Hypothesis Testing and Essay

This study material discusses hypothesis testing and essay. It covers topics such as the calculation of average monthly logarithmic return of portfolio A and B, development of hypothesis, application of T test, and valuation approaches for computing fair value of equity. It is suitable for students studying finance and economics.

HYPOTHESIS TESTING AND ESSAY

TABLE OF CONTENTS
INTRODUCTION...........................................................................................................................1
Part A...............................................................................................................................................1
(a&b) Calculation of aveage monthly logarithmic return of portfolio A and B..........................1
© Development of hypothesis...................................................................................................12
(d) Application of T test............................................................................................................12
(f) Discussion of findings..........................................................................................................12
(G) Comparison of results with previous research....................................................................13
Part B.............................................................................................................................................13
Valuation approaches for computing fair value of equity.........................................................13
CONCLUSION..............................................................................................................................15
REFERENCES..............................................................................................................................16
Table 1Portfolio A and B.................................................................................................................1
Table 2Price earning ratio of Bayer...............................................................................................14
Figure 1Porfolio A return................................................................................................................2
Figure 2Portoflio B stocks...............................................................................................................3
Figure 3Portfolio A and B comparison............................................................................................3

INTRODUCTION
Stock market is emerging as one of the important source from which investors make good
amount of money on investment. In the current report, different portfolios are prepared, one of
them is prepared by taking stocks on random basis and other one is prepared by using technical
analysis charts. By using t test weak efficient market hypothesis theory is tested. In second part
of the report, PE ratio is computed and recommendation is made to the Monsanto investors.
Part A
(a&b) Calculation of aveage monthly logarithmic return of portfolio A and B
Figure 1Portfolio A and B
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Interpretation
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29
-0.04
-0.03
-0.02
-0.01
0
0.01
0.02
0.03
0.04
Portfolio A
Figure 2Porfolio A return
It can be observed that return of the randomly selected portfolio is fluctuating consistently. This
fluctuation is observed regulalrly as on monthly basis if return is increasing then in other month
it will suerly decline. It can be said that random selection of stocks is very dangerous task and
one must avoid stock selection on random basis. Rational investors always prepare some of the
important base for making decisions and by considering same must make decision in respect to
making investment in specific stock.
0 2 4 6 8 10 12
0
2
4
6
8
10
12
Portfolio B
Figure 3Portoflio B stocks
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It can be seen from chart given above that portfolio that is created by taking in to account
technical indicators is generating good return for the investor. Return is increasing at fast rate on
the chart and then slightly value declined to some extent but again it rose to specific level. It can
be said that sudden fluctuations are observed in case of reutrn of portfolio B but most of time
return increased consistently on the portfolio.
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29
-0.04
-0.02
0
0.02
0.04
0.06
0.08
Chart Title
Portfolio A Portfolio B
Figure 4Portfolio A and B comparison
It can be observed from the chart given above that rate of change in return is high in case
of portfolio B then A. It can be seen that higher amount of return is generated by portfolio B then
portfolio A and due to this reason it can be assumed that if stocks are not selected randomly then
in that case good amount of return can be made on the stocks. There are number of methods that
can be used for stock selection. In this regard, some of the technical analysis charts can be used
and different patterns can be identified on them (Van Rooij, Lusardi. and Alessie, 2011). On that
basis best time to make purchase can be identified and it can also be find out that what will be
best time to sold the stocks.
