Investment and Valuation of Firms

Market efficiency theory

Anne Lindner Carolin Fischer Alexandra Flix Viktoria Scherer Andreas Warkentin

Universidad de huelva 03.11.2010

Investment and Valuation of Firms Market efficiency theory

Table of content
Table of content ......................................................................... 1 Introduction ............................................................................... 2 What is an efficient market? ........................................................ 3 Market efficiency theory definition.............................................. 4 Efficient Market Hypothesis .......................................................... 6 Efficient market levels ................................................................. 8 Weak-form efficiency ................................................................ 8 Semistrong-form efficiency ....................................................... 9 Strong-form efficiency ............................................................ 10 The Random Walk .................................................................... 11 Conclusion ............................................................................... 14 Bibliography ............................................................................ 15 Electronic sources .................................................................. 15

Investment and Valuation of Firms Market efficiency theory

Introduction

Valuation of firms means trying to find out how much a company is worth by gathering as much information as possible about the company. The best estimate of value provides the market

capitalisation as it multiplies the current share price with the number of issued shares. However, the market price is changing permanently according to the information which is available on the market as investors react with buying or selling of shares to all information depending on their importance. The market efficiency hypothesis deals with the information

processing on stock market and provides an idea of how the information flow can affect the valuation of firms. Based on the background of the globalisation and mobilisation of the world this hypothesis becomes increasingly important as the information flow is getting steadily faster with the new technologies which make it possible to have access to information all over the world. This assignment will firstly provide the definitions of the efficient market and the market efficiency theory. Secondly the efficient market hypothesis will be explained and the different efficient market levels are presented. Afterwards a definition and explanation of the random walk will be given and finally we will come to a conclusion about the market efficiency.

Investment and Valuation of Firms Market efficiency theory

What is an efficient market?

An efficient market can be defined as one where the current market price and the fair value resemble as all pertinent information is incorporated immediately. But even within the definition of efficient markets the occurrence of errors according to the valuation of the market price is permitted as long as they are random. As the deviations are random the chance of a stock being over- or undervalued should be equal and they should not correlate with certain variables like, e.g. a lower or higher PE ratio. This implies that no group of investors is able to consistently outperform the market over a long period of time by using any investment strategy as well keeping in mind that it is extremely unlikely that all markets are efficient to all investors. Instead, different tax rates and transaction costs impede investors from having all the same advantages.

Investment and Valuation of Firms Market efficiency theory

Market efficiency theory definition

Market efficiency is one of the most controversial topics in finance. Why? Some say the market cannot be efficient but others say it is efficient but there are some cracks in the shell of efficiency. However, the idea of market efficiency is that the market price is right. Thus, efficiency comes about as the result of competition. It always depends on the way of how investors draw a conclusion out of the competing behaviour of all stockholders who invest into the market. All investors try to be the first to get the information that will affect security prices. By trading on this information, the price will quickly reflect the new information. If an investor is about to find out some relevant news, e.g. increased sales figures, about a company, he would think about buying a stock. This action drives the price up, but if it rises too much it is possibly sold. Following this, information and competition are the essential principles guiding market efficiency. Moreover, if you think of an asset price being based on anticipating future conditions like future supply, demand, competition, etc., it needs to be kept in mind that these forecasts are made by using the information available which financial economists call information sets. The larger the information sets are the more accurate is the forecasted price. Information is the key to success. Usually, these information sets have been classified into three categories: weakform, semistrong-form and strong-form efficiency, which will be explained later on.

Investment and Valuation of Firms Market efficiency theory

Furthermore, there is one common error which does not admit the perfection of markets. If markets are efficient, it does not mean that it is impossible to make any money. It only means that one will not earn more than it should be earned for assuming that level of risk. Therefore, beating the market means earning a profit above and beyond the required profit for that level of risk. To conclude, definitions of market efficiency have to be specific not only about the market which is being considered but also about the investor group which is covered. It is extremely unlikely that all markets are efficient to all investors, but it is entirely possible that a particular market (e.g. the New York Stock Exchange) is efficient with respect to the average investor. It is possible that some markets are efficient while others are not, and that a market is efficient with respect to some investors and not to others. This is a direct consequence of different tax rates and transaction costs which confer advantages on some investors relative to others. Definitions of market efficiency are also linked up with assumptions about what information is available to investors and reflected in the price. For instance, a strict definition of market efficiency that assumes that all information, public as well as private, is reflected in market prices would imply that even investors with precise inside information will be unable to beat the market.

