Introduction to Corporate Finance

PART 2: VALUATION, RISK AND RETURN

7 List the three factors that influence a share’s expected return according to the CAPM.

8 If a particular share had no systematic risk, only unsystematic risk, what would be its expected

return?

CONCEPT REVIEW QUESTIONS 7-3

7- 4 ARE SHARE RETURNS PREDICTABLE?

Microsoft Corp. debuted as a public US company with its initial public offering (IPO) on 13 March

1986. On that day, one Microsoft share sold for US$21. In the 24 years that followed, share splits turned
      a single share purchased at the IPO into 288 shares, worth an amazing US$7,200 by August 2011.
      That represents a compound annual return of roughly 26% per year! The purpose of this section is to
      investigate whether such a spectacular outcome could have been anticipated by smart investors.
      Suppose that, upon graduating from university, you decide to open your own business. The question
      is, what kind of business should you start? A friend suggests opening a pizza restaurant. Having learned a
      few valuable lessons in your degree, you respond that the pizza business is a terrible place to start. Most
      communities are already saturated with pizza restaurants, and most offer similar varieties of pizza with a
      similar ambience, or lack thereof. You want to find a niche that is less competitive. You reason that getting
      rich selling pizzas is nearly impossible.
      As competitive as the pizza business is, it hardly compares with the competitive environment of
      modern financial markets. The sheer size and transparency of financial markets make them more
      competitive than most markets for goods and services. Financial asset prices are set in arenas that are
      typically governed by rules designed to make the process as fair and open as possible. Each day, thousands
      of professional financial analysts (to say nothing of the tens of thousands of amateurs) worldwide
      scrutinise all available information about high-profile shares such as Microsoft, hoping to find any bit
      of information overlooked by the crowd that might lead to an advantage in determining the fair value of
      those shares. The rapid growth of electronic media, especially the Internet, during the past two decades
      has caused an explosion in the total volume of financial information available to investors and accelerated
      the speed with which that information arrives. All of this means that being a better-than-average share
      prognosticator is probably more difficult than building a better pizza.
      In finance, the idea that competition in financial markets creates an equilibrium in which it is
      exceedingly difficult to identify undervalued or overvalued shares is called the efficient markets hypothesis
      (EMH). The EMH says that financial asset prices rapidly and fully incorporate new information. An
      interesting implication of this prediction is that asset prices move almost randomly over time. We must
      use the qualifier ‘almost’ in the previous sentence, because there is a kind of baseline predictability to
      asset returns that is related to risk. For example, over time, we expect shares to earn higher returns than
      bonds, because shares are riskier. Indeed, the historical record confirms this prediction. But in any given
      year, shares may do very well or very poorly relative to bonds. The efficient markets hypothesis says that
      it is nearly impossible to predict exactly when shares will do well relative to bonds or when the opposite
      outcome will occur.

LO7.4

Todd Richter, Managing

Director, Head of Equity

Healthcare Research, Bank

of America Securities

‘I don’t necessarily

believe that markets are

efficient. I believe that

markets tend toward

efficiency.’

See the entire interview on

the CourseMate website.

COURSEMATE
SMART VIDEO

Source: Cengage Learning

efficient markets

hypothesis (EMH)

Asserts that financial asset

prices rapidly and fully

incorporate new information