Risks and Returns: UK Financial Market

Requirements

Using the information listed below (a to c) prepare a report on the UK financial market by reviewing the performance of two asset classes, bonds and shares. The submitted report should:

1. Demonstrate a basic appreciation of fundamental and technical analysis and why it is used. (20 marks)
2. Set out the various strategies used by a technical and fundamental analyst when making decisions about which shares to buy and when to buy and sell them. You should include graphs and real-life examples. (20 marks)
3. What is the purpose of stock evaluation? What role does intrinsic value play in the stock valuation process? You should illustrate this by real life examples. (15 marks)

Solution

Introduction:

The UK financial market is comprised of the stock market and the bond market. The London stock exchange is the exchange which is situated in London considered the third largest stock exchange in the world with the market capitalization of up to USD 6.06 trillion. It is the oldest exchanges, and it can be traced to last 300 years. The primary market of the exchange acts as the issuer and aids the companies to have reached to the capital. It allows the companies to raise money to obtain a market valuation and increase their profile through different routes by following the firm throughout its IPO process. The products traded in the market include the shares, depository’s debt, and receipts. The secondary market is used for trading of the common stock, bonds, covered warrants, structured products, GDRs, and exchange-traded products and funds. The FTSE 100 index is the main market for the shares which is also called the “footsie.”

LSE:

The LSE or London Stock Exchange is home to the UK 100 indexes the main FTSE 100 index, the FTSE 350 index, the FTSE 250 index, and the TR UK 50 index. These sectors are composed of companies belonging to sectors including the Aerospace, Banking sector, chemical, food and production, electronics, travel and leisure, software, mining, media, health, real estate, etc. The index which is going to be discussed and analyzed in this report is the FTSE 100 index. The FTSE 100 index as of May 28, 2018, was standing at 7730 points with an increase of 13.54 points that is 0.18% say increase. The index has increased by 2.42% as compared to the last year (London Stock Exchange, 2018).

UK Bond Market:

The European bonds were seen to have higher bond prices in much of 2017 supported by the central bank policy and also through the improved global growth momentum. At the end of 2017, the investors had little room in their valuations of the bond to compensate for the unexpected risk. The global economy is facing an ongoing upswing in 2018. It shows that the European economy is going to be at the peak of the curve. It shows that from its current strong position the possibility of the upside surprises are bleak for Europe. Globally the policy of withdrawing the loose monetary policy is in process. The Bank of England had also shown its intent by raising the interest rates, this policy which is guided by the BREXIT generated headwinds and also by the inflation and sterling. Analysts have warned to be prepared for volatility in the bond markets (Morningstar UK, 2018).

In 2017, the Gilt prices fell, and the yields had increased between the expectation of increment in the interest rates of UK and consequently increment in the inflation pressures. The growth in earnings continued to lay the inflation, mean earnings minus the bonuses rose at a yearly rate of 2.1%, and it also fell in real terms by 0.4%. The yield of the ten-year gilt has risen from the 1.09% to 1.41%, whereas the short termed Gilt has climbed the threshold from 0.18% to 0.54%.  The UK credit rating has been cut down by the credit rating agency Moody from Aa1 to Aa2 and has downgraded the outlook of the country’s economy to negative from stable (Advisor-Hub, 2017).

Fundamental Analysis:

The fundamental analysis is one of the processes of valuation of business which is done at the most fundamental level. This kind of analysis examines the ratios of business for determination of the financial health of the business. It gives the idea about the value of stock regarding its intrinsic value. The fundamental analysis also takes into account various factors like the revenue, asset management, the production, and operating process of a business and the interest rate at which it takes credit. Many investors and analysts use the fundamental analysis alone for the valuation of the stock. However, the fundamental valuation combined with other valuation tools can help better in the investment purpose. The fundamental valuation aims to get the current worth of the stock and also, more importantly, how the market is valuing the stock.

Why it is used

Even though most the fundamental analysis is conducted to value the stocks, this method can also be used for any security. An investor can also use the fundamental valuation analysis for the value of the bonds by looking at the economic factor like the overall condition of the economy and the interest rates. The fundamental analysis is conducted to find the underlying value of the company in making an informed investment decision. This aim can be achieved through the thorough analysis of the financial documents of a company which it reports annually. The analysis of the company in these terms show if the company stock is overvalued or undervalued. The data is also not merely limited to the earnings and reported Financials. Investors take advantage of real-time pricing data, increasingly alternative data, and analyst estimates to figure out the underlying value of the stock.

