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AFM 492 FINANCIAL

STATEMENT ANALYSISProfessor: Changling ChenSchool of Accounting and FinancingClass 1

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MOTTO FOR THE CLASS

Tell me, I forget.

Teach me, I remember.

Involve me, I learn.

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AGENDA

Syllabus and course planA warm-up contestCourse framework

Market efficiency

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GROUP AND CASE CHOICES (NEXT WEEK DUE)

Group Members Cases Preference rank

NamesVoluntary;Section 001 (Mon):4~5 in each group;Section 002 (Wed):5~6 in each group

Find your groupASAP;Rank your choice of in-class group cases.Note confliction, if there is any.

Case 1

Case 2

Case 3

Case 4

Case 5

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CONTEST

This is a contest. The winner of this contest willreceive a Gift (ties are broken by lottery).

Rule:Pick a number (an integer) between 0 and 100,

inclusive. The person whose number is closest to2/3 of the average number for the class is thewinner. We will check the results towards the endof the class.

Name: My pick is:

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WINNER OF THE CONTEST?

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BEAUTY CONTEST GAME

Pick up the most beautiful (popular) faces

It is not a case of choosing those [faces] that, tothe best of ones judgment, are really the

prettiest, nor even those that average opiniongenuinely thinks the prettiest. We have reachedthe third degree where we devote ourintelligences to anticipating what average opinionexpects the average opinion to be. And there are

some, I believe, who practice the fourth, fifth andhigher degrees. (Keynes, General Theory of Employment Interest and Money, 1936).

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BEAUTY CONTEST GAME

Investor rationality: Keynes believed that similarbehavior was at work within the stock market.

This would have people pricing shares not basedon what they think their fundamental value is, but

rather on what they think everyone else thinkstheir value is, or what everybody else wouldpredict the average assessment of value is.

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WHO ANALYZES FINANCIALSTATEMENTS?

Security analystsInvestorsBankers

Management consultantsCorporate managersOther stakeholders

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FINANCIAL REPORTING INCAPITAL MARKETS?

Savings

BusinessIdeas

FinancialIntermediaries

InformationIntermediaries

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USING FINANCIALSTATEMENTS?

BusinessEnvironment andStrategy Analysis

Accounting Analysis

Cost of Capital Intrinsic Value

Prospective Analysis

Financial Analysis

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WHAT IS EMH?

Fama (1970): Security prices always fullyreflect the available information.How? Immediately and Without bias.What information set?

In past price (weak)In public domain (semi-strong)Both public and private (strong)

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EQUITY SECURITY ANALYSIS AND EMH

Perfectly efficient markets would make itimpossible to identify mispriced stocks using publicinformation.

If markets are extremely efficient, the few who

receive newly announced financial informationcould trade advantageously on it before it is fullydisseminated to the rest of the market.

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WHY DO WE BELIEVE MARKETS AREEFFICIENT?

Stock prices are hard to predictStock prices adjust quickly to newinformationStock prices do not react to non-information No one consistently outperforms themarket:

There is no consistent evidence that actively managedmutual funds produce superior returns for investors.

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SUN-TIMES STOCK-PICKING CONTESTS

In the four years since Mr. Monk, wearing an NFL shirt in support of the

Bears, has chaired and inspired the Sun-Times stock-picking contest,his stocks have posted annual returns that beat the major indexes eachtime. (Rich Hein/Sun-Times)

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THEORETICAL CHALLENGES TO THE EMH(I)

The theoretical case for the EMH:Investors are rationalSome investors are irrational, but their biasescan go both directions and their trades cancel

outSome systematic irrationality, but it is eliminatedby rational arbitrageurs

Investors could be biased in a systematicmanner. The faith is in the process of arbitrage. But the faith may not be wellfounded. 16

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THEORETICAL CHALLENGES TO THE EMH(II)

Arbitrage is almost always costly and risky.Lack of substitutesFundamental risk of substitutesNoise trader risk

It requires sufficient mispricing to functionproperly. Arbitrage and mispricing mustco-exist. (Lee, JAE, 2001)

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EMPIRICALLY EVIDENCE OF MARKETINEFFICIENCY

Excess volatility in returnsReturns are too volatile to be explained by adiscounted dividend model

Stock prices react to non-information1987 market crash

Returns predictabilityCross-sectional returns exhibit predictablepatterns

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LONG-RUN REVERSALS:DEBONDT AND THALER (1985)

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POST-EARNINGS-ANNOUNCEMENT DRIFT:BALL AND BROWN (1968)

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PEAD AND EARNINGS PERSISTENCE (CHEN2012)

PersistenceHIGH

PEAD hedgereturn HIGH

Investorsappear tonot fullyunderstandearningspersistence.

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MARKET EFFICIENCY IS A JOURNEY.

[Market] efficiency is a journey, not a destination. Therefore, the pertinent questions on the matter of market efficiency are not yes or no, becausestrictly speaking the answer is always no. Pricediscovery is an on-going process and the currentprice of a security is best regarded as a noisy (orincomplete) proxy for a securitys true fundamentalvalue.

--Charles M. C. Lee, Journal of Accounting andEconomics (2001)

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