Solution

Chapter 1

A Framework for Business Analysis and Valuation Using Financial Statements

Question 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.

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

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

Market 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...