Technical Analysis

This analysis is the analysis of an instrument for the prediction of the course of prices by studying the historical market data and the volume and price. While the fundamental analysis examines the dividends, earnings, new products, and research on the company and its securities, the technical analyst, on the other hand, fear about the growth and if the investors have the means to support the opinions. The technical analysts use many techniques in their analysis, but all are centric on the analysis of price and volume. The use of charts is a primary technique in this analysis. The charts are used to recognize the price patterns, and the trend of the market in the markets and the try is to use the patterns (Navin, 2016).

Why it is used

The chart study is one of the many tools which are used to analyze the company in technical terms. The technical analysts who use the supply and demand indicators are monitoring the margin levels, cash in brokerage accounts, short interest, overall the liquidity of the investor for the aim of determining the value of money left. Stock prices are in the end what the investors think, and the analysis of their thinking is as critical as the estimates of earnings. The use of charts in searches of the patterns like the head and shoulders or the moving averages, or the top and bottom reversal patterns, and find in the shape of lines of resistance and support and obscure formations like pennants, cup-handle patterns, and flags. The analysts use wide market indicators like the mathematical transformations of price like the advance/decline price, the up and down volume. These all indicators inform on the price trend of the asset in the short term period and give a prediction on the probability of its direction.

Strategies for Fundamental Analysis

For the analysis part, we are going to pick one stock from the UK financial market, which is the Marks and Spencer Group PLC.

Earnings per Share:

Earnings Per Share= (Net Inome)/(Total No of Shares Outstanding)

The company earnings are assigned to each of its shares showing the earnings per share that the company has reported. It shows the value of the company regarding its total shareholders. The earnings per share are calculated as;

The ratio for Marks & Spence is shown below:

	2013	2014	2015	2016	2017	Current	Q1	5-Yr	Index
EPS	0.28	0.32	0.3	0.25	0.07	0.05	0.11	0.24	-0.26

 

Price per Earnings Ratio

It is another ratio which shows how much price the investor is prepared to pay against the earnings of the stock. The ratio compares the stock price to its earnings per share. It is computed by:

Price Per Earnings Per Share= (Stock Price) / (Earnings Per Share)

The ratio for Marks & Spence is shown below:

Valuation
	2008	2009	2010	2011	2012	2013	2014	2015	2016	2017	Current	Q1	5-Yr	Index
Price/Earnings	5.38	12.45	10.42	8.21	12.58	14.14	15.6	17.33	22.73	27.61	27.25	23.7	20.06	13.82

 

Price to Book Value

It is the ratio which is also called as the price to equity ratio, which compares the price or value of the share with the book value. The ratio can be calculated by dividing the most recent price of the stock with the book value per share reported in the last quarter. The ratio for Marks & Spence is shown below:

 

Valuation
	2008	2009	2010	2011	2012	2013	2014	2015	2016	2017	Current	Q1	5-Yr	Index
Price/Book	1.9	3.54	2.66	1.75	2.69	2.83	2.81	2.41	1.82	1.77	1.75	1.52	2.37	1.72

 

Price to Sales Ratio

It is the ratio which shows the comparison of the company stock price with its revenues. It is also known as the sales multiply or the revenue multiple. The ratio for Marks & Spence is shown below:

Valuation
	2008	2009	2010	2011	2012	2013	2014	2015	2016	2017	Current	Q1	5-Yr	Index
Price/Sales	0.38	0.69	0.6	0.5	0.61	0.69	0.76	0.72	0.54	0.48	0.47	0.41	0.66	1.26

 

DCF Method:

DCF is one of the many methods for fundamental analysis. The Discounted valuation presents the value of a stock as the present value of all the possible cash flows in the future. These cash flows will be discounted at the rate which shows the risk of the cash flows. The basis of this model is that an investor always invests in expectation of generating revenues in future. The model starts with this simple intention. The value of the stock is the function of the cash flows expected from the asset to produce in future. Thus, assets with a higher value will produce higher cash flows and the ones with the lower value will have lower cash flows. As per this model,

The value of an asset = (E(CF_1))/(1-r)^1 +⋯……+(E(CF_n))/(1-r)^n

Here.

