I: An Introduction
The 2007 global financial crisis ignited by reckless bankers and their flawed reward structures will be felt for years to come. Emerging from the wreckage, however, is renewed support for the over-arching objective of traditional finance theory, namely the long-run maximisation of shareholder wealth using the current market value of ordinary shares (common stock) as a benchmark.
If capitalism is to survive, it is now widely agreed that conflicting managerial aims and short-term incentives, which now seem to characterize every business sector, must become entirely subordinate to the preservation of ownership wealth, future income and capital gains.
And as we shall discover, the key to resolving this principle-agency problem begins with a theoretical critique of how shares are valued. This not only underpins the practical measures of current and historical stock market performance published in the financial press (price, yield, cover, and the P/E ratio) used by market participants throughout the world. It also provides private individuals and the companies or financial institutions acting on their behalf with a common framework to analyse all their future investment decisions, whether it is an individual share transaction, a market placement, or corporate takeover activity.
Some Observations on Traditional Finance Theory
Based on the Separation Theorem of Irving Fisher (1930), traditional normative theory explains how corporate management should maximise shareholder wealth by maximising the expected net present value (NPV) of all a firm's investment projects.
According to Fisher, in a world of perfect capital markets, characterised by rational-risk averse investors, with no barriers to trade and a free flow of information, it is also irrelevant whether a company's future project cash flows are distributed as dividends to match shareholders consumption preferences at any point in time. If a company decides to retain profits for reinvestment, shareholder wealth measured by share price will not fall, providing that:
Management's minimum required return on new projects financed by retention (the discount rate) at least equals the shareholders' opportunity rate of return (yield) that they can expect to earn on alternative investments of comparable risk, or their the opportunity cost of capital (borrowing rate).
If shareholders need to borrow to satisfy their consumption (income) requirements they can do so at the market rate of interest, leaving management to reinvest current earnings (unpaid dividends) on their behalf to finance future investment, growth in earnings and future dividends.
Following Fisher's logic, all market participants should therefore earn a return commensurate with the risk of their investment. And because perfect markets are also efficient markets, shares are immediately and correctly priced at their intrinsic value in response to managerial policy, just like any other information and current events.
Yet, we now know that markets are imperfect. Investors may be irrational, there are barriers to trade and information is limited (particularly if management fail to communicate their true intentions to shareholders) any one of which invalidates Fisher's theorem. As a consequence, the question subsequent twentieth century academics sought to resolve was whether an imperfect capital market can also be efficient. To which the answer was a resounding "yes".
Based on the pioneering work of Eugene Fama, which began to emerge in the 1960s, modern finance theory now hypothesises that real-world stock markets may not be perfect but are reasonably efficient. Shareholder wealth maximisation is premised on the law of supply and demand. Large numbers of investors are assumed to respond rationally to new public information, good, bad, or indifferent. They buy, sell, or hold shares in a market without too many barriers to trade. A privileged few, with access to insider information, or either the ability, time or money to analyse all public information, may periodically "beat the market" by being among the first to react to events. But share price still reverts quickly if not instantaneously to a new equilibrium value, correctly priced, in response to the technical and fundamental analyses of historical trends and the latest news absorbed by the vast majority of market constituents.
Today's trading decisions are assumed to be independent of tomorrow's events. So, markets are assumed to have "no memory". And because share prices and returns therefore exhibit random behaviour, conventional wisdom, now termed the Efficient Market Hypothesis (EMH), states that in its semi-strong form:
- Short term, investors win some and lose some.
- Long term, the market is a "fair game" for all, providing returns commensurate with their risk.
Today, even in the wake of the first global financial crisis of the 21st century, governments, markets, financial institutions, companies and many analysts continue to cling to the wreckage by promoting policies premised on the theoretical case for semi-strong efficiency. But since the 1987 crash there has been an increasing unease within the academic community that the EMH in any form is "bad science". Many observe that "it puts the cart before the horse" by relying on simplifying assumptions, without any empirical evidence that they are true. Financial models premised on rationality, efficiency and randomness, which are the bedrock of modern finance, therefore attract legitimate criticism concerning their real world applicability.