Investment and Valuation of Firms Market efficiency theory

Efficient Market Hypothesis

The Efficient Market Hypothesis is a cornerstone of modern financial theory and was summed up by Eugene Fama in his influential article Efficient Capital Markets in 1970. It states that it is impossible to beat the market as financial markets should widely be seen as efficient regarding to the distribution of information. According to this, it is impossible, by means of information, to gain exceedingly high returns on investment in comparison to the whole market. Since market participants behave rational, stocks are always traded at their fair value and represent the net present value of all future cash flows of the concerning investment. There are no under- or over-valued stocks. When information arises, the news spread very quickly and they are incorporated into the prices of securities without delay. This can be seen as a result of the stock market efficiency which causes that share prices always reflect all relevant information. Furthermore, they do not follow a certain pattern; hence, they are not predictable. Thus, neither technical analysis, which is the study of past stock prices, nor even fundamental analysis, which describes the analysis of financial information such as company earnings, asset values, etc. would enable an investor in the long term to achieve returns greater than those that can be obtained by holding a randomly selected portfolio of individual stocks with comparable risk. So, it does not matter how much the investor informs him beforehand as the extent of the attainment of returns is due to chance and the only way to get higher returns seems to be a holding in riskier investments. In literature about Efficient Market Hypothesis can also be found graduation as it differentiates between three different levels of the hypothesis itself: the weak-form efficiency, semistrong-form
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Investment and Valuation of Firms Market efficiency theory

efficiency and the strong-form efficiency. Each of them contains different implications about how markets work, which will be explained in detail in the following chapter. Despite of the multitude of supporters of the Efficient Market Hypothesis, an equal amount of counter evidences can be found. For example, Warren Buffet, who is one of the worlds most famous investors, has consistently beaten the market over a long period of time which normally is impossible under the terms of the Efficient Market Hypothesis. Moreover, he is not the only investor who did so. As well, events such as the stock market crash in 1987 and the one we are just in are contradictory to the hypothesis. The crash from 1987 verifies that stock prices can seriously deviate from their fair values as the Dow Jones Industrial Average fell by over 20% in a single day.

Investment and Valuation of Firms Market efficiency theory

Efficient market levels

After defining an efficient market, it is also important to mention that there is not only one, but that we can differentiate between three forms of market efficiency. As already mentioned above, the market efficiency hypothesis was developed by the US-american economist Eugene Fama in 1970. He assumes that if security prices at any time fully reflect all available information, markets are efficient.

Moreover, he applies to the information processing in capital markets. Based on his classifications three forms of market efficiency have to be differenced. First of all, the weak-from has to be marked-off the semistrong-form, and finally, the so called strong-form efficiency has to be defined.
Weak-form efficiency

Markets are weak-form efficient, if all information about the exchange rate trend of the past are contained in the actual market price. Other information, e.g. profit forecasts, merger announcements, etc., are not relevant for the future price developments, only past oriented data. Buckley, Ross and Westerfield describe the weak-from efficiency mathematically as follows: Pt = Pt-1 + expected profit + random errort The actual price correlates to the price of the previous period plus the expected profit and a random error. Thus, the last observed price is depending on the period t (days, weeks, months, years, etc.). However, it proceeds different with the expected profit. The expected profit depends on the risk of the underlying bonds. Because of the
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Investment and Valuation of Firms Market efficiency theory

unpredictability of the random error, it is not possible to make a forecast. The random error is developing independent from period to period, it can be positive or negative and its expected value is zero. If stock prices develop according to the above formula, then they develop along a random path, in fact, it is described as the random walk, which will be described in the following chapter. In a weak-form efficient market above average, returns cannot be gained by technical bond analyses which are based on historical rates. If systematical over-returns based on the application of technical share analysis methods could be gained compared to a buy and hold strategy, a market would not be efficient in the sense of the market efficiency hypothesis. After all, the current price reflects the information contained in all past prices, suggesting that charts and technical analyses that use past prices alone would not be useful in finding under-valued stocks.
Semistrong-form efficiency

