CapitalFormation

Real Asset and Financial Assets

Business Valuation
The value of a company is equal to the
value of its financial claims:
V
A
= V
D
+ V
E


Valuation Example
A company which owns an existing oil well
was purchased for $50M.
The investment was financed by the acquiring
company
raising $25M in equity
borrowing $25M at 8% interest
Case: We want to determine the current value
of the acquiring company.
Valuation
Value of Debt: Company borrowed $25M by issuing an 8% bond. Currently
the bond has a maturity of 10 years and is trading at an 8% YTM:


V
Int
k
F
k
V
M M
M
where
Int c F M M
k YTM Rate required by creditors
D
D
t
D
M
t
M
D
t
t
R
D
=
+
+
+
= + =
= = =
= =
=
=

( ) ( )
$2
( . )
$25
( . )
$25
:
(. )($25 ) $2
1 1
108 108
08
1
10
1
10


V
D
k
where
D Total Dividends
k Rate required by equityinvestors
Per Share
V
d
k
where
d D n
V V n
n number of shares
E
e
t
t
e
e
e
t
t
e E
=
+
=
=
=
+
=
=
=
=

( )
:
( )
:
/
/
1
1
1
1
Value of Equity
Model


Note
If D is fixed over time then as t becomes l e
V
D
k
D
k
To estimate V one needs to estimate k and D
k can be estimated u g the CAPM
E
e
t
e
t
E e
e
:
, arg :
( )
.
sin
=
+
=
=

1
1
Value of Equity
CAPM: Relation
Security Market Line (SML): Depicts the
equilibrium relationship between any
investments equilibrium return and its beta.
E
i
*
E
M
R
f
|
i
1
SML
E R E R
i f
M
f i
*
[ ] = + |
Required Return on Equity
Given
Market Risk premium E R
R
Then the required return on equity for a stock with
a would be
k R E R
k
M f
f
e f M f
e
:
.
.
. :
[ ]
. [. ]( ) .
= =
=
=
= +
= + =
10
04
2 24
04 10 2 24
|
|
EXPECTED EARNINGS
E TR M
TOC M
E EBIT M
Int M M
E EBT M
Taxes M t
E EAT M
RE no growth firm
E D M
n M
E d
( ) $20
( )
[(. )($25 )]
( )
[ . ]
( )
[ ]
( )
( ) $1.

=

=
=
=

=
8
12
2 08
10
4 4
6
0
6
5
20
Valuation:
V
E D
k
M
M
V M
V V V
V M M M
E
e
D
A E D
A
0
0
0 0 0
0
24
= = =
=
= +
= + =
( ) $6
.
$25
$25 .
$25 $25 $50
Alternative Valuation:
V M M M
V
EAT Int
k
M M
M
where
k f k f k
k
M M
M
V
EBIT t
k
M
M
where
k f t k f k
k
M M
M
A
A
c
nt
c
nt
d D e e
c
nt
A
c
t
c
t
d D e e
c
nt
0
0
0
16
08 24 16
1 1 4
144
1
1 4 08 24 144
= + =
=
+
=
+
=
= +
=
F
H
G
I
K
J
+
F
H
G
I
K
J
=
=

=

=
= +
=
F
H
G
I
K
J
+
F
H
G
I
K
J
=
$25 $25 $50
$6 $2
.
$50
:
$25
$50
.
$25
$50
. .
( ) $12 ( . )
.
$50
:
( )
$25
$50
( . ).
$25
$50
. . .
Empirical Approaches
Discounted Cash Flow Models
P/e (Multiplier) Model
Wells Fargo
Decision Tree and Monte Carlo Simulation
Models
Discounted Cash Flow Models
Gordon Model:
Assumption: Dividends will grow (g) at a
constant rate over time:
V
D g
k
D
k g
E
t
e
t
e
t
0
0 1
1
1
1
=
+
+
=

( )
( )
.
Discounted Cash Flow Models
Two-Period Growth Model:
Assumption: Assumes extraordinary growth rate
of g
1
for N years followed by a steady-state growth
rate of g
2
thereafter.
V
d g
k
d g
k
d g
k
V
k
where V
d g
k g
d g g
k g
e
e e
N
e
N
N
e
e
N
N
e
N
e
N
e
0
0 1 0 1
2
2
0 1
2
2
0 1
2
2
1
1
1
1
1
1 1
1 1 1
=
+
+
+
+
+
+ +
+
+
+
+
=
+

