Lecture Notes - Efficient Market Hypothesis

Efficient Market Hypothesis

Efficient market can be measured in various ways but the most relevant one is in terms of information processing. The term market efficiency is used to describe the way in which capital markets absorb information. An efficient market is the one in which all available information relating to a particular company is processed quickly and accurately and reflected in share prices.

New information related to a particular company is processed in a rational way and the prices of its shares are adjusted accordingly.

The kinds of information that could be reflected on share prices are the following

·         Profit warning- low profit or losses

·         Dividend announcement

·         Board changes

·         Strikes

·         Winning of new contracts

In order for the market to be efficient, there must be a large number of investors who are prepared to examine the available information relating to a company in the hope of discovering under-priced shares.

Note that efficient market is not the same as perfect market

The efficient-market hypothesis was developed by Professor Eugene Fama at the University Of Chicago Booth School Of Business as an academic concept of study through his published Ph.D. thesis in the early 1960s at the same school (Wikipedia)

Consider for example a pension fund manager who discovered that a particular company has made a scientific breakthrough and that would lead to its expected profit doubling in the next few years

·         If the market were not efficient the manager could buy shares in the company at a cheap price from small investors who had not yet discovered the firm’s new circumstances. In this situation the informed investor is gaining at the expense of the uninformed investor

·         In an efficient market however the share price of the company would reflect all information that could be known on the company and hence the informed investor would have to pay ‘fair’ price for the shares.

(FTC Foulks Lynch 2005)

The efficiency of a financial market can be measured in various ways, the most relevant ones being in terms of information processing. Information processing efficiency reflects the extent to which information regarding the future prospects of a security is reflected in its current price

There have been many tests of the efficient market hypothesis (EMH) for the USA and the UK market. For the purpose of testing, the EMH is usually broken down into three categories which are:

·         The weak form hypothesis

·         The semi-strong form hypothesis

·         The strong form hypothesis

(FTC Foulks Lynch 2005)

Weak-form efficient

The weak-form EMH claims that prices on traded assets (e.g., stocks, bonds, or property) already reflect all past publicly available information (Wikipedia). In weak-form efficiency, future prices cannot be predicted by analyzing prices from the past. Excess returns cannot be earned in the long run by using investment strategies based on historical share prices or other historical data. What this means is investors cannot generate unusual profit by analysing past information such as stock price movements in previous time periods, in such a market, since research shows that there is no correlation between share price movements in successive periods of time. Share prices appear to follow a ‘random walk’ by responding to new information as it becomes available.

Semi-strong

The semi-strong-form EMH claims both that prices reflect all publicly available information and that prices instantly change to reflect new public information. This means share prices adjust to publicly available new information very rapidly and in an unbiased fashion, such that no excess returns can be earned by trading on that information (Wikipedia). Investors cannot generate abnormal returns by analysing either published information such as published company reports, or past information, since research shows that share prices respond quickly and accurately to new as it becomes public.

Strong form

The strong-form EMH additionally claims that prices instantly reflect even hidden or "insider" information.  In strong-form efficiency, share prices reflect all information, public and private, and no one can earn excess returns. If there are legal barriers to private information becoming public, as with insider trading laws, strong-form efficiency is impossible, except in the case where the laws are universally ignored. To test for strong-form efficiency, a market needs to exist where investors cannot consistently earn excess returns over a long period of time. Even if some money managers are consistently observed to beat the market, no refutation even of strong-form efficiency follows: with hundreds of thousands of fund managers worldwide, even a normal distribution of returns (as efficiency predicts) should be expected to produce a few dozen "star" performers (Wikipedia)

The significance EMH

Efficient market is of great importance to financial management. It means that the results of management decisions will be quickly and accurately reflected in share prices. For example if a firm undertakes an investment project which will generate a large surplus then in an efficient market it should see the value of its equity rise (FTC Foulks Lynch 2005)

1.   The significance to a listed company of its shares being traded on the stock market which is found to be semi-strong form efficient is that any information relating to the company is quickly and accurately reflected in its share price (FTC Foulks Lynch 2005)

2.   Managers will not be able to deceive the market by timing or presenting of any information, such as annual reports or analyst’ briefings, since the market the market process the information quickly and accurately to produce fair prices(FTC Foulks Lynch 2005)

3.   Managers should therefore simply concentrate on making financial decisions which increase the wealth of share holders (FTC Foulks Lynch 2005)

Implications of EMH for Financial managers

1.   Timing of financial policy

·         Financial manages argue that there is a right and a wrong time to issue new securities

·         New shares should only be issued when the market is high rather than when the market is low