NMC Health
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5500 6000 6500 7000 7500 8000
0
500
1000
1500
2000
2500
3000
3500
FTSE Line Fit Plot
NMC Health
Predicted NMC Health
FTSE
NMC Health
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Rentokil
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5500 6000 6500 7000 7500 8000
0
50
100
150
200
250
300
350
FTSE Line Fit Plot
Rentokil
Predicted Rentokil
FTSE
Rentokil
ITRK
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5500 6000 6500 7000 7500 8000
0
1000
2000
3000
4000
5000
6000
FTSE Line Fit Plot
ITRK
Predicted ITRK
FTSE
ITRK
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DCC
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5500 6000 6500 7000 7500 8000
0
1000
2000
3000
4000
5000
6000
7000
8000
FTSE Line Fit Plot
DCC
Predicted DCC
FTSE
DCC
FRES
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5500 6000 6500 7000 7500 8000
0
500
1000
1500
2000
2500
FTSE Line Fit Plot
FRES
Predicted FRES
FTSE
FRES
It can be observed from the tables that are given above that with slight change in index in case of
all five firms stocks huge change will be observed. In case index change by 0.1 point significent
change can be seen in case of relevant firms stocks. In case of NMC health it can be seen that if
FTSE will changed slightly then stock will be change by 1.11. Thus, rate of change in NMC will
be higher then index. On other hand, in case of Rentokil if FTSE change by 0.1 points firm stock
may change by 0.09 points. In case ITRK beta value is 1.32 for 0.1 unit change in FTSE. This
means that in case index generate better return stock will give good return to investor. In case of
DCC beta value is 1.60 and this again reflect stock is highly sensitive in nature and if market
move upward stock will definitely perform well. Last stock is FRES and its beta value is 0.50
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which reflect that if market will be green moderarte but positive change can be observed in
stock.
© Development of hypothesis
H0: There is no significent mean difference between return generated by portfolio A and
portfolio B.
H1: There is significent mean difference between return generated by portfolio A and portfolio
B.
In respect to the given hypothesis T test will be applied on the given dataset. By using this tool it
will be identifed whether there is significent mean difference between both portfolios in terms of
return. Value of level of significence is set at 0.05 level and by comparing significence value to
this number it will be identified return generated by both stocks are same or different. Apart from
this, percentage return of both portfolios are also computed and by doing so it will be identified
whether any of them successfully beat the market.
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(d) Application of T test
(f) Discussion of findings
It can be seen from table given above that one tail level of significence is 0.020<0.05
which means that there is significent mean difference between both variables or portfolio A and
B. it can be said that portfolio B is generating higher return in specific direction then portfolio A.
It can be said that market information have significent impact on stocks returns and due to this
reason on random basis stocks can not be selected in the portfolio. On other hand, if stocks are
selected randomly then it is not possible to earn sufficient amount of return. This proved that
according to information stocks move upward and downward as reflected by efficient market
hypothesis theory. If such information will not be taken in to account then in that case loss can
be observed on investment. Thus, it can be said that efficient market hypothesis theory proved
partially. However, in this theory it is assumed that stocks can not beat market which is wrong.
During relevant time period it is observed that FTSE generate return of 12% but portfolio B
generate return of 29% in which firms are selected by considering technical analysis charts. On
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other hand, portfolio that is created on basis of random selection merely generate return of -
0.05%. It can be said that portfolio that is developed by using technical charts beat market and
perform better then portfolio in which without doing prior research stocks were selected on
random basis.
(G) Comparison of results with previous research
In previous research studies that are carried out on efficient market hypothesis it is
observed that market were efficient till 1980 but thereafter it become ineffecient and many
incidents were observed when stocks beat market in terms of returns. Efficient market hypothesis
theory failed to cover impact of market size, volatility, shareholders expectations, cyclical
fluctuations and asset bubbles. Hence, many time this theory failed. Present research study also
reflect that it is possible to beat market but stocks must be selected on basis of technical analysis
charts and trends that were observed must remain continue in future time period. In such kind of
conditions it is possible that portfolio successfully beat the market. It can also be observed that in
UK most of stocks beta value is already very high as same are highly volatile. Hence, if in such
kind of situation if portflio beat index then in that case it must not be matter of surprise for
investors and experts.