=
+ +

( ) ( )
( )
( )
( ) ( )
,
:
( ) ( ) ( )
.
V
d g
k g
k g
k
V
k
e
e
e
N N
e
N
N
e
e
N
0
0 1
1
1
1 1 1
1 1
=
+

+ +
+
F
H
G
I
K
J
+
+
( ) ( ) ( )
( ) ( )
Discounted Cash Flow Models
Three-Period Growth Model:
Assumption: Assumes extraordinary growth rate
of g
1
, a transitional period, followed by a steady-
state growth rate of g
2
thereafter.
g
g
1
g
2
Time
t
2
t
1
P/e (Multiplier) Approach
Model:


Estimation of P/e:
Take the Gordon model and divide through
by e:


V
P
e
E e
e
0 1
=
F
H
G
I
K
J
( )
V
e
P
e
d e
k g
Estimate d e k and g
e
e
= =

/
: / , , .
P/e (Multiplier) Approach
Estimation of P/e:
Use a cross-sectional regression model.
Example: Regress the P/e ratios of 150 stocks against their
historical growth rate (Elton-Gruber):


Example: Regress the P/e ratios of 300 stocks against their
growth rate, betas, and dividend-payout ratio (d/e)
(Malkiel-Craig):

( / )
( / ) .
P e a b g
P e g Elton Gruber
i i
i i
= +
= + 4 2 3
( / ) ( ) (( / ) ) ( ) P e c c g c d e c
i i i i
= + + + +
0 1 2 3
| c
Malkiel Craig found good correlations between
P e and the above lanatory iables but
found the relation was unstable over time

/ exp var ,
.
P/e (Multiplier) Approach
Estimation of P/e:
Use a cross-sectional regression model.
Example: Regress the P/e ratios of 150 stocks against their
historical growth rate (Elton-Gruber):


Example: Regress the P/e ratios of 300 stocks against their
growth rate, betas, and dividend-payout ratio (d/e)
(Malkiel-Craig):

( / )
( / ) .
P e a b g
P e g Elton Gruber
i i
i i
= +
= + 4 2 3
( / ) ( ) (( / ) ) ( ) P e c c g c d e c
i i i i
= + + + +
0 1 2 3
| c
Malkiel Craig found good correlations between
P e and the above lanatory iables but
found the relation was unstable over time

/ exp var ,
.
Forecasting the Market, Industry, and
Stock using the Multiplier Approach
Many analysts use the top-down, three-step
approach in which they try to forecast the
future values and returns of a market series,
industries, and companies in industries.
The multiplier approach can be used in such
forecast.
Stock Market Analysis and Forecast
The objective of aggregate stock market
analysis is to forecast the future market
value and rate of return of a major market
series such as the S&P 400 or S&P 500.
The forecast can be made using the
following multiplier model:
V
P
e
E eps
where V next period s value of the market index
P e next period smultipler for the market
E eps ected eps for the series
M
M
1 1
1
1
=
F
H
G
I
K
J
=
=
=
( )
: ' .
/ ' .
( ) exp .
Stock Market Analysis and Forecast
EPS Forecast Model:
Regression estimate of % change in sales
per share, S, in terms of the % change in
GDP:
g S a b GDP
S S g
t t
= = +
= +

% (% )
( )
A A
1
1
Stock Market Analysis and Forecast
EPS Forecast Model:
Estimate operating profit margin, m. This
margin tends to depend on labor and
production factors:


Given m and S, EBDIT is:


m
EBDIT
Sales
f labor t production capacity = = ( cos , )
EBDIT mS
t t
=
Stock Market Analysis and Forecast
EPS Forecast Model:
Estimate depreciation, interest, and the effective
tax rate:




Depreciation enses have increased between
and over the last years Depreication
enses are at the high end when the economy is
at a high level of capacity utilization
Dep f K Capacity
exp
.
exp
.
( )
5% 8% 20
=
Interest enses depend on corporate
leverage and Interest rate
Int f r
exp
.
( , ) = u
The effective tax rate depends on initiatives
at federal and state levels.
Stock Market Analysis and Forecast
EPS Forecast Model:
Given forecast of depreciation, interest, and
the effective tax rate, eps is:







EPS EBDIT Dep Int t
t t t t t
= [ ]( ) 1
Stock Market Analysis and Forecast
P/e Forecast Model:
The market multiplier can be estimated by
directly estimating each parameter in the
Gordon model:
P
e
d e
k g
d e market series dividend earnings ratio
k required market rate of return
g growth rate in eps for the market
=

