Behavioural Finance anlysis of 2 companies

1. St05002068 Behavioural Finance Exam Case Study Page 1 In this report, we haveto look at
whatmay be the likelihood of one these two companies being a good investment and why the
other may be a bad investment froma behavioral finance stand point, also to take into
consideration the limits behavioral finance in stock analysis, particularly in regards to analysts
perspective and an investors perspective. The two companies which are identified are from the
US and are well known, one being a company that has been around for a very long time and the
other only having been around for a shortperiod. In the context of the broader equity markets
sincepost financial crisis; has stock markets reached their previous highs due to an increase in the
fundamental drivers or is there a bubble and a case of “Irrational Exuberance” such as termed by
Alan Greenspan during the Dot.combubble based on sentiment. We will try to identify using data
and behaviouralfinance which may or may not be a prudentinvestment, taking into context the
problems of market sentiment. Netflix: Firstly, Netflixis listed on the NASDAQ; in measuring
pastperformanceagainsta benchmark, the shareprice does not track the NASDAQ
compositeindex and the share price has increased from$40 in early 2009 to $386 in 2014 with a
marketcap of $23bn, whereas the index in the sametimeframe has gone from1400 to 4100.
Thecompany has never provided its shareholders with dividends and it has earnings of $1.6bn for
2009, $2.1bn in 2010, $3.2bn in 2011 and $3.6bn in 2012. In a recent article of Forbes “Netflix
currently trades for 325 times trailing earnings and 55 times expected 2014 earnings”, which
indicates that the shareprice is extremely overvalued and there is a lot at play in regards to its
substantial increase in shareprice. It would seem this is a highly speculative investment and its
share price does not accurately reflect the fundamentals of the company, this would indicate that
this is a very risky investment and that investor sentiment is involved possibly creating a
bubble.According to analysts’ predictions (taken fromFT) shareprice forecastfor the next 12
months have a median target of $375 p/s, a high estimate of $500 p/s and a low estimate of $175
p/s, the majority of analysts advisethat investors should hold and that the shares will continue to
outperformthe market.Based on the earnings reports and the reported and forecasted results,
Netflix has justslightly beaten expectations since 2010 to 2013. For 2013 reported results have
been above analysts’ expectations for each quarter, also analysts’ revenue expectations for 2014-
15aredoublethe preceding year with an averagegrowth rate of 134.54%. Coca-Cola: Secondly,
Coca-Cola is listed on the NYSE, in measuring past performance against a benchmark, the
shareprice tracks the S&P 500 Index very closely as the share price has doubled from$20 in early
2009 to $40 in 2014 with a marketcap of $171.5bn,so

2. St05002068 Behavioural Finance Exam Case Study Page 2 has the index from 680 in 2009 to
1840 in 2014. The company gaveinvestors $1.64 dividend per sharein 2009 and $1.12 dividend
per sharein 2013 with net operating revenues of $30.9bn for 2009, $35.1bn in 2010, $46.5bn in
2011 and $48bn in 2012. In a recent article of the Wall Street Journalit highlighted that “Coke
shares tradeat 18 times 2014 earnings forecastand recently yielded 2.8%. Theyearly payment of
$1.12 a shareis expected to hit $1.42 in three years. That's 3.6% of the stock's recent price”. This
could indicate that the shareprice might be a closerepresentation of its fundamentals but again
might be slightly overvalued by analysts. However, their stock price remains very stable with
very little excessivevolatility and is seen as a less risky investment, fromits historical shareprice
it is seen as a long term investment with consistentdividends. In addition, the shares havegained
23%, in comparison to the 46% gains for the Standard & Poor's 500 index sincethe start of 2012,
which indicates that it is currently underperforming the benchmark.According to analysts’
predictions (taken fromFT) share price forecastfor the next 12 months have a median target of
$45 p/s, a high estimate of $52 p/s and a low estimate of $40 p/s and the majority of analysts
advisethat investors should buy and that the company will outperformthe market.Based on the
earnings reports and the reported and forecasted results, Coca-Cola has been in line with
analysts’ expectations for each year from2009-2012, and in 2013 their results have come in line
with forecasts for Q1 except for Q2 and Q3 of earnings reported, also analysts’ revenueforecasts
for 2013-2014 arean averagegrowth rate of 6.48%. Analysis: Behaviouralfinanceindicates that
companies shareprices deviate from fundamental values for long periods due to heuristic-driven
bias and framedependence. Such heuristics that could determine the likelihood of either stock
being a good or bad investment, and also whether market are efficient or not. They would be:
Representativeness:in which explains why shareprices deviate fromfundamental value due to
investors being overly optimistic about the futurereturns based on past good performanceand
overly pessimistic about futurereturns based on past underperformance, this might explain the
excessive optimism in earnings for Netflix in comparison to the conservativeestimates of Coca-
Cola over the next 2 years. Overconfidence:With analysts’ expectations so high, is it likely that
they are correctin their assumptions aboutboth companies outperforming the market? This stems
fromconservatismcausing mispricing as they do not adjusttheir earnings estimates in responseto
previous earnings announcements. Therefore, especially in regard to analysts’ expectations
aboutNetflix, is why there has been continued surprises and this explains why they are
overconfident, this may be why the stock has higher returns than the overallmarket. Gamblers
Fallacy: When