Part B
Valuation approaches for computing fair value of equity
There are number of approaches that can be used to compute fair value of equity like PE
ratio etc. All relevant approaches compute fair value of equity in different manner and there are
some merits and limitations of these approaches. It depend on an individual that which of
approach it use to do valuation of equity. Some of the commonly use evaluation approaches or
methods to compute fair value of equity is given below. Price earning ratio: It is the one of the most common method that is used to identify
whether shares are overvalued or undervalued in nature. In case price earning ratio of
company stock are higher then industry average it can be said that company shares are
overvalued in nature. On other hand, it is observed that company price earning ratio is
below industry then in that situation it is assumed that investment must be made on the
stocks. Hence, in this way by using price earning ratio it is identified whether company
stocks are overvalued or undervalued in nature (Hameed, Kang and Viswanathan,, 2010).
This is the reason due to which most of investors prefer to make use of price earning ratio
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for making investment decisions in day to day trading. Formula of price earning ratio is
also vey simple. One need to identify stock price and then same need to be divided by
earning per share. By doing so it can be identified on each unit of earning that is made on
per share how much fraction of price comes (Connollly, 2012). One of the major merit of
this method is that earnings of the company is taken in to account and due to this reason
in proper manner it become possible to evaluate firm shares relative to competitors or
peer firms in industry by considering earnings earned in the business. It can be said that
price earning rartio is one of the effective tool for doing valuation of company equity.
Table 1Price earning ratio of Bayer
Price 107.64
EPS 1.36
Price earnings
ratio 79.14706
Price earning ratio of Bayer is 79.14 and its ratio value is higher then same of
GlaxoSmithKline and due to this reason it can be said that firm stocks are overvalued to
some extent and investors must cautiously make investment in the firm. PEG ratio: PEG ratio is another tool that is used for valuation purpose. This ratio remove
some of the limitations of price earning ratio and help investor in making more prudent
decisions. It can be said that it is basically a valuation metric that determined relative
trade off between price of stock and earning generated per share and also company
expected growth rate. Usually, it is also observed that those firms whose growth rate is
high price earning ratio will be high. Hence, it is observed that only using PE ratio woild
make high growth companies overvalued then others. Due to this reason sometimes it
may be possible that valuation done in wrong manner. Ideal ratio of PEG is assumed 1
which means that price earning ratio value is equal to annual earning per share growth. It
can be said that if PEG ratio value is below or above 1 then in that case shares may be
undervalued or overvalued in nature.
It can be said that Monsanto shareholders must accept the deal because already firm
shares are overvalued in the market and if further price is increased to 130 then in that
case shares value will rise overnight for the investors for Monsanto. This will lead to
huge amount of capital appreciation and if investors sold their stake in the market then
they can earn good amount of return on invested amount. Hence, it can be said that
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merger is in favour of the investors and due to this reaoson investors must accept deal
that is propsoed by Bayer to Monesto. Discounted cash flow model: It is the one of the most important model because it is the
tool undern which estimation is made about the cash flows that are expected to be earned
in the business. Usually in the discounted cash flow model analysts taken in to account
annual report of the company and model its financial statements on excel sheets. In these
sheets all elements of income statement are mentioned and then in second stage
estimation is made about the likely rate at which variable value may increase in the
busineess in the upcoming time period (Chang and et.al., 2010). There are number of
methods that can be used for estimating growth rate of sales. Usually, managers estimate
growth rate of revenue and by using same increase sales value. Apart from this, many
times some other factors like economic are taken in to account to make estimation about
growth of sales. Many experts take past year figers and compute growth rates then
average of these growth rates is taken in the business and same is used to make
projection of cash flows. It can be said that there are different approaches of making
estimation of cash flows and it depend on expert that which of approach it used in
discounted cash flow model to make estimation. After using specific method of
estimating cash flows cost computation of projection is done in the business. Under this,
past year data is taken in to account and expenses as percentage of sales is computed
(Cummins and Harrington, S.E., 2013). Thereafter, either average of growth rate is taken
or last year growth rate is considered. By doing so expenses projection is done in the
business. It can be said that in the discounted cash flow model entire projection of income
and expenses is done. Finally, after making estimation of cash flows discounting of same
is done.
