exist for mortgages, various other types of
loans, and other financial assets. The corporation whose securities are being
traded is not involved in a secondary market transaction and, thus, does not
receive any funds from such a sale.

146 Part 2 Fundamental Concepts in Financial Management

Private Markets 5. Private versus public markets. Private markets, where transactions are negoti-
Markets in which trans- ated directly between two parties, are differentiated from public markets,
actions are worked out where standardized contracts are traded on organized exchanges. Bank loans
directly between two and private debt placements with insurance companies are examples of
parties. private market transactions. Because these transactions are private, they may
be structured in any manner that appeals to the two parties. By contrast,
Public Markets securities that are issued in public markets (for example, common stock and
Markets in which stan- corporate bonds) are ultimately held by a large number of individuals. Pub-
dardized contracts are lic securities must have fairly standardized contractual features, both to
traded on organized appeal to a broad range of investors and also because public investors do not
exchanges. generally have the time and expertise to study unique, nonstandardized con-
tracts. Their wide ownership also ensures that public securities are relatively
liquid. Private market securities are, therefore, more tailor-made but less
liquid, whereas publicly traded securities are more liquid but subject to
greater standardization.

Other classifications could be made, but this breakdown is sufficient to show
that there are many types of financial markets. Also, note that the distinctions
among markets are often blurred and unimportant except as a general point of
reference. For example, it makes little difference if a firm borrows for 11, 12, or
13 months, hence, whether we have a “money” or “capital” market transaction.
You should be aware of the important differences among types of markets, but
don’t get hung up trying to distinguish them at the boundaries.

A healthy economy is dependent on efficient funds transfers from people
who are net savers to firms and individuals who need capital. Without efficient
transfers, the economy simply could not function: Carolina Power & Light could
not raise capital, so Raleigh’s citizens would have no electricity; the Johnson
family would not have adequate housing; Carol Hawk would have no place to
invest her savings; and so on. Obviously, the level of employment and produc-
tivity, hence our standard of living, would be much lower. Therefore, it is
absolutely essential that our financial markets function efficiently—not only
quickly, but also at a low cost.3

Table 5-1 (on pages 148–149) gives a listing of the most important instru-
ments traded in the various financial markets. The instruments are arranged
from top to bottom in ascending order of typical length of maturity. As we go
through the book, we will look in more detail at many of the instruments listed
in Table 5-1. For example, we will see that there are many varieties of corporate
bonds, ranging from “plain vanilla” bonds to bonds that are convertible into
common stocks to bonds whose interest payments vary depending on the infla-
tion rate. Still, the table gives an idea of the characteristics and costs of the
instruments traded in the major financial markets.

Recent Trends

Financial markets have experienced many changes during the last two decades.
Technological advances in computers and telecommunications, along with the
globalization of banking and commerce, have led to deregulation, and this has
increased competition throughout the world. The result is a much more effi-

3 As the countries of the former Soviet Union and other Eastern European nations move toward
capitalism, just as much attention must be paid to the establishment of cost-efficient financial
markets as to electrical power, transportation, communications, and other infrastructure systems.
Economic efficiency is simply impossible without a good system for allocating capital within the
economy.

Chapter 5 Financial Markets and Institutions 147

cient, internationally linked market, but one that is far more complex than Derivative
existed a few years ago. While these developments have been largely positive,
they have also created problems for policy makers. At one conference, Federal Any financial asset
Reserve Board Chairman Alan Greenspan stated that modern financial markets whose value is derived
“expose national economies to shocks from new and unexpected sources from the value of some
and with little if any lag.” He went on to say that central banks must develop other “underlying”
new ways to evaluate and limit risks to the financial system. Large amounts of asset.
capital move quickly around the world in response to changes in interest and
exchange rates, and these movements can disrupt local institutions and economies.

Globalization has exposed the need for greater cooperation among regula-
tors at the international level. Various committees are currently working to
improve coordination, but the task is not easy. Factors that complicate coordina-
tion include (1) the differing structures among nations’ banking and securities
industries, (2) the trend in Europe toward financial services conglomerates, and
(3) reluctance on the part of individual countries to give up control over their
national monetary policies. Still, regulators are unanimous about the need to
close the gaps in the supervision of worldwide markets.

Another important trend in recent years has been the increased use of
derivatives. A derivative is any security whose value is derived from the price
of some other “underlying” asset. An option to buy IBM stock is a derivative,
as is a contract to buy Japanese yen six months from now. The value of the
IBM option depends on the price of IBM’s stock, and the value of the Japanese
yen “future” depends on the exchange rate between yen and dollars. The mar-
ket for derivatives has grown faster than any other market in recent years, pro-
viding corporations with new opportunities but also exposing them to new
risks.

Derivatives can be used either to reduce risks or to speculate. Suppose an
importer’s costs rise and its net income falls when the dollar falls relative to the
yen. That company could reduce its risk by purchasing derivatives whose values
increase when the dollar declines. This is a hedging operation, and its purpose is
to reduce risk exposure. Speculation, on the other hand, is done in the hope of
high returns, but it raises risk exposure. For example, several years ago Procter &
Gamble disclosed that it lost $150 million on derivative investments, and Orange
County (California) went bankrupt as a result of its treasurer’s speculation in
derivatives.

The size and complexity of derivatives transactions concern regulators, aca-
demics, and members of Congress. Fed Chairman Greenspan noted that, in the-
ory, derivatives should allow companies to manage risk better, but that it is not
clear whether recent innovations have “increased or decreased the inherent sta-
bility of the financial system.”

Distinguish between physical asset and financial asset markets.

What’s the difference between spot and futures markets?

Distinguish between money and capital markets.

What’s the difference between primary and secondary markets?

Differentiate between private and public markets.

Why are financial markets essential for a healthy economy and eco-
nomic growth?

What is a derivative, and how is its value related to that of an
“underlying asset”?

148 Part 2 Fundamental Concepts in Financial Management

TABLE 5-1 Summary of Major Market Instruments, Market Participants,
and Security Characteristics

SECURITY CHARACTERISTICS

Instrument Market Major Riskiness Original Interest Rate
(1) (2) Participants (4) Maturity on 2/1/05a

U.S. Treasury bills Money (3) (5) (6)

Sold by U.S. Treasury to Default-free 91 days 2.48%
finance federal expenditures to 1 year

Bankers’ acceptances Money A firm’s promise to Low degree of risk Up to 2.68
pay, guaranteed if guaranteed by a 180 days
by a bank
strong bank

Dealer commercial Money Issued by financially secure Low default risk Up to 2.67
paper firms to large investors 270 days

Negotiable certificates Money Issued by major money- Default risk depends Up to 2.70
of deposit (CDs) center commercial banks on the strength of 1 year
the issuing bank
to large investors

Money market Money Invest in Treasury bills, CDs, Low degree of risk No specific 1.69
mutual funds and commercial paper; maturity
held by individuals (instant
and businesses liquidity)

Eurodollar market Money Issued by banks Default risk depends Up to 2.70
time deposits outside U.S. on the strength of 1 year
the issuing bank

Consumer credit, Money Issued by banks/ Risk is variable Variable Variable,
including credit credit unions/finance but goes up to
card debt companies to individuals
20% or more

U.S. Treasury Capital Issued by U.S. No default risk, 2 to 4.65
notes and bonds government but price will decline 30 years
if interest rates rise

a The yields reported (except for corporate and municipal bonds) are from The Wall Street Journal. Money market rates assume
a 3-month maturity. Corporate and municipal bond rates are for 30-year AAA-rated bonds; quotes are from Federal Reserve
Statistical Release.

5.3 FINANCIAL INSTITUTIONS

Direct funds transfers are more common among individuals and small busi-
nesses, and in economies where financial markets and institutions are less devel-
oped. While businesses in more developed economies do occasionally rely on
direct transfers, they generally find it more efficient to enlist the services of one
or more financial institutions when it comes time to raise capital.

