Streetbites from the media perspective
The efficient market hypothesis!
Streetbites from the media perspective
 The finance equivalent to the perpetual energy machine paradox is
the efficient market hypothesis!
 See textbook pages 444-455 for related content on this story.
Videos for module 3, unit 2-of-2 (TOTAL: 8@66’38”)
o Overview of Efficient markets hypothesis (10:47)
DEFINITION 9.3 Efficient market hypothesis (“EMH”)
A market is efficient with respect to an information event if it is impossible to devise a
trading strategy that uses the information to consistently earn economic profit.
Small company stocks
$10,000
Large company stocks
Long-term corporate bonds
$7,860
$2,279
$1,000
Long-term government bonds
$100
$133
$93
Treasury bills
$21
$10
$1
1925
1950
1975
2010
FIGURE 9.4 Growth of a $1 investment at year-end 1925 in different asset classes
A one-dollar investment in Treasury bills would have grown to become worth $21 (all
figures assume automatic reinvestment of the total return). The 1,600% cumulative rate
of return from T-bills is pretty big because the 85-year sample period is pretty long.
Investment in long-term government bonds results in ending wealth of $93, about thrice
the accumulation from T-bills. Long-term corporate bonds grow even more, to $133,
and a $1 investment in large company stocks grows to an incredible $2,279. Finally,
the average small company stock investment of $1 from 1925 attains an ending wealth
in 2010 of $7,860.
Consider components of EMH definition 9.3 that are notable.
1. The financial market may be efficient with respect to one information event but not others. The
question “is the stock market efficient?” is underspecified and does not have a definite answer. The
nebulous question is like asking whether the market is “all knowing”, not a good question. Instead, a
definite information event must be specified for which a definite yes/no answer exists. For example, a
valid question is this: “is the stock market efficient with respect to announcement of a stock split?”
2. The EMH argues that stock prices quickly respond to new information. The price adjustment process,
however, takes (some) time. The length of time varies from seconds, to minutes, and maybe longer
for surprising information that is difficult to assess. Lengthy adjustment periods may reflect
information complexity rather than market inefficiency. Sometimes, for example, new information
about a single event reaches the market in bits and pieces. Consequently, the price response may
diffuse across time. The important issue is whether security prices adjust to unanticipated changes in
consensus expectations.
3. There is no violation of the EMH simply because a trading strategy uses information and (once) earns
economic profit. Instead, the EMH argues that a trading strategy cannot consistently earn economic
profit.
4. When the EMH is true then all security prices are “fair.” With fair prices the consensus expectations
push prices to the point that none are undervalued nor overvalued. Security investment earns a
return that depends exclusively on risk and unanticipated changes in consensus expectations.
5. The EMH uses economic profit as its benchmark for comparison. Perhaps a trading strategy
consistently earns positive accounting profit, but this does not violate the EMH. Instead, the EMH
argues that a trading strategy cannot consistently earn returns that exceed fair compensation for risk
exposure.
Thousands of tests on market efficiency examine many different types of information
events. Information events belong to either of three traditional categories. “Weak”
information events pertain exclusively to stock market data such as historical prices,
trading volume, price multiples, calendar effects, etc. “Semi-strong” information events
pertain to all publicly available data such as economic or political announcements,
corporate news, etc. “Strong” information events pertain to all data, public and private,
such as insider or managerial insights. Irrespective of category, an efficient market
exists when a trading strategy cannot use an information event to consistently earn
economic profit. The super-majority find tendencies that support the EMH.
Lessons about the Structure of Finance
FF14 Which definition of the information set is consistent with the Efficient Market Hypothesis
The Efficient Market hypothesis (“EMH”) claims it is not possible to use an information
set to consistently earn excess stock returns. Which statement about different forms of
the information set is most accurate?
a. for the semi-strong form of the EMH the information set includes calendar, stock market, and
all publicly available data
b. for the semi-strong form of the EMH the information set includes calendar and stock market data
c. for the weak form of the EMH the information set includes calendar, stock market, and all public and
privately available data
d. for the strong form of the EMH the information set includes calendar and stock market data
e. for the strong form of the EMH the information set includes calendar, stock market, and all publicly
available data
Lessons about the Structure of Finance
Chapter 3, Unit 2 of 2
Natural dynamics shape the cash flow!
