TESCO PLC. CASE STUDY-Financial Statement & Data Analysis
Table of Contents
- a) Efficient Market Hypothesis. 4
- b) Types of Profit warnings. 5
- Results and Analysis. 6
- Conclusion and Recommendations. 10
- References. 11
Tesco Plc. announced two major profit warnings in the year 2014 on September 22nd and 9th December. These two announcements had an adverse effect on the stock volumes. It came out that the company had misstated its profit statements and this aspect made its stock price take a deep dive. Therefore, this report presents the abnormal returns analysis for the company for the period of the warning. The report has the following sections; introduction, overview of Tesco Plc., literature Review, results and analysis and conclusion and recommendations.
Tesco Plc. a supermarket chain made major announcements towards the last quarter of the year 2014. The company had made six profit warnings in a year. The announcement was made by the incoming CEO Dave Lewis who had only spend 100 days in the company. The CEO warned the share market the predicted profits that were expected on the year ending on February 2015 had a £500 million deficit compared to the expected markets forecasts as they didn’t exceed £1.4bn. These announcements saw the company share price halve to its lowest in 14 years’ time. The accounting scandal of overstating their profits was also a major blow to investors an aspect that saw them lose confidence with the company. In less than a year, the company had made major changes including hiring a new CEO.
These situations put the company into a major crisis that lead it to face tough economic times. The top ten shareholders sold some of their shares after that scandal and the profit warning an indicator they had sensed some danger. However, while majority were frustrated with the state of the company, others had the hope that the company was at its lowest but it could still make a turnaround and recover the market share. The shares saw a deep dive by 16% after the announcements and the company traded way below other competitors like FTSE 100.
Accounting information is vital in stock markets. The accounting data that is available to the public is used to explain the changes that affect the stock prices. Many authors have evaluated literature and gave varying views on the effects of financial announcements on the aspects of stock markets. Negakis (2005) noted that the earnings and book values have no effect on the stock prices. However, various authors like Hirschey et al., 2001; Liang and Yao, 2005), identified that there exist various relationships between accounting parameters and the stock prices.
Further, Fama (1970) argues that the stock prices must reflect on the financial information that is presented to the shareholders in an efficient market. He further adds that the financial information provided to the public for the publicly owned companies influence the stock prices on an efficient market and the investors would always react to such announcements. However, some research reveal that announcements made on financial markets may not be reflected by the variations of stocks (Helbok & Walker, 2003).
Over the decades, companies have made public announcements that target the investors like takeover announcements, change of company management, assets acquisitions, dividend announcements among other financial related information. It has been established in literature that these announcements have an impact on the movement of stock prices. While some investors might perceive some announcements as a warning signs, others would not do anything when such announcements are made. The reaction is quite different ranging from one company to the other as other factors like market share play a role. According to Vega (2006), there is a change of the relationships between stock prices in the markets and the several types of public announcements made. Moshirian et al., 2012 revealed that negative public announcements adversely affected the movement of the stock prices in his study of Vilnius Stock Exchange.
In their research, Eizentas et al. (2012) evaluated abnormal returns on stocks and how it was impacted by the financial information’s signals on stock market prices. Under their study that they found few categories of financial announcements that had an influence on the stock prices. Further in their study, Kiete and Uloza (2005) adopted Cumulative Abnormal Returns and identified a semi-strong form of EMH that existed in Vilnius SE where financial brokerages exploited the market inefficiencies. They further added that financial information was a crucial key on the company returns.
Alidoro and Grigaliǌnienơ (2012) also evaluated the stock price reactions to the key financial information like profit warnings and found out that the reaction to positive financial information was a bit positive on the stock prices compared to the negative financial information. He further adds that existence of some inefficiencies leads to the investors taking advantage of that to gain profits. Generally, positive public announcements lead to a positive stock price movement while a negative public announcement may generally lead to a decline is stock prices. While some events affect these movements, some might be short lied thus the investors may not react at all to the changes.
According to EMH, investors have a limited chance to buy stocks as they are always traded at their fair value on the SE (Polk, 2013). EMH has some issues of anomalies where regular patterns are noticeable for asset returns. The patterns are regular and reliable an indicator that they can be applied in forecasting of stock prices (Jackson & Madura, 2003).
There are three forms of EMH and are based on the underlying assumptions of price efficiency. They include; weak-form market efficiency, semi-strong market efficiency and strong version of market efficiency. Under weak market efficiency it’s stated that the available financial information reflects the prices for the publicly traded assets as well as the future trends cannot be predicted by the past prices while the semi-strong established that stock prices react instantaneously to the public financial announcements while the strong version argues that private insider information and public knowledge reflect the asset prices.