In the United States and other developed nations, a set of highly efficient
financial intermediaries has evolved. Their original roles were generally quite
specific, but many of them have diversified to the point where they serve

Chapter 5 Financial Markets and Institutions 149

TABLE 5-1 (Continued)

SECURITY CHARACTERISTICS

Instrument Market Major Riskiness Original Interest Rate
(1) (2) Participants (4) Maturity on 2/1/05a

Mortgages Capital (3) (5) (6)
State and local Capital
government bonds Borrowings from commercial Risk is variable Up to 5.20
Corporate bonds Capital banks and S&Ls by 30 years

Leases Capital individuals and businesses

Preferred stocks Capital Issued by state and Riskier than U.S. Up to 4.40
Common stocksc Capital local governments to government securities, 30 years

individuals and but exempt from
institutional investors most taxes

Issued by corporations Riskier than U.S. Up to 5.22
to individuals and government securities, 40 yearsb
institutional but less risky than preferred
investors and common stocks; varying
degree of risk within bonds
depending on strength

of issuer

Similar to debt Risk similar Generally Similar to
in that firms can to corporate bonds 3 to bond yields
lease assets rather than
borrow and then 20 years
buy the assets

Issued by corporations Riskier than corporate Unlimited 6 to 8%
to individuals and bonds, but less risky
than common stock
institutional investors

Issued by corporations Risky Unlimited NA
to individuals and

institutional investors

b Just recently, a few corporations have issued 100-year bonds; however, the majority have issued bonds with maturities less than
40 years.

c While common stocks do not pay interest, they are expected to provide a “return” in the form of dividends and capital gains. As
you will see in Chapter 8, historical stock returns have averaged between 10 and 15 percent a year. Of course, if you buy a stock,
your actual return may be considerably higher or lower than these historical averages.

many different markets. As a result, the differences between institutions have Investment Banking
tended to become blurred. Still, there remains a degree of institutional identity,
and therefore it is useful to describe the major categories of financial institu- House
tions here:
An organization that
1. Investment banking houses such as Merrill Lynch, Morgan Stanley, Gold- underwrites and dis-
man Sachs, or Credit Suisse Group provide a number of services to both tributes new invest-
investors and companies planning to raise capital. Such organizations (a) help ment securities and
helps businesses
obtain financing.

150 Part 2 Fundamental Concepts in Financial Management

Commercial Bank corporations design securities with features that are currently attractive to
Traditional department investors, (b) then buy these securities from the corporation, and (c) resell
store of finance serving them to savers. Although the securities are sold twice, this process is really
a variety of savers and one primary market transaction, with the investment banker acting as a facil-
borrowers. itator to help transfer capital from savers to businesses.
2. Commercial banks, such as Bank of America, Wells Fargo, Wachovia, and
Financial Services J. P. Morgan Chase, are the traditional “department stores of finance” because
Corporation they serve a variety of savers and borrowers. Historically, commercial banks
A firm that offers a were the major institutions that handled checking accounts and through
wide range of financial which the Federal Reserve System expanded or contracted the money sup-
services, including ply. Today, however, several other institutions also provide checking services
investment banking, and significantly influence the money supply. Conversely, commercial banks
brokerage operations, are providing an ever-widening range of services, including stock brokerage
insurance, and com- services and insurance.
mercial banking. 3. Financial services corporations are large conglomerates that combine many
different financial institutions within a single corporation. Examples of finan-
Mutual Funds cial services corporations, most of which started in one area but have
Organizations that pool now diversified to cover most of the financial spectrum, include Citigroup,
investor funds to pur- American Express, Fidelity, and Prudential.
chase financial instru- 4. Savings and loan associations (S&Ls) traditionally served individual savers and
ments and thus reduce residential and commercial mortgage borrowers, taking the funds of many
risks through small savers and then lending this money to home buyers and other types of
diversification. borrowers. In the 1980s, the S&L industry experienced severe problems when
(a) short-term interest rates paid on savings accounts rose well above the
returns earned on the existing mortgages held by S&Ls and (b) commercial
real estate suffered a severe slump, resulting in high mortgage default rates.
Together, these events forced many S&Ls to merge with stronger institutions
or close their doors.
5. Mutual savings banks, which are similar to S&Ls, operate primarily in the
northeastern states, accepting savings primarily from individuals, and lend-
ing mainly on a long-term basis to home buyers and consumers.
6. Credit unions are cooperative associations whose members are supposed to
have a common bond, such as being employees of the same firm. Members’
savings are loaned only to other members, generally for auto purchases,
home improvement loans, and home mortgages. Credit unions are often the
cheapest source of funds available to individual borrowers.
7. Pension funds are retirement plans funded by corporations or government
agencies for their workers and administered primarily by the trust depart-
ments of commercial banks or by life insurance companies. Pension funds
invest primarily in bonds, stocks, mortgages, and real estate.
8. Life insurance companies take savings in the form of annual premiums; invest
these funds in stocks, bonds, real estate, and mortgages; and finally make
payments to the beneficiaries of the insured parties. In recent years, life
insurance companies have also offered a variety of tax-deferred savings
plans designed to provide benefits to the participants when they retire.
9. Mutual funds are corporations that accept money from savers and then use
these funds to buy stocks, long-term bonds, or short-term debt instruments
issued by businesses or government units. These organizations pool funds
and thus reduce risks by diversification. They also achieve economies of
scale in analyzing securities, managing portfolios, and buying and selling
securities. Different funds are designed to meet the objectives of different
types of savers. Hence, there are bond funds for those who desire safety,
stock funds for savers who are willing to accept significant risks in the hope
of higher returns, and still other funds that are used as interest-bearing

Chapter 5 Financial Markets and Institutions 151

checking accounts (money market funds). There are literally thousands of Money Market Funds
different mutual funds with dozens of different goals and purposes.
Mutual funds that
Mutual funds have grown more rapidly than most other institutions in invest in short-term,
recent years, in large part because of a change in the way corporations pro- low-risk securities and
vide for employees’ retirement. Before the 1980s, most corporations said, in allow investors to write
effect, “Come work for us, and when you retire, we will give you a retirement checks against their
income based on the salary you were earning during the last five years before accounts.
you retired.” The company was then responsible for setting aside funds each
year to make sure it had the money available to pay the agreed-upon retire-
ment benefits. That situation is changing rapidly. Today, new employees are
likely to be told, “Come work for us, and we will give you some money each
payday that you can invest for your future retirement. You can’t get the
money until you retire (without paying a huge tax penalty), but if you invest
wisely, you can retire in comfort.” Most workers recognize that they don’t
know enough to invest wisely, so they turn their retirement funds over to a
mutual fund. Hence, mutual funds are growing rapidly. Excellent information
on the objectives and past performances of the various funds are provided in
publications such as Value Line Investment Survey and Morningstar Mutual
Funds, which are available in most libraries and on the Internet.
10. Hedge funds are similar to mutual funds because they accept money from
savers and use the funds to buy various securities, but there are some
important differences. While mutual funds are registered and regulated by
the Securities and Exchange Commission (SEC), hedge funds are largely
unregulated. This difference in regulation stems from the fact that mutual
funds typically target small investors, whereas hedge funds typically have
large minimum investments (often exceeding $1 million) that are effectively
marketed to institutions and individuals with high net worths. Different
hedge fund managers follow different strategies. For example, a hedge
fund manager who believes that the spreads between corporate and
Treasury bond yields are too large might simultaneously buy a portfolio of
corporate bonds and sell a portfolio of Treasury bonds. In this case, the
portfolio is “hedged” against overall movements in interest rates, but it will
do well if the spread between these securities narrows. Likewise, hedge
fund managers may take advantage of perceived incorrect valuations in the
stock market, that is, where a stock’s market and intrinsic values differ.

