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Solution for Business Analysis and Valuation: Text and Cases 1st Edition Chapter 1, Problem 1

by Paul M., Palepu, Krishna G., Peek, Erik Healy
179 Solutions 11 Chapters 43155 Studied ISBN: 9781408056424 Accounting 5 (1)

Chapter 1, Problem 1 : 1. Matti, who has just completed his first...

1. Matti, who has just completed his first finance course, is unsure whether he should take a course in business analysis and valuation using financial statements since he believes that financial analysis adds little value given the efficiency of capital markets. Explain to Matti when financial analysis can add value, even if capital markets are efficient.

Step-By-Step Solution

1. The efficient market hypothesis states that security prices reflect all available information, as if such information could be costlessly digested and translated immediately into demands for buys or sells. The efficient market hypothesis implies that there is no further need for analysis involving a search for mispriced securities.

However, if all investors adopted this attitude, no equity analysis would be conducted, mispricing would go uncorrected, and markets would no longer be efficient. This is why there must be just enough mispricing to provide incentives for the investment of resources in security analysis. Even in an extremely efficient market, where information is fully impounded in prices within minutes of its revelation (i.e., where mispricing exists only for minutes), Matti can get rewards with strong financial analysis skills:

1.Matti can interpret the newly-announced financial data faster than others and trade on it within minutes; and

2.Financial analysis helps Matti to understand the firm better, placing him in a better position to interpret other news more accurately as it arrives.

Markets may be not efficient under certain circumstances. Mispricing of securities may exist even days or months after the public revelation of a financial statement when the following three conditions are satisfied:

1.Relative to investors, managers have superior information on their firms’ business strategies and operation;

2.Managers’ incentives are not perfectly aligned with all shareholders’ interests; and

3.Accounting rules and auditing are imperfect.

When these conditions are met in reality, Matti could get profit by using trading strategies designed to exploit any systematic ways in which the publicly available data are ignored or discounted in the price-setting process.

Capital in market efficiency is not relevant in some areas. Matti can get benefits by using financial analysis skills in those areas. For example, he can assess how much value can be created through acquisition of target company, estimate the stock price of a company considering initial public offering, and predict the likelihood of a firm’s future financial distress.

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