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What is a Random Walk?

Randomness as defined by those in finance is the observation that sequential directional returns are not correlated This does not mean that returns cannot trend upward or downward over time Randomness is a direct result of the completeness of the evaluation of public information. Stocks have an equal chance of either raising or falling as a result The valuation process is critical to this observation The market is only efficient if the valuation process is accurate What is the role of inflation in the evaluation of stock performance? What is the impact of tax policy on investment decisions? What is likely to happen at the end of this year? What is the Firm Foundation Theory? Do rapid market declines violate the EMH?
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Valuation Methodologies

Discounted cash flow it is all about present value


LBO Analysis

Forecasts, cost of capital and terminal value estimates drive this result Cost of capital is calculated using CAPM by virtually all practitioners What is the intrinsic value of the company to a private buyer What is the break up value of the company What is the value to a synergistic buyer Where are other similar companies trading What are the important differences

Comparable Analysis

Net realizable book value (Liquidation Analysis)


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History of the Debate


1953 Maurice Kendall offered the first evidence of randomness in stock prices The different forms of the EMH were first proposed by Harry Roberts in 1959 In the 1970, this work was a focus at the University of Chicago and it was driven by Eugene Fama Access to computers and data led, in the 1980s, to challenges to the EMH led by:

Much of the critical research on EMH has generated a logical response from the EMH crowd The coming of age of Behavioral Finance in the 1990s and 2000s has attempted to explain stock price movements which are not consistent with EMH

Andrew Lo Richard Roll Kenneth French and many others

Inevitable Conclusions

If you believe in EMH, you are better off buying the universe of securities rather than trying to beat the market To achieve higher returns you need to take on more risk Transaction costs are not insignificant and support the EMH conclusion Technical analysis is also ineffective
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Research Limitations

The selection of a time period to study is critical to the conclusions reached by academics There is much data collected today which was simply not available 30 years ago Computers have made analysis much more efficient Computers have also had a major impact on market efficiency The internet has leveled the playing field for all investors
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Firm Foundation Theory

What is the firm foundation theory? What are its limitations?

It relies on forecasts of cash flows to value operating assets Growth rates and discount rates are speculative. As they converge, value increases geometrically It ignores the investment horizon of the investor It does not do well in explaining values of high growth companies or companies with no current cash flow Capital requirements are difficult to predict
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Castles in the Air Theory

What is the Castles in the air theory?

What are its limitations?


Value is not defined by a stream of cash flows over a longer term but rather what investor sentiment toward the stock is likely to be in the future It relies on physic factors which are not quantifiable The investor is not only reliant on his/her skills but the sentiment of other investors Sentiment can change very quickly Easier to see after the fact Crash of 1987, Internet crash of the 2000s, real estate led crash of 20072008
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Forms of the EMH

Weak

Current prices reflect all of the information contained in past prices. Who are chartists and what does this mean for them?
Current prices reflect past prices and all of the information publicly available. Who are the fundamentalists and what does this mean for them?

Semi-Strong

Strong

Current prices reflect past prices, public information and non-public information Who are inside-traders and what does this mean for them?

How do we know?

Evidence of efficient markets


Evidence of Inefficient Markets


Weak form If you cannot generate abnormal returns using only historical price information, the market is weak form efficient. Semi-strong form If you cannot generate abnormal returns using historical information and public information, the market is semi-strong form efficient Strong form If you cannot generate abnormal returns with all information, the market is strong form efficient Weak form If you can generate abnormal returns using historical price information, the market is weak form inefficient. Semi-strong form If you can generate abnormal returns using historical information and public information, the market is semi-strong form inefficient Strong form If you can generate abnormal returns with private information, the market is strong form inefficient
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The Six Lessons of Market Efficiency

Markets have no memory

Past price changes provide no useful information about future price changes There are no cycles or persistent patterns to stock returns There is no better time than the present to make financing decisions when might you argue this conclusion is oversimplified?

The Six Lessons of Market Efficiency

Trust market Prices

In order to beat the market you have to know more than everyone else in the market. Why is this? In order to beat the market what you know must be perceived and acted on by others BTW - Why would you invest in reverse floaters? What are the implications for issuance of stock or bonds? BTW does this mean that the return for any stock will be the same? Under what circumstances would it be advisable to buy a stock even if it is fairly valued?

The Six Lessons of Market Efficiency

Read the entrails

While I dont like the term, he is saying that changes in stock price reflect an underlying change in the condition at the company. Being able to decipher these is a skill In the case of Viacom analysts had concluded (in contrast to mgt) that a purchase of Paramount was ill-advised Bonds that offer higher yields are generally riskier than others. How is risk determined for bonds?

Leverage Duration Volatility of cash flows

That said, private information will impact the price a willing buyer offers to a willing seller

The Six Lessons of Market Efficiency

There are no financial illusions investors see though strategies which do not impact cash flow

Dividends or splits do not impact the overall value of a company. What did we learn about what happens in anticipation of a split? Accounting changes which call for a change in presentation do not impact the overall value of a portfolio

Why would a management team do any of these?


Accelerated depreciation Goodwill impairment Accounting for options FIFO to LIFO changes

What did you think about the explanations offered by CEOs in the reading

Legal or Regulatory requirement Personal ambition Incentive compensation

The Six Lessons of Market Efficiency


The DIY alternative Why does it not pay for a company to diversify?

The diversification craze of the 1960s did not cause an increase in value the ITT example The PNC Equity issue

The Six Lessons of Market Efficiency


Seen one stock seen them all What is elasticity (or inelasticity) of demand?

Stock prices are elastic and therefore buying or selling opportunities are quickly executed Inelasticity comes from the perception created by the sale or purchase sale or purchase of a large block of stock

In Reality !!!

Companies issue equity when they think their stock is overvalued Companies finance with debt when long term rates are down Weighted average cost of capital drives financing decisions - what is the relationship between WACC and the discount rate used in financial models? Stock splits do result in 2+2=5. Why? You can sell equity at a lower discount when a company is doing well compared with when it is doing poorly

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