Hedge funds generally charge large fees, often a fixed amount plus 15 to
20 percent of the fund’s capital gains. The average hedge fund has done quite
well in recent years. In a recent report, Citigroup estimates that the average
hedge fund has produced an annual return of 11.9 percent since 1990. Over
the same time period, the average annual returns of the overall stock market
were 10.5 percent, and the returns on mutual funds were even lower, 9.2 per-
cent. Given the stock market’s relatively lackluster performance in recent
years, an increasing number of investors have flocked to hedge funds.
Between 1999 and 2004, the money managed by them more than quadru-
pled to roughly $800 billion. However, the same article in BusinessWeek that
highlighted the strong growth and relative performance of these funds also
suggested that their returns are showing signs of weakness and empha-
sized that they are certainly not without risk.4

Indeed, some hedge funds take on risks that are considerably higher than
that of an average individual stock or mutual fund. Moreover, in recent
years, some have also produced spectacular losses. For example, many

4 See Anne Tergesen, “Time to Hedge on Hedge Funds? New Research Shows that Returns Are Slid-
ing, and Some Don’t Help You Diversify,” BusinessWeek, September 13, 2004, p. 104.

152 Part 2 Fundamental Concepts in Financial Management

hedge fund investors suffered large losses in 1998 when the Russian econ-
omy collapsed. That same year, the Federal Reserve had to step in to help
rescue Long Term Capital Management, a high-profile hedge fund whose
managers included several well-respected practitioners as well as two Nobel
Prize–winning professors who were experts in investment theory.5

As hedge funds have become more popular, many have begun to lower
their minimum investment requirements. Perhaps not surprisingly, their
rapid growth and shift toward smaller investors have also led to a call for
more regulation.

With the notable exception of hedge funds, financial institutions have been
heavily regulated to ensure the safety of these institutions and thus to protect
investors. Historically, many of these regulations—which have included a prohi-
bition on nationwide branch banking, restrictions on the types of assets the insti-
tutions could buy, ceilings on the interest rates they could pay, and limitations
on the types of services they could provide—tended to impede the free flow of
capital and thus hurt the efficiency of our capital markets. Recognizing this fact,
policy makers took several steps during the 1980s and 1990s to deregulate finan-
cial services companies. For example, the barriers that restricted banks from
expanding nationwide were eliminated. Likewise, regulations that once forced a
strict separation of commercial and investment banking have been relaxed.

The result of the ongoing regulatory changes has been a blurring of the dis-
tinctions between the different types of institutions. Indeed, the trend in the
United States today is toward huge financial services corporations, which own
banks, S&Ls, investment banking houses, insurance companies, pension plan
operations, and mutual funds, and which have branches across the country and
around the world. For example, Citigroup combines one of the world’s largest
commercial banks (Citibank), a huge insurance company (Travelers), and a
major investment bank (Smith Barney), along with numerous other subsidiaries
that operate throughout the world. Citigroup’s structure is similar to that of
major institutions in Europe, Japan, and elsewhere around the globe.

Panel A of Table 5-2 lists the 10 largest U.S. bank and thrift holding compa-
nies, while Panel B shows the leading world banking companies. Among the
world’s 10 largest, only one (Citigroup) is based in the United States. While U.S.
banks have grown dramatically as a result of recent mergers, they are still small
by global standards. Panel C of the table lists the 10 leading underwriters in
terms of dollar volume of new debt and equity issues. Six of the top underwriters
are also major commercial banks or are part of bank holding companies, which
confirms the continued blurring of distinctions among different types of finan-
cial institutions.

What is the difference between a pure commercial bank and a pure
investment bank?

List the major types of financial institutions, and briefly describe the
primary function of each.

What are some important differences between mutual and hedge
funds? How are they similar?

5 See Franklin Edwards, “Hedge Funds and the Collapse of Long Term Capital Management,” Jour-
nal of Economic Perspectives, Vol. 13, no. 2 (Spring 1999), pp. 189–210, for a thoughtful review of the
implications of Long Term Capital Management’s collapse.

Chapter 5 Financial Markets and Institutions 153

TABLE 5-2 10 Largest U.S. Bank and Thrift Holding Companies and
World Banking Companies and Top 10 Leading Underwriters

Panel A Panel B Panel C
U.S. Bank and Thrift World Banking Leading Global
Holding Companiesa Companiesb Underwritersc

Citigroup Inc. Mizuho Financial Group (Tokyo) Citigroup Inc.
Bank of America Corp. Citigroup Inc. (New York) Morgan Stanley
J. P. Morgan Chase & Co. Allianz AG (Munich) J. P. Morgan
Wells Fargo & Co. UBS AG (Zurich) Merrill Lynch
Wachovia Corp. HSBC Holdings PLC (London) Lehman Brothers
MetLife Inc. Deutsche Bank AG (Frankfurt) Credit Suisse First Boston
Bank One Credit Agricole (Paris) Deutsche Bank AG
Washington Mutual Inc. BNP Paribas (Paris) UBS AG
U.S. Bancorp ING Group NV (Amsterdam) Goldman Sachs
SunTrust Banks Inc. Sumitomo Mitsui Financial Banc of America Securities

Group (Tokyo)

Notes:
a Ranked by total assets as of June 30, 2004. Source: “Top 150 Bank and Thrift Holding Companies with the Most Assets,”

AmericanBanker.com, October 19, 2004.
b Ranked by total assets as of December 31, 2003. Source: “World’s Largest Banking Companies by Assets,”

AmericanBanker.com, November 12, 2004.
c Ranked by dollar amount raised through new issues (stocks and bonds) in 2004. For this ranking, the lead underwriter (manager) is

given credit for the entire issue. Source: Adapted from The Wall Street Journal, January 3, 2005, p. R17.

5.4 THE STOCK MARKET

As noted earlier, secondary markets are those in which outstanding, previously
issued securities are traded. By far the most active secondary market, and the
most important one to financial managers, is the stock market, where the prices of
firms’ stocks are established. Because the primary goal of financial managers is
to maximize their firms’ stock prices, knowledge of the stock market is impor-
tant to anyone involved in managing a business.

While the two leading stock markets today are the New York Stock
Exchange and the Nasdaq stock market, stocks are actually traded using a vari-
ety of market procedures. However, there are just two basic types of stock
markets: (1) physical location exchanges, which include the New York Stock
Exchange (NYSE), the American Stock Exchange (AMEX), and several regional
stock exchanges, and (2) electronic dealer-based markets that include the Nas-
daq stock market, the less formal over-the-counter market, and the recently
developed electronic communications networks (ECNs). (See the box entitled,
“The NYSE and Nasdaq Combine Forces with the Leading Online Trading Sys-
tems.”) Because the physical location exchanges are easier to describe and
understand, we consider them first.

154 Part 2 Fundamental Concepts in Financial Management

Citigroup Built to Compete
in a Changing Environment

The financial environment has been undergoing 2. Increased globalization made it desirable for
tremendous changes, including breakthroughs in financial institutions to follow their clients and
technology, increased globalization, and shifts in the operate in many countries.
regulatory environment. All of these factors have pre-
sented financial managers and investors with oppor- 3. Changing technology led to increased economies
tunities, but those opportunities are accompanied by of scale and scope, both of which increase the
substantial risks. relative efficiency of huge, diversified companies
such as Citigroup.
Consider the case of Citigroup Inc., which was
created in 1998 when Citicorp and Travelers Group The same forces that are transforming the financial
(which included the investment firm Salomon Smith services industry have affected other industries. In
Barney) merged. Citigroup today operates in more particular, the growth of the Internet has provided
than 100 countries, has roughly 200 million cus- many companies with increased opportunities, but it
tomers and 275,000 employees, and holds more has also created additional competition and risk. For
than $1.4 trillion (that’s over a thousand billion!) example, it has altered the way millions of consumers
worth of assets. purchase airline tickets, hotel rooms, books, and
automobiles. Consequently, financial managers must
Citigroup resulted from three important trends: understand today’s technological environment and
be ready to change operations as the environment
1. A regulatory change made it possible for U.S. evolves.
corporations to engage in commercial banking,
investment banking, and insurance.