Usually, weighted average cost of capital method is used to make estimation of
discount rate. Under this method, cost of equity is computed by using capital asset pricing
model in which risk free rate of return, beta value and market return are taken in to
account. Values obtained in capital asset pricing model reflect the return that investor
required to earn for taking risk on investment (Santos and Veronesi, 2010). On other
hand, cost of debt is also computed and under this average of interest rate is taken in to
account that is related to varied sources of debt. Thereafter, proportion that debt and
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equity have on the capital structure is calculated. Finally, weight of equity is multiplied to
cost of equity and weight of debt is multiplied to cost of debt and from it finally tax rate
is deducted. In this way, weighted average cost of capital is applied in the business for
computing fair value of stock. By using weighted average cost of capital discounting of
cash flows is done in the business. Finally, by using shareholder equity fair value of
equity is computed by the stock analyst and in this way entire mode of discounted cash
flow is used to calculated fair value of equity in the business (Chen. and et.al., 2010). It
can be said that there are multiple advantage and disadvanage of using discounted cash
flow model in the business. One of the major diaadvantage of using discounted cash flow
model is that one need to make estimation of growth rate. It must be noted that growth
rate may become different in reality and due to this reason projection may prove wrong.
In case projection will become wrong then equity value will not be computed fairly.
Hence, it can be said that it is very important to make accurate estimation of cash flows
for the business firm (Dickinson, 2011). One of the major advantage of using this method
is that it usually make use of core business cash flows to estimate income that firm can
earned in its business. Thus, it can be said that by using this approach equity value is
computed in proper manner.
CONCLUSION
On the basis of above discussion it is concluded that efficient market hypothesis theory
does not work practically. This is because there are number of factors that are not taken in to
account in this theory. It must be noted that varied factors collectively have impact on stock and
due to this reason it is possible that always stock failed to perform better then market. It is also
concluded that investors must make use of valuation approaches like price earning ratio and PEG
ratio in order to make decisions. By using these tools prudent decisions can be taken by the
investors.
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REFERENCES
Books and Journals
Chang, C.T. and et.al., 2010. Optimal ordering policies for deteriorating items using a discounted
cash-flow analysis when a trade credit is linked to order quantity. Computers & Industrial
Engineering. 59(4). pp.770-777.
Chen, W.N. and et.al., 2010. Optimizing discounted cash flows in project scheduling—An ant
colony optimization approach. IEEE Transactions on Systems, Man, and Cybernetics, Part
C (Applications and Reviews). 40(1). pp.64-77.
Cummins, J.D. and Harrington, S.E. eds., 2013. Fair rate of return in property-liability
insurance . Springer Science & Business Media.
Dickinson, V., 2011. Cash flow patterns as a proxy for firm life cycle. The Accounting
Review. 86(6). pp.1969-1994.
Edmans, A., 2011. Does the stock market fully value intangibles? Employee satisfaction and
equity prices. Journal of Financial economics. 101(3). pp.621-640.
Hameed, A., Kang, W. and Viswanathan, S., 2010. Stock market declines and liquidity. The
Journal of Finance. 65(1). pp.257-293.
Santos, T. and Veronesi, P., 2010. Habit formation, the cross section of stock returns and the
cash-flow risk puzzle. Journal of Financial Economics. 98(2). pp.385-413.
Van Rooij, M., Lusardi, A. and Alessie, R., 2011. Financial literacy and stock market
participation. Journal of Financial Economics. 101(2). pp.449-472.
Online
Connollly, T,P., 2012. [Online]. Is it overvalued? Look at the PEG ratio. Available through:<
https://blogs.cfainstitute.org/insideinvesting/2012/08/16/is-it-overvalued-look-at-the-peg-
ratio/>.
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