1. John, 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 John when financial analysis can add value, even if capital markets are efficient. The 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. The 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), John 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. Markets may be not efficient under certain circumstances. Mispricing of securities may exist days or even 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 are not perfectly aligned with all shareholders’ interests; and 3.
accounting rules and auditing are imperfect.
When these conditions are met in reality, John could get profit by using trading strategies designed to exploit any systematic ways in which the publicly available data are ignored or discounted in the price-setting process. Capital in market efficiency is not relevant in some areas. John can get benefits by using financial analysis skills in those areas. For example, he can assess how much value can be created through acquisition of target company, estimate the stock price of a company considering initial public offering, and predict the likelihood of a firm’s future financial distress. 4. Four steps for business analysis are discussed in the chapter (strategy analysis, accounting analysis, financial analysis, and prospective analysis). As a financial analyst, explain why each of these steps is a critical part of your job and how they relate to one another. Managers have better information on a firm’s strategies relative to the information that outside financial analysts have. Superior financial analysts attempt to discover “inside information” from analyzing financial statements. The four steps for business analysis help outside analysts to gain valuable insights about the firm’s current performance and future prospects. 1.
Business strategy analysis is an essential first step because it enables the analysts to frame the subsequent accounting, financial, and prospective analysis better. For example, identifying the key success factors and key business risks allows the identification of key accounting policies. Assessment of a firm’s competitive strategy facilitates evaluating whether current profitability is sustainable. Finally, business strategy analysis enables the analysts to make sound assumptions in forecasting a firm’s future performance. 2.
Accounting analysis enables the analysts to “undo” any accounting distortion by recasting a firm’s accounting numbers. Sound accounting analysis improves the reliability of conclusions from financial analysis. 3.
The goal of financial analysis is to use financial data to...
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