3. St05002068 Behavioural Finance Exam Case Study Page 3 an individual erroneously believes
that the onset of a certain randomevent is less likely to happen following an event or a series of
events, therefore people tend to apply the law of big numbers to small numbers and in doing so
incorrectly predict a reversal; so in the case of both companies investors and analysts may
believe that becausethey are suffering with overconfidencein their beliefs that continual growth
will occur. In regard to Netflix, according to analysts stocks could fall with a broad
marketdecline but it will continue to outperformthe index, even though it has increased
dramatically, they predict that it will continue to go up. The problemwith this is, analysts
werepredicting the same leading up to the stock crashing from$280 p/s to $70 p/s in 2011, even
though it beat analysts’ earnings estimates it crashed because800,000 subscribers leftin a very
shortperiod of time. Anchoring:Analysts havetheir expectations anchored in the past and this
explains why they are continually being surprised by the earnings announcement, this is certainly
the casefor Netflix as all expectations have been well below the actual earnings, whereas the
casefor Coca-Cola is very different as their expectations and the reality are the generally the
same, which helps to explain the stocks stability. I would argue that heuristics are playing a role
in the deviation from the shares fundamental value, this is certainly the casein Netflix as there
seems to be a herding and bandwagon effect by investors, as positivenews regarding its
performanceis having a big impact on the companies shareperformanceover the shortterm which
could explain how its price has increased tenfold since 2009. According to the Barberis,
Schleifer & Vishny model; there is an under reaction of stock prices to news such as earnings
announcements, and overreaction of stock prices to a series of good or bad news. As both of
these companies are watched very closely and news continues on matters relating to the
companies this will invariably impact on the price, but this is going to be of much greater impact
on Netflix than on Coca-Cola as news may make prices much more volatile. In regard to Netflix,
in the context of this model as it has had a long record of good news it has led to its stock being
overpriced and eventually would havelow average returns after it, therefore its overvalued price
will eventually revert to its mean. As it has continual good news, it will invariably impact on its
price in an upward direction, but justas in the in the late 90’s with the Dot.combubble investors
should be wary of a company that has not consistentconcrete performance with erratic shareprice
movements driven by herding and news announcements. This will invariable mean that the price
will continue to be volatile and may drop considerably to revert to its fundamentals, as an
investor looking for a solid long term investment, it is not a good option, however for a shortterm
risk loving investor investing in Netflix may produceshortterm rewards butwill not remain so for
long.

4. St05002068 Behavioural Finance Exam Case Study Page 4 However, in regards to Coca-Cola
analysts and investors could be using representativeness as a heuristic, because Coca-Cola is
seen as a growth stock becauseof its consistent earnings growth; this does not mean that it will
sustain this in the future, on the flip side if it continues to produceconsistentgrowth it would be a
less risky investmentfor the medium to long term in comparison to Netflix. Also investing in
Coca-Cola, people must be careful to avoid Hedonic Editing, in which they would see the
income fromdividends as a separate frame, indicating that they perceive the income as a silver
ling against loss if the stock doesn’tperformand the income is seen separately as a bonus when
prices increase. Itis important for an investor not use metal accounting and to make the
distinction between capital gains and dividends as they are one in the sameand any income
should be reinvested to gain fromcompound interest. According to Barberis et al (1998) “when a
positive earnings surpriseis followed by another positive surprise, theinvestor raises the
likelihood that he is in the trending regime, whereas when a positive surpriseis followed by a
negative surprise, the investor raises the likelihood that he is in the mean-reverting regime”.
Based on this assumption, this would indicate that Netflix is in a trending regime and that Coca-
Cola is in a mean-reverting regime, which could mean that Coca-Cola is following the mean
(average) therefore having greater stability, whereas investors perceive Netflix to be in a trending
regime going upwards, buthow far can it go up. Therefore based on their theory, stocks with
consistentgood news and past high returns areovervalued and investors can gain abnormal
returns by betting against the overreaction to consistent patterns of good news (Netflix), whereas
stocks thathave had a history of bad or mediocre news become undervalued and investors can
gain returns frominvesting in these stocks(Coca-Cola).However taking thesebiases and heuristics
into account, there is substantialcontradictions between modern theories of investmentand those
of behaviouralfinance (e.g. an accuratemeasurement and investor tolerance for risk), the
behaviouraltheory will not accurately predict or explain stock price movements or investor
behaviour fromthe pastor to the future, it only seeks to look at it froma cognitive perspective. As
this field is still in its early stages it may be prudent to take this into consideration froman
investment standpoint and be cautious with any decision, whether it is based on fundamental,
technical or behaviouralanalysis. Conclusion: In summary, with the limitations of behavioural
financeas a tool to identify which stocks may be a good or bad investment, fromthe analysis
aboveit would seem more prudentthat for a secure investmentwould be in Coca-Cola. Whereas,
Netflix short term performanceis outstanding, and an investor with a high appetite for risk may
invest, it is obvious that the company’s sharepriceis being impacted by much more than its
fundamentals and analysts’ expectations.

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