Market Efficiency and Investment Valuation

The question of whether markets are efficient, and if not, where the inefficiencies lie, is central to investment valuation. If markets are, in fact, efficient, the market price provides the best estimate of value, and the process of valuation becomes one of justifying the market price. If markets are not efficient, the market price may deviate from the true value, and the process of valuation is directed towards obtaining a reasonable estimate of this value. Those who do valuation well, then, will then be able to make 'higher' returns than other investors, because of their capacity to spot under and over valued firms. To make these higher returns, though, markets have to correct their mistakes - i.e. become efficient - over time. Whether these corrections occur over six months or five years can have a profound impact in which valuation approach an investor chooses to use and the time horizon that is needed for it to succeed.

There is also much that can be learnt from studies of market efficiency, which highlight segments where the market seems to be inefficient. These 'inefficiencies' can provide the basis for screening the universe of stocks to come up with a sub-sample that is more likely to have under valued stocks. Given the size of the universe of stocks, this not only saves time for the analyst, but increases the odds significantly of finding under and over valued stocks. For instance, some efficiency studies suggest that stocks that are 'neglected' be institutional investors are more likely to be undervalued and earn excess returns. A strategy that screens firms for low institutional investment (as a percentage of the outstanding stock) may yield a sub-sample of neglected firms, which can then be valued using valuation models, to arrive at a portfolio of undervalued firms. If the research is correct the odds of finding undervalued firms should increase in this sub-sample.

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