In literature the semistrong-form of efficiency is also known as the half-strong-form as well as the middle-strong-form. If rate changes of the past and all public known and available information are reflected in the market price, then it can be defined as the semistrong-form of efficiency. If a market is semistrong-form efficient, then it is also and at least a weak-form efficient market. The above mentioned information include among others information provided by media, information provided by private information services and by investment advisors, shareholder impartations, annual reports, annual balance sheets, change in interest rates, boom forecasts and other private communication, as long as these are accessible publically.
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Investment and Valuation of Firms Market efficiency theory

Rates will adapt immediately after the publication of the above mentioned information. From this it follows that in a semistrong-form efficient market over-average returns cannot be gained in systematic form by using a fundamental share analysis which is based on general accessible information. In conclusion, current prices fully reflect all publicy available information, including such things as annual reports and news items.
Strong-form efficiency

The strong-form efficiency of markets is also known as the strict-form of market efficiency. In this case, a strong-form efficient market is characterized by the fact that the rate of the shares includes all relevant information, private as well as public information.

Consequently, people with a monopolistic access to information, e.g. members of an executive board or investment broker, are not able to gain returns which are higher than the average of markets. In the view of followers of the strong-form efficiency, there is no such thing as the possibility to keep secrets according to information stated above. E.g. Buckley, Ross and Westerfield mention the discovery of a gold mine which cannot be hidden. Moreover, the market would respond to the changes of conditions even before an insider could have the opportunity to acquire a share. However, the weak-form efficiency is part of the semistrong-efficiency and

nevertheless these forms are both part of the strong-form efficiency. Finally, current prices fully reflect all information, both public and private (i.e. information only known to insiders).

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Investment and Valuation of Firms Market efficiency theory

The Random Walk

Firstly, it is important to note that in general the Random Walk is a mathematical formalisation of a trajectory that consists of taking successive random steps. The areas in which analyses have been applied were computer science, physics, ecology, economics,

psychology and a number of other fields as a fundamental model for random processes in time. In the case of economics it is called the Random Walk Hypothesis which will be explained in the following. The forthcoming definition says that the Random Walk Hypothesis is a financial theory stating that stock market prices evolve according to a random walk, and thus, the prices of the stock market cannot be predicted. This is consistent with the Efficient Market Hypothesis. The information found on investopedia defines the theory as follows, stock price changes have the same distribution and are independent of each other, so that the past movement or trend of a stock price or market cannot be used to predict its future development. In general, it can be said that the Random Walk Hypothesis is an investment and financial theory, which claims that market prices follow a random path up and down without any influence by past price movements. Thus, making it impossible to forecast with any accuracy in which direction the market will move at any time. In other words, the theory claims that the path a stock's price follows is a random walk that cannot be determined from historical price information, especially not in the short-term. Investors who support the Random Walk Theory think that it is impossible to outperform the market without taking on additional risk and believe that neither fundamental analysis nor technical analyses have any validity.
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Investment and Valuation of Firms Market efficiency theory

However, some proponents of this theory do assume that markets move gradually upwards in the long run. The concept can be traced back to the French mathematician Louis Bachelier. His Ph.D. thesis was titled "The Theory of Speculation" (1900) and contains some remarkable insights. The same idea was later developed in the book The Random Character of Stock Market Prices (1964) by Paul Cootner. In 1965, Eugene Fama popularized the term in his article article Random Walks In Stock Market Prices, which was a less technical version. Later on, in 1973 a book appeared called A Random Walk Down Wall Street by Burton Malkiel. The theory that stock prices move randomly was earlier proposed by Maurice Kendall in his 1953 paper, The Analytics of Economic Time Series, Part 1: Prices. An interesting test of the hypothesis from Wikipedia:

Random walk hypothesis test by increasing or decreasing the value of a fictitious stock based on the odd/even value of the decimals of pi. The chart resembles a stock chart.