Physical Location The Physical Location Stock Exchanges

Exchanges The physical location exchanges are tangible physical entities. Each of the larger
ones occupies its own building, has a limited number of members, and has an
Formal organizations elected governing body—its board of governors. Members are said to have
having tangible “seats” on the exchange, although everybody stands up. These seats, which are
physical locations that bought and sold, give the holder the right to trade on the exchange. There are
conduct auction currently 1,366 seats on the New York Stock Exchange (this number has remained
markets in designated constant since 1953). In early 2005, a seat on the NYSE sold for $1.0 million,
(“listed”) securities. which was considerably lower than the record high of $2.65 million. Seat prices
are at multiyear lows due to low trading volume, declines in commissions
earned, and recent scandals that have rocked the NYSE.

Most of the larger investment banking houses operate brokerage departments,
and they own seats on the exchanges and designate one or more of their officers
as members. The exchanges are open on all normal working days, with the
members meeting in a large room equipped with telephones and other electronic
equipment that enable each member to communicate with his or her firm’s
offices throughout the country.

Like other markets, security exchanges facilitate communication between
buyers and sellers. For example, Merrill Lynch (the fourth largest brokerage
firm) might receive an order in its Atlanta office from a customer who wants to
buy shares of GE stock. Simultaneously, the Denver office of Morgan Stanley
(the second largest brokerage firm) might receive an order from a customer
wishing to sell shares of GE. Each broker communicates electronically with the
firm’s representative on the NYSE. Other brokers throughout the country are

Chapter 5 Financial Markets and Institutions 155

The NYSE and Nasdaq
Combine Forces with the
Leading Online Trading Systems

The forces that spurred consolidation in the financial shareholders will own the remaining 30 percent. Two
services industry have also promoted online trading days after this stunning announcement, Nasdaq
systems that bypass the traditional exchanges. These announced its own plans to purchase Instinet.
systems, which are known as electronic communica-
tions networks (ECNs), use electronic technology to These announced mergers confirm the growing
bring buyers and sellers together. As of early 2005, importance of electronic trading and have led many
the majority of these transactions were conducted by to conclude that the floor traders who buy and sell
two firms: Instinet Group and Archipelago. stock on the NYSE may soon become a thing of the
past as an increasing number of transactions take
The rise of ECNs has accelerated the move place electronically. Others contend that there will
toward 24-hour trading. Large clients who want to remain a role for these floor traders for at least the
trade after other markets have closed may utilize an foreseeable future. In any event, what is clear is that
ECN, thus bypassing the NYSE and Nasdaq. The the financial landscape of stock trading will continue
move toward faster, cheaper, and continuous trading to undergo dramatic changes in the upcoming years.
obviously benefits investors, but it does present regu-
lators, who try to ensure that all investors have access Sources: Katrina Brooker, “Online Investing: It’s Not Just for
to a “level playing field,” with a number of headaches. Geeks Anymore,” Fortune, December 21, 1998, pp. 89–98;
“Fidelity, Schwab Part of Deal to Create Nasdaq
Recognizing the new threat, the two leading Challenger,” The Milwaukee Journal Sentinel, July 22,
exchanges have not been content to stand idly by. In 1999, p. 1; Aaron Lucchetti, Susanne Craig, and Dennis K.
April 2005, the NYSE announced plans to acquire Berman, “NYSE to Acquire Electronic Trader and Go
Archipelago and to turn itself into a public company. Public,” The Wall Street Journal, April 21, 2005, p. A1; and
If the deal goes through, the new company will be “Nasdaq Agrees to Buy Instinet for $1.88 Billion,”
called NYSE Group Inc., and 70 percent of the www.wsj.com, Wall Street Online, April 22, 2005.
combined company will be owned by those who
currently hold seats on the NYSE. Archipelago

also communicating with their own exchange members. The exchange members
with sell orders offer the shares for sale, and they are bid for by the members
with buy orders. Thus, the exchanges operate as auction markets.6

6 The NYSE is actually a modified auction market, wherein people (through their brokers) bid for
stocks. Originally—about 200 years ago—brokers would literally shout, “I have 100 shares of Erie for
sale; how much am I offered?” and then sell to the highest bidder. If a broker had a buy order, he or
she would shout, “I want to buy 100 shares of Erie; who’ll sell at the best price?” The same
general situation still exists, although the exchanges now have members known as specialists who
facilitate the trading process by keeping an inventory of shares of the stocks in which they
specialize. If a buy order comes in at a time when no sell order arrives, the specialist will sell off
some inventory. Similarly, if a sell order comes in, the specialist will buy and add to inventory. The
specialist sets a bid price (the price the specialist will pay for the stock) and an asked price (the price
at which shares will be sold out of inventory). The bid and asked prices are set at levels designed to
keep the inventory in balance. If many buy orders start coming in because of favorable develop-
ments or sell orders come in because of unfavorable events, the specialist will raise or lower prices
to keep supply and demand in balance. Bid prices are somewhat lower than asked prices, with the
difference, or spread, representing the specialist’s profit margin.

Special facilities are available to help institutional investors such as mutual or pension funds
sell large blocks of stock without depressing their prices. In essence, brokerage houses that cater to
institutional clients will purchase blocks (defined as 10,000 or more shares) and then resell the stock
to other institutions or individuals. Also, when a firm has a major announcement that is likely to
cause its stock price to change sharply, it will ask the exchanges to halt trading in its stock until the
announcement has been made and digested by investors.

156 Part 2 Fundamental Concepts in Financial Management

Over-the-Counter The Over-the-Counter and the Nasdaq Stock Markets
(OTC) Market
A large collection While the stocks of most large companies trade on the NYSE, a larger number of
of brokers and stocks trade off the exchange in what has traditionally been referred to as the
dealers, connected over-the-counter (OTC) market. An explanation of the term “over-the-counter”
electronically by will help clarify how this term arose. As noted earlier, the exchanges operate as
telephones and auction markets—buy and sell orders come in more or less simultaneously, and
computers, that exchange members match these orders. If a stock is traded infrequently, perhaps
provides for trading in because the firm is new or small, few buy and sell orders come in, and matching
unlisted securities. them within a reasonable amount of time would be difficult. To avoid this prob-
lem, some brokerage firms maintain an inventory of such stocks and stand pre-
Dealer Market pared to make a market for these stocks. These “dealers” buy when individual
Includes all facilities investors want to sell, and then sell part of their inventory when investors want
that are needed to to buy. At one time, the inventory of securities was kept in a safe, and the stocks,
conduct security when bought and sold, were literally passed over the counter.
transactions not
conducted on the Today, these markets are often referred to as dealer markets. A dealer market
physical location includes all facilities that are needed to conduct security transactions, but they are
exchanges. not made on the physical location exchanges. These facilities include (1) the rela-
tively few dealers who hold inventories of these securities and who are said to
“make a market” in these securities; (2) the thousands of brokers who act as
agents in bringing the dealers together with investors; and (3) the computers, ter-
minals, and electronic networks that provide a communication link between deal-
ers and brokers. The dealers who make a market in a particular stock quote the
price at which they will pay for the stock (the bid price) and the price at which
they will sell shares (the ask price). Each dealer’s prices, which are adjusted as
supply and demand conditions change, can be read off computer screens all
across the world. The bid-ask spread, which is the difference between bid and
asked prices, represents the dealer’s markup, or profit. The dealer’s risk increases
if the stock is more volatile, or if the stock trades infrequently. Generally, we
would expect volatile, infrequently traded stocks to have wider spreads in order
to compensate the dealers for assuming the risk of holding them in inventory.

Brokers and dealers who participate in the over-the-counter market are
members of a self-regulatory body known as the National Association of Securities
Dealers (NASD), which licenses brokers and oversees trading practices. The com-
puterized network used by the NASD is known as the NASD Automated Quota-
tion System (Nasdaq).