=
=
=
/
/ ' .
.
.
Stock Market Analysis and Forecast
P/e Forecast Model:
d/e: d/e for the market series tends to
fluctuate. If dividends are stable and the
economy is growing, d/e moves inversely
with the economy.
K: Using the CAPM, next periods required
market return is equal to the risk-free rate
and market risk premium.


k R E R R
where
f M f
= +
=
[ ( ] ,
: .
|
| 1
Stock Market Analysis and Forecast
P/e Forecast Model:
K: A relation exist between RF rate and market RP: The
lower Rf the greater RP.
G: The growth rate in eps can be related to the retention
ratio (f) and the rate of return on investments:

The rate of return on investment, I, can be estimated using
ROE for market series:


g f i =
ROE
EPS
Equity Per Share
EPS
Sales Per Share
Sales
Assets
Assets
Equity
ROE Asset Turnover Ratio Asset Turnover Ratio Liquidity Ratio
= =
F
H
G
I
K
J
F
H
G
I
K
J
F
H
G
I
K
J
=
.
( ) ( )( )
Stock Market Analysis and
Forecast


Value and Expected Rate
V
P
e
E eps
E d d e E eps
E r
V E d
V
t
t
t
t t t
t t
:
( )
( ) ( ( / ) ) ( )
( )
( )
=
F
H
G
I
K
J
=
=
+

1
1
0
Stock Market Analysis and Forecast
Example:
Chapter 12 (Section 12.4) provides an example of
forecasting the S&P 400 series using the
preceding model. The example uses data from
Standard and Poors Analysts Handbook. The
information can be found in Stockch12.xls.
EXHIBIT 12.4-2
FORECAST OF MARKET SERIES
(1) Variable
(Per Share) 1995 1996 REASON
(2) Sales (S) $655 $710 Projected % Change in GDP = 6%.
%ASales = 1.38 (% AGDP)}
% A Sales = 1.38(6%) = .083
S96 = (1 + .083)S95
S96 = (1 + .083)($655) = $710
(2) Operating Profit
Margin
(m = EBDIT/S)
15.8% 15% Operating profit margins will not increase
as a result of the high level of capital
capacity utilization (85%), but will
decrease slightly because of expected small
increase in unit labor cost.
(3) EBDIT $103.50 $106.50 EBDIT = m S
EBDIT = (.15) ($710) = $106.50
(4) Depreciation
(D)
$31.60 $34.13 Because of the high level of capacity
utilization (85%), an 8% increase in
capital expenditures is expected.
(5) Interest
(I)
$12.50 $11.87 Projected 5% decrease in interest
expenses based on a lower interest rate
expectation.
(6) Tax Rate
(t)
(Taxes paid/EBT)
35% 35% Expect no change in the tax rate.
(7) EPS $38.35 $39.32 EPS = (EBDIT - D - I)(1 - t)
EPS = ($106.50-$34.13-$11.87)(1-.35)
EPS = $39.32
EXHIBIT 12.4-2
MARKET FORECAST CONTINUED
(8)
Dividend/Earnings
(d/e)
.37 .40 The dividend to earnings ratio is expected
to increase slightly based on the
assumption of higher earnings in 1996
and stable dividends.
(9) Required Return
(k)
9% Projected risk-free rate of 6%.
Projected market risk premium of 3%.
(10) Net Profit
Margin
(EPS/Sales)
.04 .04 Expect no change in net profit margin,
given the assumption of only a slight
change in operating profit margin.
(11) Asset Turnover
(Sales/Asset)
.95 .95 Expect no change in asset turnover ratio.
(12) Liquidity Ratio
(Asset/Equity)
3.4 3 Expect slight decrease in liquidity ratio.
(13) Return on
Equity
(ROE)
11% 11.4% ROE = EPS/Sales =
(EPS/S)(S/Assets)(Assets/Equity)
ROE = (.04) (.95) (3) = .114
(14) Growth Rate
(g)
6.8% g = (Retention Ratio)ROE
g = (1 - (d/e))ROE
g = (.6)(.114) = .068
(15) P/e 18.8 18.5 P/e = (d/e)/(k-g)
P/e = .4/(.09-.068) = 18.5
(16) Dividends
(d)
$15.50 $15.73 d
96
= (d/e)EPS
96
d
96
= (.4)($39.32) = $17.73
(17) Index Value
(V)
721 727.42 V
96
= (P/e)EPS
96
V
96
= (18.5)(39.32) = 727.42
(18) Expected Rate 3% E(Rate) = [(727.42+15.73)/721] 1
E(Rate) = .03
Industry Analysis
Industry analysis is the next step in the top-down, three-step approach to
fundamental stock analysis.
In evaluating industries, it is important to note that if there is little difference
in the performances among different industries, then there is no need to study
industries. If the aggregate stock market, for example, is expected to generate
a 12% rate of return, while the return amongst all industries only ranges
between 11% and 13%, then there would not be much purpose in conducting
an industry analysis: one could get a 12% expected return by just randomly
selecting industries. Studies of industrial performance, though, do show a
wide dispersion in the rates of return among industries. In 1995, for example,
the S&P 500 increased 37.6%, with the performances among industries
ranging from -15% (trucking industry) to 80% (biotech). This suggest
industry analysis is important and explains why many investment companies
maintain a staff of industry analysts.
Ultimately, we want to be able to find the right stocks for investment. It is
easier, though, to find a good company and stock from a good industry, than to
find a good company and stock from a bad or declining industry.