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Investment and Valuation of Firms Market efficiency theory

Burton G. Malkiel, an economist professor at Princeton University and writer of A Random Walk Down Wall Street, implemented a test where his students were given a hypothetical stock that was initially worth fifty dollars. The closing stock price for each day was determined by a coin flip. If the result was head, the price would close a half point higher, but if the result was tail, it would close a half point lower. Thus, each time, the price had a fifty-fifty chance of closing higher or lower than the previous day. Cycles or trends were determined from the tests. Then, Malkiel put the results into a chart and formed graph which he took to a chartist, a person who seeks to predict future movements by seeking to interpret past patterns on the assumption that history tends to repeat itself. The chartist told Malkiel that they needed to buy the stock immediately. When Malkiel told him it was based purely on flipping a coin, the chartist was very unhappy. Malkiel argued that this indicates that the market and the stocks could be just as random as flipping a coin. The random walk hypothesis was also applied to NBA basketball. Psychologists made a detailed study of every shot the Philadelphia 76ers made over one and a half seasons of basketball. The psychologists found no positive correlation between the previous shots and the outcomes of the shots afterwards. Economists and protectionists of the random walk hypothesis apply this to the stock market. The actual lack of correlation of past and present can be easily seen. If a stock goes up one day, no stock market participant can accurately predict that it will raise again the next. Just as a basketball player with the hot hand can miss the next shot, the stock that seems to be on the raise can fall at any time, making it completely random.

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Investment and Valuation of Firms Market efficiency theory

Conclusion
Who wants to sleep well, puts his money on an account, who wants to eat well, invests in shares. This quote from John D. Rockefeller just shows us how strong the belief of some people is that beating the market is possible. What brings us to a very simple conclusion: market efficiency is definitely one of the most controversial topics in the stock market as nobody can bring forward a beating argument for his opinion. Coming back to the beginning of the essay one could say that we will approximate to the strong-form efficiency as all the new technologies make it possible to have access to new information 24 hours per day, seven days a week. But at the moment, we have probably still the semistrong-form efficient market as insider

information are still not accessible for everyone at the same time. Anyway, the question is: will it ever be possible to have all information for everyone at the same time? Nobody can tell that for sure. Furthermore, the random walk theory gives evidence that it must be possible to beat the market even if it is just by chance as nobody can predict the future development of a stock accurately. However, for sure is that the efficient market hypothesis is a good approach to explain the development of the stock markets to a very fast changing market just by giving or hiding special information.

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Investment and Valuation of Firms Market efficiency theory

Bibliography
Damodaran, A. (2002): Investment Valuation, Tools and Techniques for Determining the Value of Any Asset, Univerisity Edition, Second Edition, New York, 2002 Franke, J.; Hrdle, W.; Hafner, C. (2004): Einfhrung in die Statistik der Finanzmrkte, Statistik und ihre Anwendungen, Zweite Auflage, New York 2004 Van Horne, J.; Wachowicz, J. (2005): Fundamentals of Financial Management, twelfth edition, Madrid 2005

Electronic sources
http://www.e-m-h.org/Damo.pdf http://financial-dictionary.thefreedictionary.com/Market+Efficiency http://www.businessdictionary.com/definition/market-efficiency.html http://pages.stern.nyu.edu/~adamodar/New_Home_Page/invemgmt/ effdefn.htm http://studix.wiwi.tu-dresden.de/Wikifi/index.php/Effizienzmarkthypothese http://en.wikipedia.org/wiki/Efficient-market_hypothesis http://www.investopedia.com/terms/m/marketefficiency.asp http://faculty.london.edu/edimson/assets/documents/spellbou.pdf http://en.wikipedia.org/wiki/Random_walk
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Investment and Valuation of Firms Market efficiency theory

http://en.wikipedia.org/wiki/Random_walk_hypothesis http://www.investopedia.com/terms/r/randomwalktheory.asp http://www.jurikres.com/faq/efficien.htm http://www.investorwords.com/4029/random_walk_theory.html http://www.financeprofessor.com/financenotes/lessonsoftheweek/ma rketefficiency.html

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