Lessons about the Structure of Finance
 Two sides of a balance sheet move step by step together,
responsive to measurable natural dynamics – follow the cash flow!
 See textbook pages 126-150 for relevant readings.
Videos for Module 3, Unit 2-of-2 (TOTAL: 8@66’38”)
o Overview of Efficient markets hypothesis (10:47)
o Natural growth rate dynamics - g_sustainable (6:04)
o Natural growth rate dynamics - stability (7:36)
o Forecast TA given g_sustainable (7:43) [GR1]
o Introduction to cash flow formulas (6:04)
o The cash surplus (1:49) [CF4]
o The price-to-cash flow from operations ratio (14:05) [CF3a]
o Cash is the equalizer (12:30) [Example 9]
NATURAL GROWTH RATES CONTINUED…
g internal 

Rt
At  Rt
(retention ratio)(ROA)
1  (retention ratio)(ROA)
(retention ratio)(ROA)

when ROA 
when ROA 
Net income t
Total assets t
Net income t
Total assets t1
The sales growth rate at ginternal is characterized by a measurable period of stable net
profit margin, asset turnover ratio, and payout ratio.
Find the Sales growth rate for GR2a on the daily handout!
Lessons about the Structure of Finance
GR2d Find new equity price-to-book ratio given constant p/e and ginternal
Find below the Company’s financial statements for year 2525.
Income, 1/1 – 12/31/2525
Sales
$16,200
total costs $15,600
net income $600
dividends $290
new retained earnings $310
Balance Sheet, 12/31/2525
$555 Current assets
$1,955 Debt
$3,600 PP&E
$2,200 Stockholders’ equity
$4,155 Total assets
$4,155
For 2526 the asset turnover (salestotal assets), net profit margin (=net income 
sales), payout ratio (=dividendsnet income) and price-to-earnings ratio (now 18.1) will
be constant. The number of shares outstanding is 110. The firm seeks maximum
growth by relying exclusively on retained earnings; external financing will be zero.
What is the equity price-to-book ratio at year-end 2526?
{ CLUES: g = 8.06% ; P2526 = $106.69 }
a. 4.63
b. 5.09
c. 6.78
d. 6.16
e. 5.60
FOLLOW-UP: What’s happened to the debt ratio? Is that good?
FORMULA 3.4a, 3.4b, and 3.4c The sustainable growth rate
A company with constant asset turnover ratio, net profit margin, dividend payout ratio,
and debt-to-equity ratio grows at the “sustainable growth rate”:
g sustainable 

Rt 1 Dt / SE t 
At  Rt 1 Dt / SE t 
(retentionratio)(ROE)
1  (retentionratio)(ROE)
 (retentionratio)(ROE)
when ROE 
when ROE 
Net incomet
Stockholders equity t
Net incomet
Stockholders equity t 1
The variables R, A, D, and SE denote New retained earnings, Total assets, Total debt,
and Stockholders’ equity, respectively.
Lessons about the Structure of Finance
PANEL A: Status Quo for year 2525
Balance Sheet, 12/31/2525
Income Statement, 1/1 to 12/31/2525
400 Debt (D)
Sales
$3,000
.
600 Equity (SE)
total expenses
2,850
Total (A)
$1,000 Liabilities &
Net Income
150
$1,000
Equity
Dividends
60
New Retained Earnings (R)
90
PANEL C: Effect on year 2526 of growth at rate gsustainable
Balance Sheet, 12/31/2526
Income Statement, 1/1 to 12/31/2526
471 Debt (D)
Sales
$3,530
.