Stages of Industrial Development
From an investment perspective, the identification of good
industries comes from finding those sectors whose
expected returns exceed their require returns. As a starting
point, it is helpful to understand the nature of the industry
in terms of its current stage of development.
Industrial organizational theory describes industries in
terms of the five stages of development that define the
typical industry's life cycle. These stages include:
Pioneering,
Rapid Accelerating Growth,
Mature Growth,
Stabilization,
Deceleration and Decline.

Pioneering
Pioneering Stage: This is the start-up stage of the
industry.
It is the stage in which firms in the industry are
just beginning to identify their markets.
The stage is characterized by high development
costs, small or modest sales, and small or negative
profit margins.
Examples of the pioneering stage would be the
car industry at the beginning of the century or the
computer industry in the 1950s.
Rapid Accelerating Growth
Rapid Accelerating Growth Stage: In this stage, the
market for the industry starts to develop. From a low sales
base, sales begin to increase at an increasing rate, often
resulting in excess demand for the industry's product.
During this phase, firms in the industry respond to their
growing market by developing their production capacity.
The Rapid Accelerating Growth Stage is characterized by
high profit margins, with profit increasing significant (as
much as 100% in some years) from a low sales base.
The car industry in the 1950s, the computer industry in the
1970s, and the internet and biotech industries of the 1990s
would be example of this second stage of industry
development.
Mature Growth Stage
Mature Growth Stage: This is a stage in which sales continue to
increase, but not at an accelerating rate.
From a relatively high sales base, sales growth tends to be above the
growth rate of the economy, but below the rates experienced in the
previous stage. For example, if the economy were growing at 5%, the
industry might be growing between 7% and 10% during this stage.
The Mature Growth Stage is the period when the industry's profit
attracts other firms into the industry. The increased competition
resulting from the entry of new firms often causes prices to decrease in
the industry during this time, lowering profit margins.
The greater competition also may lead to increases in advertising
expenditures and other costs related to differentiating a firm's product
or to constraining entry of new firms into the industry.
Stabilization
Stabilization Stage: This is a stage where the
industry reaches an equilibrium in which the
number of firms in the industry is set, demand is
stable, and production capacity is at a level to
meet demand.
In this stage, the industry growth rate matches the
economy's and profit margins are tight but stable.
For many industries, the stabilization stage is the
longest period in their life cycle.
Decleration and Declining Growth
Decleration and Declining Growth Stage: In this stage, the
industry's sales growth may increase at a decreasing rate or
decline.
It is a period in which there is a switch in demand brought
about by better substitutes
Examples:
Home computers and word processing software for typewriters
Cars for horses

Industry Life Cycle
sales in growth %
Time
Pioneering
1 Stage
Growth Rapid
2 Stage
Growth Mature
3 Stage
Growth Stable
4 Stage
on Decelerati
5 Stage
Note
Remember:
Finding a good company in a good industry does
not necessarily mean that the stock of that
company is a good investment. For example, a
good company in a growing industry may be
experiencing high sales and profit margins, but it
could also be selling at a price that yields a return
below its required return; that is, the good
company's stock could be overpriced.