N is the life of the stock

E(CFt) is the cash flow reaped in t time

R is the discounting rate

For Marks & Spencer:

Cash flow Projected
	Y1	Y2	Y3	Y4	Y5
Levered Free Cash Flow (GBP, Millions)	£525.42	£498.02	£490.25	£500.96	£340.00
Present Value	£485.16	£424.63	£385.98	£364.18	£228.23
Discount Rate (@ 8.3%)
PV of next 5 years cash flows:	£1,889

 

Terminal Cash Flow Value:

Terminal Cash Flow Value of MKS = FCFY5 × (1 + grwt)/ (Disct rt – g)

Terminal Cash Flow Value of MKS= £340 × (1 + 1.48%)/ (8.4% – 1.48%)

Terminal cash flow by Perpetuity Method grth rt (g)= 1.48%= £5,068

PV of terminal cash flow value: £3,403

Equity Valuation:

Equity Value MKS(GBP)= Present value of coming five years CFS+ terminal CFvalue

£5,291 = £1,889 + £3,403

MKS Total Value Per Share=(( Total Equity value))/((Shares ) ) (£5,291 )/((1,623) )

Discount on the Share Price

Value of MKS per share in GBP= £3.27

Discount rate (on share price MKS £3.11): 4.72%

Estimation of the Discount Rate:

Discount rate is the MKS Cost of Equity = Rf + (Beta * Risk Premium)

Discount rate = 8.4% = 1.48% + (0.801 * 8.45%)

The discount rate is assumed by calculating the Cost of Equity.

Estimation of Bottom-Up Beta

The unlevered beta is adjusted by the tax rate for the financial risk providing the levered beta. The beta range is assumed to be from 0.8 to 2. The market value of MKS equity is utilized, i.e. (£5,041,387,944).

Levered B = Unlevered B (1 + (1- T) (D/E))

0.581 = 0.451 (1.0 + (1.0- 19.0%) (35.63%))

Levered B = 0.8

Strategies for Technical Analysis

The strategies and tools used for the technical analysis are listed below:

Trend Line

The trend line is a line of slope which is explained by the two highs or the two lowest. The trend line is drawn between the two price pivot points which are a diagonal line. These trend lines are used to judge the exit and entry investment points of timings. This line is also called the Dutch line. Trend lines are widely used in the technical analysis. For the establishment of the trend line, the historical data of prices are used to present in a chart form. Charting software’s is used to draw these lines. It is significant to prefer a chart which is aligned with the trading strategy (MRAO.UK, 2018).  The following graph has been taken from Yahoo Finance (2018).

(Yahoo Finance, 2018)

Support and Resistance

The support trend line is the one which is shaped when the stock price declines and then bounces back to a rotate point which lines up the two preceding spin-around points. The concept of the support and resistance is that the progress of the stock price will discontinue and turn around at a definitely determined cost level. The support level is the level of the stock price at which the values are likely to find the support when it is declining. That often means that the price is more likely to rebound off the level as compared to breaking from it. However, when the price has traversed this certain level with a sum higher than it is expected that it will carry on increasing in anticipation of it finding a new resistance level.

Following tables have been taken from Dailyfix.com (2018).

PIVOT POINTS
Symbol	S3	S2	S1	P	R1	R2	R3
FTSE 100	7670.57	7685.57	7694.73	7700.57	7709.73	7715.57	7730.57

 

SUPPORT & RESISTANCE
UK100
S1	7802	W	R3	8100	W
S2	7630	M	R2	8000	W
S3	7489	M	R1	7904	M

(Dailyfix.com, 2018)

Open-high-low-close chart

The Open-high-low-close chart is also known as the OHCL chart or the bar chart is the chart which is used for the illustration of the price movements of a share for a period. The perpendicular lines of the chart are the price-ranges the lowest and the highest prices at one unit of time. The tick marks show the opening in value on the left and the closing value on the right side.  The Japanese candlestick chart is one more way of showing the market stock prices with starting and closing prices.

Purpose of Stock Evaluation

Knowing the worth and value of assets is a requirement for the decision process in selecting of the investments for an investor. The decision on the suitable price to give for the investment, financing, and the choices of dividends is critical when running a business. The main aim of this is to make sensible estimates of the value of the assets in financial and real terms. There are assets which are easier to find value than others. The uncertainty linked with the valuation is different for each asset. However, the main principles remain the same.

It is a basic concept of investment that the investor does not have to pay higher than the worth of an asset. It is a logical statement. However, the fact is often forgotten and is rediscovered after spending some time in every market and every generation. One would say that the price is justified if there are others who are willing to pay the same price. However, this is absurd in fundamental analysis terms. It is the foundation on which the fundamental analysis is based. Valuation or the price of stocks in the market is often not right. It is the basis of this analysis. The fundamental analysis is based on this assumption that market has either overvalued or undervalued the asset and the real price or worth, is the one in which the asset will move towards in time. There can be many areas of disagreement from the estimation of this true value of how much time it would take to achieve the true value. The agreement on this point is authentic that one cannot just pay the price for an asset to others is willing to pay for it (Damodaran, 2011).