Nasdaq started as just a quotation system, but it has grown to become an
organized securities market with its own listing requirements. Over the past
decade the competition between the NYSE and Nasdaq has become increasingly
fierce. In an effort to become more competitive with the NYSE and with interna-
tional markets, the Nasdaq and the AMEX merged in 1998 to form the Nasdaq-
Amex Market Group. The merger turned out to be less than successful, and in
early 2005 the AMEX members agreed to buy the exchange back from the
NASD. Since most of the larger companies trade on the NYSE, the market capi-
talization of NYSE-traded stocks is much higher than for stocks traded on
Nasdaq ($12.6 trillion compared with $3.7 trillion at year-end 2004). However,
reported volume (number of shares traded) is often larger on Nasdaq, and more
companies are listed on Nasdaq.7

Interestingly, many high-tech companies such as Microsoft and Intel have
remained on Nasdaq even though they easily meet the listing requirements of the
NYSE. At the same time, however, other high-tech companies such as Gateway,
America Online, and Iomega have left Nasdaq for the NYSE. Despite these defec-

7 One transaction on Nasdaq generally shows up as two separate trades (the buy and the sell). This
“double counting” makes it difficult to compare the volume between stock markets.

Chapter 5 Financial Markets and Institutions 157

tions, Nasdaq’s growth over the past decade has been impressive. In the years
ahead, competition between Nasdaq and the NYSE will no doubt remain fierce.

What are the differences between the physical location exchanges
and the Nasdaq stock market?
What is the bid-ask spread?

5.5 THE MARKET FOR COMMON STOCK Closely Held
Corporation
Some companies are so small that their common stocks are not actively traded; A corporation that is
they are owned by only a few people, usually the companies’ managers. These owned by a few
firms are said to be privately owned, or closely held, corporations, and their stock individuals who are
is called closely held stock. In contrast, the stocks of most larger companies are typically associated
owned by thousands of investors, most of whom are not active in management. with the firm’s
These companies are called publicly owned corporations, and their stock is management.
called publicly held stock.
Publicly Owned
A recent study found that institutional investors owned about 46 percent of Corporation
all publicly held common stocks. Included are pension plans (26 percent), A corporation that is
mutual funds (10 percent), foreign investors (6 percent), insurance companies owned by a relatively
(3 percent), and brokerage firms (1 percent). These institutions buy and sell rela- large number of
tively actively, however, so they account for about 75 percent of all transactions. individuals who are not
Thus, institutional investors have a significant influence on the prices of individ- actively involved in its
ual stocks. management.

Types of Stock Market Transactions

We can classify stock market transactions into three distinct categories:

1. Trading in the outstanding shares of established, publicly owned companies: the
secondary market. Allied Food Products, the company we analyzed in Chapters 3
and 4, has 50 million shares of stock outstanding. If the owner of 100 shares
sells his or her stock, the trade is said to have occurred in the secondary
market. Thus, the market for outstanding shares, or used shares, is the second-
ary market. The company receives no new money when sales occur in this
market.

2. Additional shares sold by established, publicly owned companies: the primary
market. If Allied decides to sell (or issue) an additional 1 million shares to raise
new equity capital, this transaction is said to occur in the primary market.8

3. Initial public offerings by privately held firms: the IPO market. In the summer
of 2004 Google sold shares to the public for the first time at $85 per share.
By September 2005, the stock was selling for $303, so it had more than
tripled. Several years ago, the Coors Brewing Company, which was owned
by the Coors family at the time, decided to sell some stock to raise capital
needed for a major expansion program.9 These types of transactions are called

8 Allied has 60 million shares authorized but only 50 million outstanding; thus, it has 10 million
authorized but unissued shares. If it had no authorized but unissued shares, management could
increase the authorized shares by obtaining stockholders’ approval, which would generally be
granted without any arguments.
9 The stock Coors offered to the public was designated Class B, and it was nonvoting. The Coors
family retained the founders’ shares, called Class A stock, which carried full voting privileges.
The company was large enough to obtain an NYSE listing, but at that time the Exchange had a
requirement that listed common stocks must have full voting rights, which precluded Coors from
obtaining an NYSE listing.

158 Part 2 Fundamental Concepts in Financial Management

Going Public going public—whenever stock in a closely held corporation is offered to the
The act of selling stock public for the first time, the company is said to be going public. The market
to the public at large for stock that is just being offered to the public is called the initial public
by a closely held offering (IPO) market.
corporation or its
principal stockholders. IPOs have received a lot of attention in recent years, primarily because a
number of “hot” issues have realized spectacular gains—often in the first few
Initial Public Offering minutes of trading. Consider the 1999 IPO of Red Hat Inc., the open-source
(IPO) Market provider of software products and services. The company’s underwriters set an
The market for stocks offering price of $14 per share. However, because of intense demand for the
of companies that are issue, the stock’s price rose more than 270 percent the first day of trading.
in the process of going
public. With the recent stock market decline, we have also seen a decline in the
number of new IPOs. Table 5-3 lists the largest, the best performing, and the
worst performing IPOs of 2004, and it shows how they performed from their
offering dates through year-end 2004. As the table shows, not all IPOs are as
well received as Red Hat’s. Moreover, even if you are able to identify a “hot”
issue, it is often difficult to purchase shares in the initial offering. These deals are
generally oversubscribed, which means that the demand for shares at the offering
price exceeds the number of shares issued. In such instances, investment bankers
favor large institutional investors (who are their best customers), and small
investors find it hard, if not impossible, to get in on the ground floor. They can
buy the stock in the after-market, but evidence suggests that if you do not get in
on the ground floor the average IPO underperforms the overall market over the
long run.10

Indeed, the subsequent performance of Red Hat illustrates the risks that
arise when investing in new issues. Figure 5-2 plots Red Hat’s stock price from
the time of its IPO in 1999 to early February 2005. After its dramatic first day
run-up, Red Hat’s stock closed just above $54 per share. Demand for the stock
continued to surge, and the price reached a high of just over $300 in December
1999. Soon afterward, the company announced a two-for-one stock split. (Note
that Figure 5-2 considers the stock split.) The split effectively cut the stock’s
price in half, but it doubled the number of shares held by each shareholder.
After adjusting for the split, the stock’s price stood at $132 per share in early
January 2000. Soon thereafter, Red Hat’s price tumbled—indeed, by mid-year
2001 its price was $3.50 per share, which was equivalent to $7.00 per share
before the split. As Figure 5-2 shows, Red Hat’s stock has slowly rebounded
over the past few years, but its price still remains below its initial offering price
of $14.

Amidst concerns about the allocation of IPO shares, Google Inc.’s highly
publicized 2004 IPO attracted attention because of its size (Google raised $1.67
billion in stock) and the way it was conducted. Rather than having the offer
price set by its investment bankers, Google conducted a Dutch auction in which
individual investors directly placed bids for shares. In a Dutch auction, the actual
transaction price is set at the highest price (“the clearing price”) that causes all of
the offered shares to be sold. Investors who set their bids at or above the clear-
ing price receive all the shares they subscribed to at the offer price. While
Google’s IPO was in many ways precedent setting, it remains unclear whether
other firms going public in the future will be able, or willing, to use the Dutch
auction method to allocate shares in their IPOs.

It is important to recognize that firms can go public without raising any
additional capital. For example, the Ford Motor Company was once owned

10 See Jay R. Ritter, “The Long-Run Performance of Initial Public Offerings,” Journal of Finance,
Vol. 46, no. 1 (March 1991), pp. 3–27.