·         If the market is efficient how are financial managers to know if tomorrow’s prices are going to be higher or lower than today’s

2.   Profit valuation

·         Managers use require rate of return drawn from securities traded on the capital market to evaluate new projects

3.   Mergers and acquisitions

·         If shares are correctly priced, the rationale behind mergers and takeovers may be questioned (FTC Foulks Lynch 2005)

Exam Type Questions

1.   Define the three forms of the EMH. Which form(s) is/are generally confirmed by empirical evidence?

2.   Describe what is meant by market efficiency

3.   What are the implications of the EMH for financial manages

(FTC Foulks Lynch 2005)

Lecture Notes - Dividend Policy

DEFINING DIVIDEND POLICY

Brealey et al defined dividend policy as “ the trade off between retaining earnings on the one hand and paying out cash and issuing new shares on the other.” Brealey et al (1986:417)

DIVIDEND CONTROVERSY

Over the last century, three schools of thought have emerged over dividend policy.

•      One faction sees dividends as attractive and as a positive influence on stock prices.

•      A second bloc believes that stock prices are not related to dividend payout levels.

•      The third group of theories maintains that firm dividend policy is irrelevant in stock price valuation.

The question is If dividends are so irrelevant as is being purported by Modigliani and Miller "Why do corporations pay dividends?" and also, "Why do investors pay attention to dividends?" Black [1976]

Theories of Dividend Policy

Irrelevance Theory

Modigliani and Miller researched and produced a paper stating that dividends were irrelevant to share value. They were of the view that the determinants of value of a share are the availability of projects with positive NPV’s rather than pattern of dividends paid out by a company to its shareholders

According to them under ideal conditions, the value of the firm is unaffected by dividend policy

Argument against MM preposition

1. If dividends are so irrelevant "Why do corporations pay dividends?" and also, "Why do investors pay attention to dividends?" Black [1976]

Argument for MM preposition

1. Dividend policy makes no difference because it has no effect on either stock prices or the cost of equity - Black and Scholes (1974),

Bird-in-hand theory

This theory states that dividends are more predictable than capital gains because managers can stabilize dividends, but cannot control stock price.

Therefore, dividend payments are safe cash in hand while the alternative capital gains are at best cash in the bush.

Tax Preference Theory

The theory argued taxes are paid on dividends in the year they are received while taxes on capital gains do not have to be paid until the stock is sold. Again taxes on capital gains may be less than on dividends, which are considered ordinary income. Thus depending on the tax situation of the investor, investors will prefer that companies retain the earnings and promote capital appreciation

THE CLIENTELE EFFECT

—  Some shareholders may prefer stocks that do not pay dividends.

—  Other shareholders may prefer stocks that pay a regular dividend.

—  Investors will form their well-diversified portfolios of stocks to have the desired dividend policy.

—  All clienteles would prefer not to be constantly rebalancing their portfolios as firm switch policies. Rebalancing is expensive due to transactions costs.

Main Factors Determining Dividend Policy

Dividend turn to be lower when there are more investment opportunities as the theory suggests. However, many businesses tend to base their dividend on the profit or earnings of the most recent year

How dividends are paid

Cash dividend

These are payment of cash by the firm to share holders

Stock dividends

This is the distribution of additional shares to share holders e.g., right issues

Dividend payout ratio:  this is the fraction of earnings paid out as dividends

Legal limitations on dividend

State laws- help to protect creditors against excessive payment of dividend

placing of limits on dividend payments

Stock repurchases

Some firms buys back from its share holders

Ex-dividend date – This is the date that determines whether a shareholder is entitled to dividend payment

   Example

The key dates of Wal-Matt’s quarterly dividends

March 8                 March 19           March 22   March 22       April Declaration  With – dividend       Ex-dividend        Record date         Payment

       date                 date              date                                             date

Scrip Dividend

This is when a company allows it share holders to take their dividend in the form of new shares rather than cash