Role of Intrinsic Value in Stock Valuation

It is, of course, possible to purchase an asset without consideration of its intrinsic value, however the investors consider it as an important aspect of the portfolio selection. The analysis in this respect is less scientific than technical analysis. However, the estimation needs through calculations. The aim of stock valuation is to look for investment having the intrinsic value higher than its present market value. It will make it an undervalued stock which means that the investor can expect to invest in it with the possibility of adjusting its price to its true value which is higher than what the investor had paid realizing a capital gain for the investor. The intrinsic value is based on the concept that certain objects have a value which is independent of the outside factors. Intrinsic value is based beyond the brand recognition, goodwill, patents and other intangible assets like research expense, technology all can become a factor for the true value of the company.

Real Life Example:

The share price of Mark & Spencer is £3.11 as compared to its intrinsic value of £3.26 as calculated above. The intrinsic value of MKS has been calculated and shown in the above section of DCF. The share price of Mark & Spenser is below the future cash flow valuation, however it is not at a moderate discount of lower than 20%. Similarly, the share price of Mark & Spencer is also not at a substantial discount rate which is lower than 40%. It shows that the company is not slightly overvalued as compared to its true value and its market price is expected to decline in the near future. The company revenues are expected to grow at 0.2% annually, which is not a healthy percentage. It shows that the company is undervalued or simply is neutrally showing the same price as its worth. Even though the company is not performing well in its revenues, the earnings are better. One can however not indulge in investing in such a company when there are other options available. The company Marks & Spencer was included in the top performing companies in the London stock exchange. The earnings are however expected to grow substantially at 20% annually. The Return on Equity of the company has been lower than 20% in last year (Simply Wall Street Pyt Ltd, 2018).

Conclusion:

The analysis of the company Mark & Spencer that the company is slightly overvalued, and the analysis of fundamental and technical analysis tools and strategies show that even though both analyses are found as opposite, both can be utilized simultaneously for better results. The fundamental analysis will yield the results of long-term price valuation, and technical analysis will show the results of short-term price valuation.

References:

Advisor-Hub, 2017. UK bond market review. [Online] Available at: https://www.adviser-hub.co.uk/Articles/entryid/199/analysis-and-opinion-uk-bond-market-review-september-2017 [Accessed 28 May 2018].

Dailyfix.com, 2018. FTSE 100. [Online] Available at: https://www.dailyfx.com/ftse-100 [Accessed 28 May 2018].

Damodaran, A., 2011. The Little Book of Valuation: How to Value a Company, Pick a Stock and Profit. John Wiley & Sons.

London Stock Exchange, 2018. London Stock Exchange. [Online] Available at: http://www.londonstockexchange.com/home/homepage.htm [Accessed 28 May 2018].

Morningstar UK, 2018. Schroders: Prepare for Volatility in Bond Markets. [Online] Available at: http://www.morningstar.co.uk/uk/news/164097/schroders-prepare-for-volatility-in-bond-markets.aspx [Accessed 28 May 2018].

MRAO.UK, 2018. Technical Analysis. [Online] Available at: https://www.mrao.cam.ac.uk/~mph/Technical_Analysis.pdf [Accessed 28 May 2018].

Navin, J., 2016. Go To These 2 Research Websites for Fundamental and Technical Stock Analysis. [Online] Available at: https://www.forbes.com/sites/johnnavin/2016/09/19/2-excellent-research-sites-for-fundamental-technical-analysis-of-stocks/#5888908f29be [Accessed 28 May 2018].

Simply Wall Street Pyt Ltd, 2018. MKS. [Online] Available at: https://simplywall.st/stocks/gb/retail/lse-mks/marks-and-spencer-group-shares#close [Accessed 28 May 2018].

Yahoo Finance, 2018. Marks and Spencer Group plc. [Online] Available at: https://sg.finance.yahoo.com/chart/MKS.L#eyJpbnRlcnZhbCI6ImRheSIsInBlcmlvZGljaXR5IjoxLCJ0aW1lVW

5pdCI6bnVsbCwiY2FuZGxlV2lkdGgiOjgsInZvbHVtZVVuZGVybGF5Ijp0cnVlLCJhZGoiOnRydWUsImNyb3NzaG

FpciI6dHJ1ZSwiY2hhcnRUeXBlIjoibGluZSIsImV4dGVuZGVkIjpmYWxzZSwibWFya2V0U2 [Accessed 28 May 2018].