Profit warnings according to analysts refer to an unexpected outcome in that the earnings for a given period or quarter may not reach the current expectations. The earnings shortfall maybe due to low sales, reduced net profits, escalating expenses, earnings per share among others. The warnings are normally made for the ending year even though quarterly announcements can be made (Kasznik & Lev, 1995). Profit warnings that there will be a shortfall of profits, sends a negative message to investors and that would lead negative reactions that could lead to a decline in stock price movement. When a company publishes its financial information, a decline in sales could be a profit warning and if the decline is persistent, then the stock prices may be influenced negatively overtime. Reduced profits that maintain a trend over several quarters consecutively or even in years could send a signal to investors and the stock prices and volume would be negatively affected (Skinner, 1994).
Profit warnings will influence the stock prices differently ranging from a company to the other. Large-sized companies would be less affected by profit warnings compared to medium or small sized companies. Also, a profit warning may lead to an overreaction by the investors in that when there is a sudden drop of profits with unclear circumstances, that could be a red signal to them especially when there are accounting scandals (Tserandash & Xiaojing, 2010). An underreaction indicates less reaction by the investors after a warning has been send and this could be when the profit drop is less significant. No reaction by the investors come in when there is an expected drop but the market is promising so the company will gain. Profit warnings are quite useful as they send a signal to the investors to act for the sake of the company. The shareholders may chip in and help the company recover from pressing debts that could be leading to declining profits. The investors can as well offer decisions to help the company recover.
This section presents the findings of the abnormal returns for Tesco for 22-9-2014 & 09-12-2014 period after a profit warning was send. It’s expected that the stock volumes and prices declined tremendously after the announcements. Also, the findings present the company returns for the period, CAPM, AR and CAR for Tesco Plc.
A ten-day (-5 & +5 days) analysis for abnormal returns was done with an average trading volume of -260 and -10 days. The results are presented in the figure below.
Figure 1: -5 & +5 DAYS AR
From the results as shown in Figure 1 above, 5 days before the announcement of 22nd September, the returns were normal but at the 5th to 6th day, there was a sharp incline indicating the abnormal returns that were because of stock sales due to the warnings. After the period of two days, the curve took a deeper curve with negative returns before assuming the normal curve again. The results are in line with Eizentas et al. (2012) who noted that financial announcements had an adverse effect on the stock prices.
Also, the researcher calculated the daily cumulative abnormal return s for the company for -5 days and +20 days for each of the profit warning using CAPM. The results are as shown below.
22ND September Profit Warning
The figure below presents the September profit warning.
Figure 2: Sep. Profit warning
From the results as shown in Figure 2 above, the abnormal returns are experiencing a declining curve that majorly operates on the negative side.
Figure 3: December Profit Warning
Results as shown in Figure 3 reveal that the abnormal returns for December are moderately operating along the zero line but with a sharp plunge on the 21st day. The cumulative abnormal returns operate on the negative side. This is an indicator that the stock was not doing well. Comparing the two profit warnings, they almost assume a similar curve even though in December there was adverse effects compared to September.
From the results presented above, they are in line with the literature in that the profit warnings issued adversely affected the stock prices of the company. The findings collaborate with Skinner (1994, 1997) and (Kasznik and Lev, 1995) who identified profit warnings having unimpressive implications on the stock markets as the case presented by the findings.
The study concludes that profit warnings have negative effects on stock markets and would influence the stock price movements. The abnormal returns because of such announcements are short lived as for the case of Tesco, it was experienced for two days then was followed by a sharp decline. Profit warnings are treated as negative announcements and would trigger investors to sell part or all their shares if the company keeps issuing profit warnings every other time like for the case of Tesco. In the study, I would recommend that Tesco to have both an external and internal accounting team that will compare the accounting figures and accounting misstatements can be avoided prior publishing the financial reports.
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Creative accounting describes a best practice in accounting and is undertaken to solve individual conflict of interest that arise in a workplace as they care more on self-interests while overlooking the ethical dimensions of accounting. Managers and accountants can manipulate their financial statements and reports as a misuse of their position in the company thus giving a false information to the shareholder. Motivations for creative accounting are known to be the stimulating behavior for creative accounting in the company. One of the key motivators for creative accounting is one reporting a decline in business income to lower the payable tax. Also, when a manager reduces the company losses to huge figures to make the company to appear having a better performance in future. Lastly, also providing a positive view on the expectations, securities valuation as well as reducing the existing risks in an anticipated capital markets to maintain the performance of the company.