TOPICS:

1. Beta is a measure of systematic risk. It measures sensitivity of returns of an

individual share compared to the returns on a market portfolio. In Pakistani
environment, where many companies are inter-linked through family control,
do you believe that beta values are useful for portfolio management?

2. If more than half of the companies on the Karachi Stock Exchange do not pay
cash dividends, what would be an appropriate what to estimate their value?

3. The concept of efficiency in finical markets is very narrow since it relates only
to information arbitrage i.e. the speed at which information is absorbed by
share prices. Do you think that in an emerging market like Pakistan we should
adopt a broader definition which also includes fairness and justice?

‘Financial Management 1’ Sahar M

Essays

1. The concept of efficiency in finical markets is very narrow since it relates only to
information arbitrage i.e. the speed at which information is absorbed by share prices.
Do you think that in an emerging market like Pakistan we should adopt a broader
definition which also includes fairness and justice?

Stock Markets of the Developed Nations

Stock market is a place where Company’s shares are sold to the public. The driving
force behind the stock market is the basic economic principle of supply and demand.
The number of stocks open to the public is the supply and the number of people
willing and able to purchase the stock is its demand. Markets react promptly and
uncharacteristically to a range of financial and macroeconomic variables, along with
rumors of war, change in regulatory business environment, political climate seen as
negative by the business (investing) community, interest rate variation to general
performance of the economy.
An efficient capital market is one in which all the available information relating to a
particular company is processed quickly and accurately and reflected in the share
price (Information Arbitrage). Information relating to a particular company is
evaluated in a rational way and the price of its shares is adjusted accordingly. This
means that when new information is available, which alters the expectations of
investors about the future prospects of a company; we should expect an
instantaneous and unbiased reaction from the market in the form of a revised share
price. The kind of information that may alter investor expectations can take various
forms including profit warnings, dividend announcements, board changes, strikes,
new contracts won and so on.

What happens at Karachi Stock Exchange (KSE)?

The Karachi Stock Exchange was declared the “Best Performing Stock Market of the
World for the year 2002” by the international magazine “Business Week”. Similarly
the US newspaper, USA Today, termed Karachi Stock Exchange as one of the best
performing bourses in the world. Even the graph below showing the market
performing during the period June 1998 to June 29, 2007 shows a Bullish (upward)
trend.

KSE Market Performance graph

However, it is interesting to examine how the Pakistani market really responds, in

terms of stock market activity, to changes in its fundamental economic
variables.
No significant relationship has been found between industrial production and the KSE
index. KSE is moved largely by speculative motives rather than ‘real’ production
and performance oriented motives. It is not efficient in the sense that it does
not reflect the country’s true economic activity but is highly affected by changes
in monetary variables. The concentration of ownership of KSE shares in the
hands of a few, including large institutional investors and foreign owners etc,
whereas the meager amount of floating shares reflect the share ownership by
the general public. this encourages stock market manipulations by a selected
group of individuals and does not let the index reflect a true picture of the
economy. Therefore, saying that the KSE doesn’t represent the actual position of
Pakistan’s Economy is true. Regardless of the political instability, unfavorable
business environment, increase in terrorist attacks and power crises the KSE has
been operating independently and doing wonders in the last decade.

Is Fairness and Justice the solution?

The most fundamental principle of justice—one that has been widely accepted since
it was first defined by Aristotle more than two thousand years ago—is the principle
that “equals should be treated equally and unequal unequally.”
While another philosopher - John Rawl’s categorizes justice as fairness. His theory is
based on two basic principles; the first principle of justice is that each person is to
have an equal right to the most extensive basic liberty compatible with a similar
liberty for others. While Rawl’s second principle of justice states that social and
economic inequalities are to be arranged so that they are both reasonably expected
to everyone’s advantage and positions and offices should be open to all.
Furthermore, the Nobel prize winner Economist, Amartya Sen in his book
‘Development as Freedom’ sheds light on way to achieve Equality and fairness in
society: “As a process of expanding the real freedoms that people enjoy,
development requires the removal of major sources of unfreedom: poverty as well as
tyranny, poor economic opportunities as well as systematic social deprivation,
neglect of public facilities as well as intolerance or over activity of repressive states.”
Sen argues that for economies to develop, democratization of the political
communities is crucial as the citizens should be empowered to voice their opinions.
Full human development can only be achieved in a healthy and stable environment.
Therefore, a just and fair economic system should be devised that encourages
equality at least up to the limit of providing the weak and needy with the basic
requirements, to meet a minimum standard of living.

Conclusion:
In the real world it is nearly impossible to promise Fairness and Justice for all; till
today it is a highly desirable phenomena, which fails to exist on Earth. It is nearly
impossible to provide the basic ‘freedoms’ talked of by both Sen and Rawls,
especially in emerging economies like ours.
According to me we should try to increase the efficiency of Pakistani stock exchanges
by:
• Converting KSE from a guarantee into a regular company with share capital
and its shares should be made to float the market just like any other
company.

• Bring in a large number of investors who are prepared to examine the

available information relating to a company in the hope of unearthing mis-
priced shares.

