Corporate Financing
and Market Efficiency
“If a man’s wit be wandering, let him study mathematics”
– Francis Bacon, 1625
Market Efficiency
• Efficient market hypothesis says that security prices
reflect all available information
• ... or (slightly weaker but more reasonably) prices
reflect all information up to the point where extra
profits would not cover the cost of gaining more
information (i.e. no free lunches)
Three forms of the efficient
market hypothesis
• Weak form
- prices reflect information in past prices
• Semi-strong form
- prices reflect public information
• Strong form
- prices reflect all available information
Some important implications
• securities always sell for ‘fair price’ (zero NPV)
• security price prediction is impossible
• security price changes will be random
How do Professional Money
Managers Perform?
• Evidence from contests in The Wall street
Journal
• Evidence of performance Relative to the
S&P 500
• Both support the notion of efficient markets.
Annual returns of U.S. pension equity
funds (source: Lakonishok, Shleifer &
Vishny)
1983
1984
1985
1986
1987
1988
1989
Average
Return on
Fund
17.8%
3.8
33.3
18.1
4.0
17.9
29.2
17.7%
S&P 500
22.5%
6.3
32.2
18.5
5.2
16.8
31.5
19.0%
Funds underperforming
59%
63
38
50
61
47
61
54%
The random walk hypothesis
• the rough idea: at each point in time share price is
discounted value of forecast of future dividends.
• so change in share price is simply the discounted value
of change in forecast of future dividends but . . .
• expected change in forecast is zero and so expected
change in price is zero.
Level
160
Which is the real market index?
This one?
140
L
e
v120
e
l
100
80
0
5
10
15
20
25
30
Months
Months
35
40
45
50
55
60
... Or this one?
Level
220
200
180
L
160
e
v
e
140
l
120
100
80
0
5
10
15
20
25
30
Months
35
Months
40
45
50
55
60
Testing for random walks
• Some apparent non-randomness;
- Autocorrelation (i.e. correlation between price change
at t and change at t+1)
Autocorrelation of weekly returns 1962-1985 (See
Conrad & Kaul, 1988)
- Variance test (Does variance of price changes increase
in proportion to length of time?)
Events studies
Object:
• To measure speed of response to events (i.e measure market
efficiency)
• To measure effect of event on value (assuming market
efficiency)
• Capital markets appear to react quickly to new information.
Examples of events:
mergers, earnings & dividend announcements, stock
repurchases, stock splits, share & debt issues, block sales,
listings, brokers reports, economic news, interest rate changes,
etc.
Six lessons of market efficiency
1. Markets have no memory
2. Trust market prices
3. Reading the entrails
4. There are no financial illusions
5. The do-it-yourself alternative
6. Seen one stock, seen them all
Efficient Market Theory
Fundamental Analysts
– Research the value of stocks using NPV and other
measurements of cash flow
Efficient Market Theory
Technical Analysts
– Forecast stock prices based on the watching the
fluctuations in historical prices (thus “wiggle
watchers”)
Behavioral Finance
Factors related to efficiency and psychology
1. Attitudes towards risk
2. Beliefs about probabilities
3. Overreaction?
The Celebrated Fama and French
(1992) study
• They study the relationship between the
stock values (prices) and the accounting
value of equity (book value).
• Time Period Studied: 1963-1990
• Methodology
• Order stocks according to price to book value ratio and divide into ten
groups (portfolios)
• After one year record the return for each portfolio
• Repeat two steps above year after year.
The Results of the
Fama & French (1992) study
• Portfolios made up of stocks with low price to
book value ratios (value stocks) experienced a
21.4% return per year. (Removing inflation
during this time period results in a 15.18%
return per year.)
• Portfolios of stocks with high price to book
value ratios (growth stocks) experienced a 8%
return per year. (Removing inflation results in
a 2.47% return per year.)
Who cares?
• What will you have if you invest $2,000 per year
into your IRA? (Assume you are 30 and will work
until you are 65, and use real rates.)
• If you earn the return that was provided by the growth stocks:
– Your total accumulated wealth: $109,232
– Your yearly income will be: $2,698
(You better go on a diet!)
• If you earn the return that was provided by value stocks:
– Your total accumulated wealth: $1,839,369
– Your yearly income will be: $279,216
(How about some lobster?)
US performance of large & small firm
stocks
10000
Value (log
scale)
Small
1000
Large
100
10
1
26
50
80
Year
0.1
The Size Effect
• Many small stock are also value stocks.
• There is less information regarding small stocks (less
analysts follow them), small stocks are less liquid than
larger stocks.
• Several studies show small stocks earn higher returns than
large firms. [For example: Banz (1981), Reinganum
(1982), Keim (1983)] Is it because they are riskier? Are
the results time specific?
Is the performance of small stocks driven
by their high book value to price ratios?
• After controlling for size, Lakonishok, Scheilfer and
Vishny (1993) report value stock returns are still higher
than growth stocks.
• Other studies suggest that higher returns can be earned by
investing in small firms that are value stocks (a combined
effect.) [Loughran 1997)]
Are these results specific to the stock
markets in the U.S. ?
• Fama and French (1997) find similar results
(value stocks earn higher returns) in twelve
developed countries.
• Barry, Goldreyer, Lockwood and
Rodriguez (2000) find similar results for
companies in emerging capital markets.
Can we expect similar results in
the future?
• Do many money mangers know about these
results?
• Why hasn’t competition already eliminated
these opportunities?
• Does the market overreact?
In the long run
• several variables appear to forecast long-term returns
- past returns (regression towards mean)
- dividend yields
- P/E or P/BV ratios
- Size
- Seasonality effects (January)