Industry Analysis and Forecast
Like the market series, the value and rate of return for an industry can
be estimated using the multiplier approach.
V
P
e
E eps
EBDIT mS or EBDIT a b EBDIT
EPS EBDIT Dep Int t
P
e
d e
k g
d e and g can be estimated similar to market series
or each can related to the market
E d d e E eps
E r
V E d
V
t
I
t
I
t
I
I M
t t t
t t
=
F
H
G
I
K
J
= = +
=
=

=
=
+

( )
[ ]( )
/
/
.
( ) ( ( / ) ) ( )
( )
( )
1
1
1
0
Industry Analysis and Forecast
Example:
Chapter 12 (Section 12.4) provides an example of
forecasting the return from the retail drug industry
using the preceding model. The example uses
data from Standard and Poors Analysts
Handbook. The information can be found in
Stockch12.xls.
EXHIBIT 12.4-4
FORECAST OF INDUSTRY SERIES
RETAIL DRUG STORE INDUSTRY (RDS)
Variable
(Per Share) 1994 1995 REASON
(1) Sales (S) $361.71 $386.26 Projected % Change in PERSONAL
CONSUMPTION EXPENDITURE-
MEDICAL (PCE-MC) = 6.7%.
%ASales = .92(%APCEMC)
%ASales = .92(.067) = .062
S95 = (1 + .062)S94
S95 = (1 + .062)($361.71) = $386.26
(2) Operating Profit
Margin
(m = EBDIT/S)
6.42% 6.375% Operating profit margins will not increase
as a result of the high level of capital
capacity utilization (85%), but will
decrease slightly because of expected small
increase in unit labor cost.
(3) EBDIT $23.26 $24.62 EBDIT = m S
EBDIT = (.06375) ($386.26) = $24.62
(4) Depreciation
(D)
$5.32 $5.50 A slight increase in capital expenditures is
expected because of the level of industry
capacity utilization.
(5) Interest
(I)
$1.10 $1.00 Projected small decrease in interest
expenses based on a lower interest rate
expectation.
(6) Tax Rate
(t)
(Taxes paid/EBT)
38% 36% Industry is expected to move toward the
35% tax rate for the market.
(7) EPS $10.51 $11.60 EPS = (EBDIT - D - I)(1 - t)
EPS = ($24.62-$5.50-$1.00)(1-.36)
EPS = $11.60
EXHIBIT 12.4-4
INDUSTRY FORECAST CONTINUED
(8) P/e 15.48 17.32 Historically, the industry P/e has been
slightly higher than the market P/e, but
lower in recent years. Based on a micro
analysis, the industry is expected to have a
lower k than the market and a higher g.
The higher g is based on a projected high
asset turnover ratio for the industry. The
industry P/e is projected to be 5% higher
than the projected P/e for the market:
P/e
I
= (1.05) (16.5) = 17.32
where: E(P/e)
M
= 16.5
(9) Dividends
(d)
4.64 d
95
= (d/e)eps
95
d
95
= (.4)($11.60)
Project increase in d/e from .34 to .4.
(10) Index Value
(V)
162.71 200.97 V
95
= (P/e) (EPS
95
)
V
95
= (17.32) (11.60) = 200.97
(11) Expected Rate 26.36%
E(Rate) = [(200.97+4.64)/162.71] 1
E(Rate) = .2636.
(12) Beta .5 .5 Project no change in systematic risk.
(13) Required
Return
(k)
7.5% SML: k = R
f
+ [R
M
- R
f
] |
K = .06 + [.03](.5) = .075.
RECOMMENDATION: ALLOCATE MORE INVESTMENT FUNDS TO RDS
Company Analysis and Forecast
Like the market and industry series, the value
and rate of return for a company can be
estimated using the multiplier approach.
In analyzing a company, the parameters can be
estimated using a microeconomic analysis or by
comparing the companys performance with the
industry and market.
An example of forecasting the return for the
Walgreen company is presented in Section 12.4.
Data for the analysis is in Stockch12.xls.

