210 CHAPTER 5 Stocks and Their Valuationmean that new developments could not cause a stock’s price to soar or to plummet, but
it does mean that stocks in general are neither overvalued nor undervalued—they are
fairly priced and in equilibrium. However, there are certainly cases in which corporate
insiders have information not known to outsiders.
If the EMH is correct, it is a waste of time for most of us to analyze stocks by look-
ing for those that are undervalued. If stock prices already reflect all publicly available
information, and hence are fairly priced, one can “beat the market” consistently only
by luck, and it is difficult, if not impossible, for anyone to consistently outperform the
market averages. Empirical tests have shown that the EMH is, in its weak and semi-
strong forms, valid. However, people such as corporate officers, who have inside
information, can do better than the averages, and individuals and organizations that are
especially good at digging out information on small, new companies also seem to do
consistently well. Also, some investors may be able to analyze and react more quickly
than others to releases of new information, and these investors may have an advantage
over others. However, the buy-sell actions of those investors quickly bring market
prices into equilibrium. Therefore, it is generally safe to assume thatˆrir, thatPˆ 0
P 0 , and that stocks plot on the SML.^17For a stock to be in equilibrium, what two conditions must hold?
What is the Efficient Markets Hypothesis (EMH)?
What are the differences among the three forms of the EMH: (1) weak form, (2)
semistrong form, and (3) strong form?
What are the implications of the EMH for financial decisions?Actual Stock Prices and Returns
Our discussion thus far has focused on expectedstock prices and expectedrates of return.
Anyone who has ever invested in the stock market knows that there can be, and there
generally are, large differences between expectedand realizedprices and returns.
Figure 5-5 shows how the market value of a portfolio of stocks has moved in recent
years, and Figure 5-6 shows how total realized returns on the portfolio have varied from
year to year. The market trend has been strongly up, but it has gone up in some years
and down in others, and the stocks of individual companies have likewise gone up and(^17) Market efficiency also has important implications for managerial decisions, especially those pertaining to
common stock issues, stock repurchases, and tender offers. Stocks appear to be fairly valued, so decisions
based on the premise that a stock is undervalued or overvalued must be approached with caution. However,
managers do have better information about their own companies than outsiders, and this information can
legally be used to the companies’ (but not the managers’) advantage.
We should also note that some Wall Street pros have consistently beaten the market over many years,
which is inconsistent with the EMH. An interesting article in the April 3, 1995, issue of Fortune(Terence
P. Paré, “Yes, You Can Beat the Market”) argued strongly against the EMH. Paré suggested that each stock
has a fundamental value, but when good or bad news about it is announced, most investors fail to interpret
that news correctly. As a result, stocks are generally priced above or below their long-term values.
Think of a graph with stock price on the vertical axis and years on the horizontal axis. A stock’s fundamen-
tal value might be moving up steadily over time as it retains and reinvests earnings. However, its actual price
might fluctuate about the intrinsic value line, overreacting to good or bad news and indicating departures
from equilibrium. Successful value investors, according to the article, use fundamental analysis to identify
stocks’ intrinsic values, and then they buy stocks that are undervalued and sell those that are overvalued.
Paré’s argument implies that the market is systematically out of equilibrium and that investors can act on
this knowledge to beat the market. That position may turn out to be correct, but it may also be that the
superior performance Paré noted simply demonstrates that some people are better at obtaining and inter-
preting information than others, or have just had a run of good luck.