Chapter 5 Financial Markets and Institutions 159

TA B L E 5 - 3 Initial Public Offerings in 2004

U.S. PERCENT CHANGE
Proceeds FROM OFFER
(Billions)
Issuer Issue First Day Through
Date $2.86 Trading 12/31/04
The Biggest IPOs 2.02
Genworth Financial 05/24/04 1.92 unch. ϩ38.5%
Assurant 02/04/04 1.80 ϩ12.3% ϩ38.9
Google 08/18/04 1.69 ϩ18.0 ϩ126.8
Semiconductor Manufacturing Intl. 03/11/04 1.31 Ϫ11.3 Ϫ38.5
Freescale Semiconductor 07/16/04 1.06 ϩ37.1
China Netcom 11/10/04 1.01 ϩ7.9 ϩ22.6
LG Philips 07/15/04 1.01 ϩ14.1 ϩ19.9
Navteq 08/06/04 0.93 ϩ110.7
Dex Media 07/21/04 Ϫ6.3 ϩ31.4
Dreamworks Animation 10/27/04 ϩ15.0 ϩ34.0

ϩ2.6
ϩ38.4

U.S. PERCENT CHANGE
Proceeds FROM OFFER
(Millions)
Issuer Issue Offer First Day Through
Date Price $169.0 Trading 12/31/04
The Best Performers 84.5
Shanda Interactive Ent 05/12/04 $11.00 26.0 ϩ8.8% ϩ286.4%
51Job 09/28/04 14.00 36.5 ϩ51.1 ϩ271.2
Marchex 03/30/04 6.50 20.1 ϩ35.4 ϩ223.1
Volterra Semiconductor 07/28/04 8.00 ϩ177.0
eCOST.com 08/27/04 5.80 248.4 ϩ3.1 ϩ175.0
Cogent 09/23/04 12.00 10.5 ϩ3.5 ϩ175.0
Jed Oil 04/05/04 5.50 60.0 ϩ49.8 ϩ165.5
Syneron Medical 08/05/04 12.00 ϩ103.6 ϩ155.0
Kinetic Concepts 02/23/04 30.00 621.0 Ϫ10.4 ϩ154.3
Kanbay International 07/22/04 13.00 106.9 ϩ34.7 ϩ140.8
ϩ16.9

U.S. PERCENT CHANGE
Proceeds FROM OFFER
(Millions)
Issuer Issue Offer First Day Through
Date Price $ 33.6 Trading 12/31/04
The Worst Performers 145.5
Xcyte Therapies 03/16/04 $ 8.00 26.4 Ϫ8.6% Ϫ65.5%
Staktek Holdings 02/05/04 13.00 110.4 ϩ14.5 Ϫ64.3
AlphaSmart 02/06/04 54.0 Ϫ50.8
Corgentech 02/12/04 6.00 10.6 ϩ2.0 Ϫ48.3
Corcept Therapeutics 04/14/04 16.00 12.0 ϩ20.3 Ϫ47.9
Daystar Technologies 02/05/04 12.00 86.0 Ϫ43.0
Infosonics 06/16/04 ϩ1.9 Ϫ40.3
Linktone 03/03/04 5.00 1,803.0 Ϫ1.0 Ϫ40.0
Semiconductor 6.00 110.1 Ϫ2.5
Manufacturing International 03/11/04 14.00 ϩ24.4 Ϫ38.5
Cherokee International 02/19/04 Ϫ33.7
17.50 Ϫ11.3
14.50 ϩ13.8

Source: “Initial Public Offerings of Stock Bounce Back in 2004,” The Wall Street Journal, January 3, 2005, p. R10.

160 Part 2 Fundamental Concepts in Financial Management

F I G U R E 5 - 2 Red Hat Inc.’s Stock Price Performance from
Its IPO to February 2005

Source: finance.yahoo.com.

exclusively by the Ford family. When Henry Ford died, he left a substantial part
of his stock to the Ford Foundation. When the Foundation later sold some of it
to the general public, the Ford Motor Company went public, even though the
company itself raised no capital in the transaction.

Differentiate between closely held and publicly owned corporations.
Differentiate between primary and secondary markets.
What is an IPO?
What is a Dutch auction? Why is it used?

5.6 STOCK MARKETS AND RETURNS

Anyone who has ever invested in the stock market knows that there can be, and
generally are, large differences between expected and realized prices and returns.
Figure 5-3 shows how total realized portfolio returns have varied from year to
year. As logic would suggest (and as we demonstrate in Chapter 8), a stock’s
expected return as estimated by investors at the margin is always positive, for
otherwise investors would not buy the stock. However, as Figure 5-3 shows, in
some years actual returns are negative.

Stock Market Reporting

Up until a couple of years ago, the best source of stock quotations was the busi-
ness section of a daily newspaper, such as The Wall Street Journal. One problem
with newspapers, however, is that they report yesterday’s prices. Now it is pos-
sible to obtain quotes all during the day from a wide variety of Internet

Chapter 5 Financial Markets and Institutions 161

sources.11 One of the best is Yahoo!, and Figure 5-4 shows a detailed quote for
GlaxoSmithKline PLC (GSK). As the heading shows, GlaxoSmithKline is traded
on the New York Stock Exchange under the symbol GSK. (The NYSE is just one
of many world markets on which the stock trades.) The first two rows of infor-
mation show that GSK last traded at $45.55, and the stock traded thus far during
the day from as low as $45.40 and as high as $45.65. (Note that the price is
reported in decimals rather than fractions, reflecting a recent change in trading
conventions.) The last trade was at 11:05 A.M. ET on February 4, 2005, and its
price range during the past 52 weeks was from $38.80 to $47.59.

The next three lines show that GSK opened trading on February 4th at
$45.42, that it closed on February 3rd at $44.65, and that its price rose by $0.90
(or a 2.02 percent increase) from the previous close to the current price. So far
during the day, 401,700 shares had traded hands. GlaxoSmithKline’s average
daily trading volume (based on the past three months) was 1,349,318 shares, so
trading was relatively light that day. The total value of all of GlaxoSmithKline’s
stock, called its market cap, was $130.09 billion.

The last three lines report other market information for GSK. If it were trad-
ing on Nasdaq rather than a listed exchange, the most recent bid and ask quotes
from dealers would have been shown. However, because it trades on the NYSE,
these data are not available. GSK’s P/E ratio (price per share divided by the
most recent 12 months’ earnings) is 17.16, and its earnings per share for the most
recent 12 months was $2.66. (Note that ttm stands for “trailing 12 months”—in
other words, the most recent 12 months.) The mean of the analysts’ one-year tar-
get price for GSK is $49.67. GSK’s dividend is $1.46 per share, so the quarterly
dividend is $0.365 per share, and the dividend yield, which is the annual divi-
dend divided by the price, is 3.24 percent.

F I G U R E 5 - 3 S&P 500 Index, Total Returns: Dividend Yield
+ Capital Gain or Loss, 1968–2004

Percent 1972 1976 1980 1984 1988 1992 1996 2000 2004
40 Years

30

20

10

0

–10

–20

–30
1968

Source: Data taken from various issues of The Wall Street Journal, “Investment Scoreboard” section.

11 Most free sources provide quotes that are delayed by 15 minutes. Real time quotes can be
obtained for a fee.

162 Part 2 Fundamental Concepts in Financial Management

F I G U R E 5 - 4 Stock Quote for GlaxoSmithKline, February 4, 2005

Source: finance.yahoo.com.

In Figure 5.4, the chart to the right plots the stock price during the day; how-
ever, the links below the chart allow you to pick different time intervals for plot-
ting data. As you can see, Yahoo! provides a great deal of information in its
detailed quote, and even more detail is available on the screen page below the
basic quote information.

Stock Market Returns

In Chapters 8 and 9 we will discuss in detail how stock returns are calculated,
the connection between stock market risk and returns, and the techniques that
analysts use to value stocks. However, it is useful at this point for you to have a
rough idea how stocks have performed in recent years. Figure 5-3 shows how
the returns on large U.S. stocks have varied over the past years, and the box
entitled “Measuring the Market” provides some information on the major U.S.
stock market indices and their performances since the mid-1990s.

Since 1968 the market trend has been strongly up, but by no means does it
go up every year. Indeed, as we can see from Figure 5-3, the overall market has
been down in 9 of the 37 years, including the three consecutive years of
2000–2002. The stocks of individual companies have likewise gone up and
down.12 Of course, even in bad years some individual companies do well, so
“the name of the game” in security analysis is to pick the winners. Financial
managers attempt to put their companies into the winners’ column, but they
don’t always succeed. In subsequent chapters, we will examine the decisions
managers make to increase the odds of their firms performing well in the
marketplace.