EXHIBIT 12.4-5
FORECAST OF COMPANY
WALGREEN
Variable 1995 1996 REASON
(1) Sales (S) $10.395B $11.44b Based on a microeconomic analysis of
projected new stores, a 10% increase in
sales is projected.
S
96
= (1 + .10)S
95
S
95
= (1 + .10)($10.395B) = $11.44B
(2) Net Profit
Margin
(m = EAT/S)
3.09% 3.2% Walgreen's net profit margins have been
increasing more than the industry's due to
its marketing innovations. An increase in
margins is projected.
(3) EAT $318M $366M EAT
96
= m S
96
EAT
96
= (.032) ($11.44B) = $366M
(4) Number of
Shares
(n)
246.14M 246.14M No change projected.
(5) EPS $1.29 $1.49 EPS
96
= EAT
96
/n
EPS
96
= $366M/246.14M = $1.49.
EXHIBIT 12.4-5
WALGREEN FORECAST CONTINUED
(6) P/e 20.58 22 Walgreen's P/e is projected to continue a
trend of being higher than the indusrty
and market P/e.
(7) Dividends
(d)
$0.45 D
96
= (d/e)eps
96
D
95
= (.3)($1.49)
No expected change in d/e.
(8) Stock Price
(V)
$26.55 $32.78 V
96
= (P/e) (EPS
96
)
V
96
= (22) ($1.49) = $32.78
(9) Expected Rate 25.16% E(Rate) = [($32.78-$0.45)/$26.55)] 1
E(Rate) = .2516
(10) Beta .36 .36 Project no change in systematic risk.
(11) Required
Return
(k)
7.08% SML: k = R
f
+ [R
M
- R
f
] |
K = .06 + [.03](.36) = .0708.
RECOMMENDATION: ALLOCATE MORE INDUSTRY INVESTMENT FUNDS TO
WALGREEN
TECHNICAL ANALYSIS
Theory of Contrary Opinion
Follow the Smart Money
Diffusion Index
Dow Theory
Moving Averages
Charting
THEORY OF CONTRARY
OPINION
FIND OUT WHAT CERTAIN
GROUPS OF INVESTORS ARE
DOING, THEN DO THE
OPPOSITE.
Contrarian Indicators
Odd Lot Trades
Mutual Fund Cash Position
Credit Balances in Brokerage Accounts
Investment Advisory Opinions
Put/Call Ratio
Short Interest Ratio
FOLLOW THE LEADER

Rule: Find out what the leaders are doing,
then follow their lead.
Confidence Index
Spreads
Short Sales by Specialists
Debit Balance at Broker Firms
DIFFUSION INDICATORS
Diffusion Indicators are used to determine the
pervasiveness of a market trend.
Advances Minus Declines: Number of stocks that
have advanced (A) minus the number of stocks
that have declined (D).
Breadth of the Market = Sum of (A - D).
Diffusion Index = A + .5(no change)/T. If index
is near 60%, market is overbought; if index is near
40%, market is oversold.
SIGNS THE MARKET IS
NEAR A PEAK
Stock Index Increasing
A-D decreasing
BOM stable
Diffusion Index near 60%
SINGS THE MARKET IS
NEAR A TROUGH
Market Index is decreasing
A-D is increasing
BOM stable
Diffusion Index is near 40%
DOW THEORY
Primary Trend: Long-term trend that carries
the market; rooted in fundamentals; may
last for years.
Secondary Trend: Reflects resistance levels
to the primary trend.
Minor Trend: Random movements; day-to-
day fluctuations; ignore.
BULL TREND
Each successive peak is higher than the
previous peak.
Stock prices increase on heavy volume.
Stock prices decrease on light volume.
BEAR TREND
Each successive trough is lower than the
previous trough.
Stock prices decrease on heavy volume.
Stock prices increase on light volume.
EFFICIENT MARKET
THEORY
LECTURE MATERIAL COMES FROM
CHAPTER 13.
MOST EXTENSIVELY RESEARCHED
AREA IN FINANCE.
METHODOLOGY IS MORE
IMPORTANT THAN THE FINDINGS.
YOU DONT HAVE TO AGREE WITH
EMH; RESPECT IT.
PROPOSITIONS
PROPOSITIONS
Market consist of
fundamentalist.
Information is
disseminated
efficiently.
News is random.
IMPLICATIONS
Stocks Market price
(P) is equal to the
intrinsic value of the
stock (V).
P = V at all times.
P = V fluctuates
randomly.
EMPIRICAL TESTS
WEAK-FORM TEST
SEMISTRONG-FORM TEST
STRONG-FORM TEST
WEAK-FORM TEST
Test of whether information contained in
historical prices is reflected in current
prices.
Ho: Investors cannot earn abnormal returns
from strategies based on historical trends.
Tests
Time Pattern Tests
Return Predictability Tests
SEMISTRONG-FORM TEST
Test of whether publicly available information is
fully reflected in current prices.
Ho: Investors, on average, cannot earn abnormal
returns from trading strategies based on publicly
available information.
Tests
Cross-Sectional Test
Event Studies
STRONG-FORM TESTS
Test of whether all information - public and
private - is fully reflected in security prices.
Tests to determine if those close to firm who have
privileged information can earn abnormal returns.
Two Null Hypotheses:
Ho: Investors cannot earn abnormal returns from
private information.
Ho: Investment analysts cannot earn abnormal return
from their information.