Lecture Notes - Efficient Market Hypothesis

Efficient Market Hypothesis Efficient market can be measured in various ways but the most relevant one is in terms of information processing. The term market efficiency is used to describe the way in which capital markets absorb information. An efficient market is the one in which all available information relating to a particular company is processed quickly and accurately and reflected in share prices. New information related to a particular company is processed in a rational way and the prices of its shares are adjusted accordingly. The kinds of information that could be reflected on share prices are the following • Profit warning- low profit or losses • Dividend announcement • Board changes • Strikes • Winning of new contracts In order for the market to be efficient, there must be a large number of investors who are prepared to examine the available information relating to a company in the hope of discovering under-priced shares. Note that efficient market is not the same as perfect market The efficient-market hypothesis was developed by Professor Eugene Fama at the University Of Chicago Booth School Of Business as an academic concept of study through his published Ph.D. thesis in the early 1960s at the same school (Wikipedia) Consider for example a pension fund manager who discovered that a particular company has made a scientific breakthrough and that would lead to its expected profit doubling in the next few years •If the market were not efficient the manager could buy shares in the company at a cheap price from small investors who had not yet discovered the firm’s new circumstances. In this situation the informed investor is gaining at the expense of the uninformed investor •In an efficient market however the share price of the company would reflect all information that could be known on the company and hence the informed investor would have to pay ‘fair’ price for the shares. (FTC Foulks Lynch 2005) The efficiency of a financial market can be measured in various ways, the most relevant ones being in terms of information processing. Information processing efficiency reflects the extent to which information regarding the future prospects of a security is reflected in its current price There have been many tests of the efficient market hypothesis (EMH) for the USA and the UK market. For the purpose of testing, the EMH is usually broken down into three categories which are: • The weak form hypothesis • The semi-strong form hypothesis • The strong form hypothesis (FTC Foulks Lynch 2005) Weak-form efficient The weak-form EMH claims that prices on traded assets (e.g., stocks, bonds, or property) already reflect all past publicly available information (Wikipedia). In weak-form efficiency, future prices cannot be predicted by analyzing prices from the past. Excess returns cannot be earned in the long run by using investment strategies based on historical share prices or other historical data. What this means is investors cannot generate unusual profit by analysing past information such as stock price movements in previous time periods, in such a market, since research shows that there is no correlation between share price movements in successive periods of time. Share prices appear to follow a ‘random walk’ by responding to new information as it becomes available. Semi-strong The semi-strong-form EMH claims both that prices reflect all publicly available information and that prices instantly change to reflect new public information. This means share prices adjust to publicly available new information very rapidly and in an unbiased fashion, such that no excess returns can be earned by trading on that information (Wikipedia). Investors cannot generate abnormal returns by analysing either published information such as published company reports, or past information, since research shows that share prices respond quickly and accurately to new as it becomes public. Strong form The strong-form EMH additionally claims that prices instantly reflect even hidden or "insider" information. In strong-form efficiency, share prices reflect all information, public and private, and no one can earn excess returns. If there are legal barriers to private information becoming public, as with insider trading laws, strong-form efficiency is impossible, except in the case where the laws are universally ignored. To test for strong-form efficiency, a market needs to exist where investors cannot consistently earn excess returns over a long period of time. Even if some money managers are consistently observed to beat the market, no refutation even of strong-form efficiency follows: with hundreds of thousands of fund managers worldwide, even a normal distribution of returns (as efficiency predicts) should be expected to produce a few dozen "star" performers (Wikipedia) The significance EMH Efficient market is of great importance to financial management. It means that the results of management decisions will be quickly and accurately reflected in share prices. For example if a firm undertakes an investment project which will generate a large surplus then in an efficient market it should see the value of its equity rise (FTC Foulks Lynch 2005) 1.The significance to a listed company of its shares being traded on the stock market which is found to be semi-strong form efficient is that any information relating to the company is quickly and accurately reflected in its share price (FTC Foulks Lynch 2005) 2.Managers will not be able to deceive the market by timing or presenting of any information, such as annual reports or analyst’ briefings, since the market the market process the information quickly and accurately to produce fair prices(FTC Foulks Lynch 2005) 3.Managers should therefore simply concentrate on making financial decisions which increase the wealth of share holders (FTC Foulks Lynch 2005) Implications of EMH for Financial managers 1.Timing of financial policy •Financial manages argue that there is a right and a wrong time to issue new securities •New shares should only be issued when the market is high rather than when the market is low •If the market is efficient how are financial managers to know if tomorrow’s prices are going to be higher or lower than today’s 2.Profit valuation •Managers use require rate of return drawn from securities traded on the capital market to evaluate new projects 3.Mergers and acquisitions •If shares are correctly priced, the rationale behind mergers and takeovers may be questioned (FTC Foulks Lynch 2005) Exam Type Question 1.Define the three forms of the EMH. Which form(s) is/are generally confirmed by empirical evidence? 2.Describe what is meant by market efficiency 3.What are the implications of the EMH for financial manages (FTC Foulks Lynch 2005) Reference 1.Brealey, R., Myers S. and Marcus, 2009 Fundamentals of Corporate Finance, McGraw-Hill Irwin, New York 2.FTC Foulks Lynch,2005 Financial Management and Control, Kaplan publishing