Would you expect a portfolio that consisted of the S&P 500 stocks to
be more or less risky than a portfolio of Nasdaq stocks?

If we constructed a chart like Figure 5-3 for an average S&P 500
stock, do you think it would show more or less volatility? Explain.

12 If we constructed a graph like Figure 5-3 for individual stocks rather than for the index, far
greater variability would be shown. Also, if we constructed a graph like Figure 5-3 for bonds, it
would have similar ups and downs, but the bars would be smaller, indicating that gains and losses
on bonds are generally smaller than those on stocks. Above-average bond returns occur in years
when interest rates decline, losses occur when interest rates rise sharply, but interest payments tend
to stabilize bonds’ total returns. We will discuss bonds in detail in Chapter 7.

Chapter 5 Financial Markets and Institutions 163

5.7 STOCK MARKET EFFICIENCY Efficient Markets

Figure 1-1 (presented back in Chapter 1) suggests that a stock’s price is affected Hypothesis (EMH)
by its intrinsic value, which is determined by the true level and riskiness of the
cash flows it is likely to provide, and investors’ perceptions about the stock’s The hypothesis that
intrinsic value. In a well-functioning market, investors’ perceptions should be securities are typically
closely related to the stock’s intrinsic value, in which case the stock price would in equilibrium—that
be a reasonably accurate reflection of its true value. they are fairly priced
in the sense that the
A body of theory called the efficient markets hypothesis (EMH) holds price reflects all
(1) that stocks are always in equilibrium and (2) that it is impossible for an publicly available
investor to consistently “beat the market.” Essentially, those who believe in the information on each
EMH note that there are 100,000 or so full-time, highly trained, professional ana- security.
lysts and traders operating in the market, while there are fewer than 3,000 major
stocks. Therefore, if each analyst followed 30 stocks (which is about right, as ana-
lysts tend to specialize in the stocks in a specific industry), there would on average
be 1,000 analysts following each stock. Further, these analysts work for organiza-
tions such as Goldman Sachs, Merrill Lynch, Citigroup, Prudential, and the like,
which have billions of dollars that can be used to take advantage of bargains. In
addition, as a result of SEC disclosure requirements and electronic information
networks, as new information about a stock becomes available, these 1,000 ana-
lysts generally receive and evaluate it at about the same time. Therefore, the price
of a stock will adjust almost immediately to any new development. That makes it
very difficult for anyone to consistently pick stocks that will beat the market.

Levels of Market Efficiency

If markets are truly efficient, then stock prices will rapidly adjust to all relevant
information as it becomes available. This raises an important question: What types
of information are available to investors and, therefore, incorporated into stock
prices? Financial theorists have discussed three forms, or levels, of market efficiency.

Weak-Form Efficiency

The weak form of the EMH states that all information contained in past stock
price movements is fully reflected in current market prices. If this were true,
then information about recent trends in stock prices would be of no use in select-
ing stocks—the fact that a stock has risen for the past three days, for example,
would give us no useful clues as to what it will do today or tomorrow. People
who believe that weak-form efficiency exists also believe that “tape watchers”
and “chartists” are wasting their time.13 For example, after studying the past his-
tory of the stock market, a chartist might “discover” the following pattern: If a
stock falls three consecutive days, its price typically rises 10 percent the follow-
ing day. The technician would then conclude that investors could make money
by purchasing a stock whose price has fallen for three consecutive days.

But if this pattern truly existed, wouldn’t other investors also discover it,
and then why would anyone be willing to sell a stock after it had fallen three
consecutive days if he or she knows the stock’s price would likely increase by
10 percent the next day? In other words, if a stock were selling at $40 per share
after falling three consecutive days, why would investors sell the stock at $40 if
they expect it to rise to $44 per share the next day? Those who believe in weak-
form efficiency argue that if the stock were really likely to rise to $44 per share

13 Tape watchers are people who watch the NYSE tape, while chartists plot past patterns of stock
price movements. Both are called “technicians,” and both believe that they can tell if something is
happening to the stock that will cause its price to move up or down in the near future.

164 Part 2 Fundamental Concepts in Financial Management

Measuring the Market

Stock indexes are designed to show the performance S&P 500 Index
of the stock market. The problem is that there are many
stock indexes, and it is difficult to determine which Created in 1926, the S&P 500 Index is widely
index best reflects market actions. Some are designed regarded as the standard for measuring large-cap
to represent the whole equity market, some to track U.S. stock market performance. The stocks in the
the returns of certain industry sectors, and others to S&P 500 are selected by the Standard & Poor’s Index
track the returns of small-cap, mid-cap, or large-cap Committee as being the leading companies in the
stocks. We discuss below three of the leading indexes. leading industries, and for accurately reflecting the
U.S. stock market. It is value weighted, so the largest
Dow Jones Industrial Average companies (in terms of value) have the greatest influ-
ence. The S&P 500 Index is used for benchmarking
Unveiled in 1896 by Charles H. Dow, the Dow Jones by 97 percent of all U.S. money managers and pen-
Industrial Average (DJIA) provided a benchmark for sion plan sponsors, and approximately $700 billion is
comparing individual stocks with the overall market, for managed so as to obtain the same performance as
ascertaining the trend in stock prices over time, and for this index (that is, in indexed funds).
comparing the market with other economic indicators.
The industrial average began with just 10 stocks, was Nasdaq Composite Index
expanded in 1916 to 20 stocks, and then to 30 in
1928. Also in 1928, The Wall Street Journal editors The Nasdaq Composite Index measures the perfor-
began adjusting the index for stock splits, and making mance of all common stocks listed on the Nasdaq
substitutions. Today, the DJIA still includes 30 compa- stock market. Currently, it includes more than 5,000
nies. They represent almost a fifth of the market value companies, and because many of the technology-
of all U.S. stocks, and all are both leading companies in sector companies are traded on the computer-based
their industries and widely held by individual and insti- Nasdaq exchange, this index is generally regarded as
tutional investors. Visit http://www.dowjones.com to an economic indicator of the high-tech industry.
get more information about the DJIA. You can find out Microsoft, Intel, and Cisco Systems are the three
how it is calculated, the current divisor, the companies largest Nasdaq companies, and they comprise a high
that make up the DJIA, more history about the DJIA, percentage of the index’s value-weighted market
and other interesting facts. In addition, there is a capitalization. For this reason, substantial movements
DJIA time line annotated with historical events. in the same direction by these three companies can
move the entire index.

tomorrow, its price would actually rise to somewhere near $44 per share imme-
diately, thereby eliminating the trading opportunity. Consequently, weak-form
efficiency implies that any information that comes from an examination of past
stock prices cannot be used to make money by predicting future stock prices.

Semistrong-Form Efficiency

The semistrong form of the EMH states that current market prices reflect all publicly
available information. Therefore, if semistrong-form efficiency exists, it would do no
good to pore over annual reports or yesterday’s Wall Street Journal looking at sales
and earnings trends and various types of ratios based on historical data because
market prices would have adjusted to any good or bad news contained in such

Chapter 5 Financial Markets and Institutions 165

Recent Performance ning to rebound again in 2003. During the last 10
years the average annualized returns of these indexes
The accompanying figure plots the value that an ranged from 9.8 percent for the S&P 500 to 10.5 per-
investor would now have if he or she had invested cent for the Nasdaq Composite Index. The Nasdaq
$1.00 in each of the three indexes on January 1, 1995. experienced a huge bubble in 1999, reflecting overly
The returns on the three indexes are compared with an optimistic valuations of technology companies. How-
investment strategy that only invests in T-bills. For the ever, in 2000 the bubble burst and technology stock
returns on T-bills, the one-year Treasury constant matu- valuations spiraled downward, causing the Nasdaq
rity rate is used. Over the past 10 years, each of these Index to revert back to a level comparable to the
indexes performed quite well through 1999. However, S&P 500 and Dow Jones Industrial Average Index.
for a couple years each index stumbled before begin-

Growth of a $1 Investment Made on January 1, 1995

Value of $1 Investment Nasdaq
7 DJIA
6 S&P 500
5 T-bills
4

3

2

1

0 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005
1995 Years

reports back when the news first came out over the Internet. With semistrong-
form efficiency, investors should not expect to earn above-average returns except
with good luck or information that is not publicly available.14 However, insiders
(for example, CEOs and CFOs) who have information that is not publicly avail-
able are able to earn above-average returns even under semistrong-form efficiency.