• Making the KSE board accountable to the investor public would also
encourage broader share ownership and prevent accumulation of
majority of shares in the hands of a selected few.
• Another way of ensuring that the KSE index reflect the true
performance of the Pakistani economy is to adopt a share index which is a
‘composite’ of all the shares listed in the stock exchange rather than an
index of just a few selected shares which are most widely traded. This
move will discourage manipulation of the index and result in a more realistic
appraisal of the stock market in relation to other markets in the region
and beyond.
 References
Essay 1:

• http://stockinvesting101.net/how-does-the-stock-market-work/

• http://money.howstuffworks.com/personal-finance/financial-
planning/stock1.htm

• http://www.kse.com.pk/aboutus/annualreports

• http://oak.cats.ohiou.edu/~piccard/entropy/rawls.html

• http://en.wikipedia.org/wiki/John_Rawls#A_Theory_of_Justice

• http://www.foreignaffairs.com/articles/55653/richard-n-cooper/the-road-from-
serfdom-amartya-sen-argues-that-growth-is-not-enoug?page=3

• Fundamentals of Corporate Finance, R. Brealey, S. Myers and A. Marcus,

McGrawHill, 1995 Page 314

• Development as Freedom, Alfred A. Knopf, Amartya Sen, 1999

2. If more than half of the companies on the Karachi Stock Exchange do not pay cash
dividends, what would be an appropriate what to estimate their value?

Introduction:
Dividends are payments made by a corporation to its shareholder out of its profits.
Cash dividend is the type most people are familiar with - it is a cash amount, usually
paid on a per-share basis. Dividend-paying stocks consist mainly of well-established
and mature firms who have grown to extend that they have become market leaders,
characterized by having slow but very steady earnings growth. These established
companies are mainly concerned with maintaining their position by increasing
efficiency and keeping shareholders happy with dividend payments. Mostly investors
buy the shares because of the large size and history promises low-risk investments.
Furthermore, these companies tend to maintain dividend payments, providing a
sense of safety to investors looking to diversify into the equity markets without the
high risks of investing in growth companies. Nevertheless, it doesn’t mean that the
companies that do not pay out cash dividends don’t have a value, there are many
ways we can determine the firm’s value.

What to look at if not Cash Dividend?

1. WACC - Weighted Average Cost of Capital
wdkd(1-T) + wpskps + wceks.
The weights are simply observed through the balance sheet of the company. It tells
us about the debt and equity percentage of the Company. For example 40% of debt
and 60% of equity. The part of the formula relating to preference shares is ignored,
as they are not offered in Pakistan.
Now, the calculation of ks and kd is the problem.
Kd (cost of debt) = kd(1-T)
kd = interest rate of any fixed security of the firm
For example: take the cost of a 30 year bond.
T is the tax savings
The portion of ks is a bit problem. ks can be calculated using the CAPM model or
Discounted Cash Flow method, but both require the cash flows i.e. the dividends and
thus cannot be calculated in this scenario. But the third option is calculating k s
through the Bond-Yield-Plus-Risk Premium Approach. Simply take the firms long term
debt and add a judgmental risk premium of 3-5% depending on the strengths and
weakness of the company. Thus put the weights and the cost of debt and equity into
the formula mentioned above to find the value of the company.
For the newly formed listed company it is not possible to use WACC so as the result
we could use IPO’s that is initial public offering in which we have to estimate the
future cash flows of the company and as a result from which share price is found.
2. We could also find out the value of the company through its liquidity and
performance. That is through calculating the ratio’s for example gross profit
margin, net profit margin, stock turnover, debtor’s payout and creditor’s
payout. For the liquidity purpose Asset test ratio and current ratio are used.
All can be calculated through the financial statements of the company.
3. Stock dividends and splits, actions that change the number of shares
outstanding without altering the value of the underlying assets. Traders
consider splits a positive progression in value and goodwill for companies and
their investors. Corporate executives use stock splits as marketing and
investor relation tools. They know that stock splits make shareholders feel
better and engender a sense of greater wealth.
4. Liquidation Value: Companies that are losing money are often evaluated by
collecting information about their value as a "going concern." The easiest way
to measure a company is the liquidation value. Total all assets of the
company. Subtract all liabilities. The result is the net worth or book value.
This is the value of an orderly liquidation of a company.
5. Company’s value can also be judged through the payment of long term
debt patterns and the profitability of the company, market value of the
company. Some companies do not give dividends because to expand in
future, which can be reflected through the reserves of the company, thus the
higher capital gains. In Pakistan or even in any part of the world, most
companies try to spread conspiracies about there growth or future plans
through informal channels which should not be made the grounds for
estimating the value of the company.
6. Price-to-book value: This ratio is calculated by dividing share price by book
value, which equals a company's assets less its liabilities, per share. This ratio
is typically relevant when evaluating companies with significant assets.
Companies with low price-to-book values are often viewed as value stocks.
7. Price-to-cash-flow ratio: This ratio equals a company's share price divided
by cash flow per share. Cash flow equals earnings plus depreciation,
amortization, and other non-cash expenses. This ratio can be helpful when
evaluating companies with significant noncash expenses.
8. Price-to-sales ratio: This is calculated by dividing share price by annual
sales per share and can be useful when evaluating companies with little or no
profits.