Another implication of semistrong-form efficiency is that whenever informa-
tion is released to the public, stock prices will respond only if the information is
different from what had been expected. If, for example, a company announces a

14 Strictly speaking, these returns should be adjusted for risk. We discuss the relationship between
risk and return in Chapter 8.

166 Part 2 Fundamental Concepts in Financial Management

30 percent increase in earnings, and if that increase is about what analysts had
been expecting, the announcement should have little or no effect on the com-
pany’s stock price. On the other hand, the stock price would probably fall if ana-
lysts had expected earnings to increase by 50 percent, but it probably would rise
if they had expected a 10 percent increase.

Strong-Form Efficiency

The strong form of the EMH states that current market prices reflect all pertinent
information, whether publicly available or privately held. If this form holds,
even insiders would find it impossible to earn abnormally high returns in the
stock market.15

Many empirical studies have been conducted to test for the three forms of mar-
ket efficiency. Most of these studies suggest that the stock market is indeed highly
efficient in the weak form, reasonably efficient in the semistrong form (at least for
the larger and more widely followed stocks), but not true for the strong form
because abnormally large profits are often earned by those with inside information.

Implications of Market Efficiency

If the EMH were correct, it would be a waste of time for most of us to seek bar-
gains by analyzing stocks. That follows because, if stock prices already reflect all
publicly available information and hence are fairly priced, we can “beat the
market” only by luck or with inside information, making it difficult, if not
impossible, for most investors to consistently outperform the market averages.
To support this viewpoint, efficient market proponents often point out that even
the professionals who manage mutual fund portfolios do not, on average, out-
perform the overall stock market as measured by an index like the S&P 500.16
Indeed, the relatively poor performance of actively managed mutual funds helps
explain the growing popularity of indexed funds, where administrative costs are
relatively low. Rather than spending time and money trying to find undervalued
stocks, index funds try instead to match overall market returns by buying the
basket of stocks that makes up a particular index, such as the S&P 500.17

15 Over the years, several cases of illegal insider trading have made the news headlines. These cases
involved employees of several major investment banking houses and even an employee of the SEC.
In the most famous case, Ivan Boesky admitted to making $50 million by purchasing stocks of firms
he knew were about to merge. He went to jail, and he had to pay a large fine, but he helped disprove
the strong-form EMH. More recently, Martha Stewart was imprisoned after being convicted on
obstruction of justice charges surrounding a federal investigation of insider trading of ImClone
Systems Inc. shares.
16 For a discussion of the recent performance of actively managed funds, see Jonathan Clements,
“Resisting the Lure of Managed Funds,” The Wall Street Journal, February 27, 2001, p. C1.
17 We should also note that some Wall Street pros have consistently beaten the market over many
years, which is inconsistent with the EMH. An interesting article in the April 3, 1995, issue of
Fortune (Terence P. Paré, “Yes, You Can Beat the Market”) argued strongly against the EMH. Paré
suggested that each stock has a fundamental value, but when good or bad news about it is
announced, most investors fail to interpret this news correctly. As a result, stocks are generally
priced above or below their long-term values.

Think of Figure 1-1, which was illustrated in Chapter 1, with stock price on the vertical axis
and years on the horizontal axis. A stock’s fundamental value might be moving up steadily over
time as it retains and reinvests earnings. However, its actual price might fluctuate about the intrinsic
value line, overreacting to good or bad news and indicating departures from equilibrium. Successful
value investors, according to Paré, use fundamental analysis to identify stocks’ intrinsic values, and
then they buy stocks that are undervalued and sell those that are overvalued.

Paré’s argument implies that stocks are at times systematically out of equilibrium and that
investors can act on this knowledge to beat the market. That position may turn out to be correct, but
it may also be that the superior performance Paré noted simply demonstrates that some people are
better at obtaining and interpreting information than others, or have been lucky in the past.

Chapter 5 Financial Markets and Institutions 167

It is important to understand that market efficiency does not imply that all Behavioral Finance
stocks are always priced correctly. With hindsight, it is apparent that at any
point in time the situation shown in Figure 1-1 back in Chapter 1 tends to hold Incorporates elements
true, with some stocks overvalued and others undervalued. However, as the effi- of cognitive
cient markets hypothesis implies, it is hard to identify ahead of time the stocks psychology into finance
in each category. To beat the market, you must have above-average information, in an effort to better
above-average analytical skills, or above-average luck. understand how
individuals and entire
Finally, it is important to understand that even if markets are efficient and markets respond to
all stocks are fairly priced, an investor should still be careful when selecting different circumstances.
stocks for his or her portfolio. To earn the greatest expected return with the least
amount of risk, the portfolio should be diversified, with a mix of stocks from
various industries. We will discuss diversification in greater detail in Chapter 8.

Is the Stock Market Efficient?

During the past 25 years, many empirical studies have been conducted to test
the validity of the three forms of market efficiency. Until 10 years ago, most of
these studies suggested that the stock market was highly efficient in the weak
form and reasonably efficient in the semistrong form, at least for the larger and
more widely followed stocks. However, the evidence also suggested that the
strong form EMH did not hold, because those who possessed inside information
could and did (illegally) make abnormal profits.

More recently, the empirical support for the EMH has been somewhat
diminished. As we indicate in the behavioral finance box, skeptics point to the
recent stock market bubble and suggest that at the height of the boom the prices
of the stocks of many companies, particularly in the technology sector, vastly
exceeded their intrinsic values. These skeptics suggest that investors are not sim-
ply machines that rationally process all available information—rather, a variety
of psychological and perhaps irrational factors also come into play. Indeed,
researchers have begun to incorporate elements of cognitive psychology in an
effort to better understand how individuals and entire markets respond to dif-
ferent circumstances.18

Keep in mind that the EMH does not assume that all investors are rational.
Rather, it assumes that whenever stock prices deviate from their intrinsic values
due to the availability of new information, investors will quickly take advantage
of these mispricings by buying undervalued stocks and selling overvalued
stocks. Thus, investors’ actions work to drive prices to their equilibrium level.
Critics of the EMH stress, however, that the stock market is inherently risky and
that rational investors trading in an irrational market can lose a lot of money
even if they are ultimately proven to be correct. For example, a “rational”
investor in mid-1999 might have concluded that the Nasdaq was overvalued
when it was trading at 3,000. If that investor had acted on that assumption, he or
she would have lost a lot of money the following year when the Nasdaq soared
to over 5,000 as “irrational exuberance” pushed the prices of already overvalued
stocks to even higher levels. Ultimately, if our “rational investor” had the
courage and patience to hold on, he or she would have been vindicated, because
the Nasdaq subsequently fell to about 1,300.

18 Three noteworthy sources for students interested in behavioral finance are Richard H. Thaler,
Editor, Advances in Behavioral Finance (New York: Russell Sage Foundation, 1993); Andrei Shleifer,
Inefficient Markets: An Introduction to Behavioral Finance (New York: Oxford University Press, 2000);
and Nicholas Barberis and Richard Thaler, “A Survey of Behavioral Finance,” Chapter 18, Handbook
of the Economics of Finance, edited by George Constantinides, Milt Harris, and René Stulz, part of the
Handbooks in Economics Series (New York: Elsevier/North-Holland, 2003). Students interested in
learning more about the efficient markets hypothesis should consult Burton G. Malkiel, A Random
Walk Down Wall Street (New York: W.W. Norton & Company, 1999).