706 Equity (SE)
total expenses
3,354
Total (A)
$1,177 Liabilities &
Net Income
176
$1,177
Equity
Dividends
70
New Retained Earnings (R)
106
EXERCISES 3.2
2. Find below items from the company’s income statement.
Income, 1/1 - 12/31/2525
Sales
$12,000
all costs
$10,800
Net income
$1,200
Dividends
$920
New retained earnings
$280
Total assets at 12/31/2525 equal $3,650 and the debt-to-assets ratio is 45%. If the
company is growing at their sustainable growth rate, what are Total assets at
12/31/2526? ©GR1
ANSWER: Use formula 2.5 to find that the debt-to-equity ratio equals 0.8182 (= 0.45 / (1 –
0.45)). Apply formula 3.4a and find that gsustainable equals 16.21% (= $280 x (1 + 0.8182) /
[$3,650 – $280 x (1 + 0.8182)]). Total assets at 12/31/2526 therefore equals $4,241 (= $3,650 x
(1 + .1621)).
Lessons about the Structure of Finance
Lessons about the Structure of Finance
FORMULA 3.5 Cash flow to shareholders
CF to shareholders = Dividends  Net equity issues
FORMULA 3.6 Cash flow to creditors
CFto creditors = Interest  Net debt issues
FORMULA 3.7 Cash flow to capitalists
CF to capitalists = CF to shareholders + CFto creditors .
Lessons about the Structure of Finance
FORMULA 3.8 The link between assets and capitalists
CFfrom assets = CF to capitalists
Cash flow from assets identically equals Cash flow to capitalists. This identity assumes
that stakeholder cash flows wash out and do not create value. The discussion on the
importance of CF to capitalists for allocating resources applies to CFfrom assets too. For an
asset investment to receive financing, capitalists must believe that the venture promises
to deliver sufficient future Cash flow from assets to justify the investment.
FORMULA 3.9 Cash flow from assets, expanded version
CFfrom assets = EBIT + Depreciation  Taxes  NWC - Capital expenditures
where EBIT = Sales  COGS  SGA  Depreciation,
FORMULA 3.10 Cash flow from operations
CFfrom operations = EBIT + Depreciation  Taxes
= EBITDA  Taxes
EBITDA, “earnings before interest, taxes, depreciation and amortization,” is increasingly
popular in the financial press
From http://www.forbes.com/sites/investopedia/2010/10/07/operating-cash-flow-better-than-net-income/
Lessons about the Structure of Finance
Lessons about the Structure of Finance
Comparison of formulas 3.9 and 3.10 reveals that the Cash flow from assets equals
Cash flow from operations when the company spends absolutely nothing on Net
working capital and PP&E. Usually, though, some funds get used on Net working
capital or PP&E so not all Cash flow from operations immediately returns to capitalists.
Combining several of the preceding formulas yields a key expression.
FORMULA 3.11 Cash flow from assets, summary version
CFfrom assets = CFfrom operations  NWC - capital expenditures
Besides cash flow, many analysts watch the company’s Cash surplus:
Lessons about the Structure of Finance
FORMULA 3.12 Cash surplus
cash surplus =  Cash
= CFfrom operations  NWC(excluding Cash)  Capital expenditures  CFfrom assets
CF4 Find cash surplus in simplistic setting
Find below the Company’s balance sheet at year-end 2525.
Balance Sheet, 12/31/2525
Cash $495
$1,650
Current liabilities
Other current assets $705
$1,250
Debt
PP&E $3,800
$2,100
Stockholders equity
$5,000
$5,000 Total
and also for year-end 2526.
Balance Sheet, 12/31/2526
Cash $540
$720
Current liabilities
Other current assets $900
$920
Debt
PP&E $2,400
$2,200
Stockholders equity
$3,840
$3,840 Total
How much is the cash surplus?
{ANSWER: $45 }
EXAMPLE 9 Combine the balance sheet with income statement items to find cash flows
Find below the Company’s balance sheet at year-end 2525.
Cash
Other current assets
PP&E
Balance Sheet, 12/31/2525
$ 90
$200
Current liabilities
300
180
Debt
680
690
Stockholders equity (80 shares)
$1,070
$1,070
Total
For year 2526 the following are forecast: the stock price should end the year at $7.50
per share; Sales equal $2,100; operating margin (= EBIT  Sales) is 14%;
Depreciation is 15% of PP&E; Interest is 10% of debt; Taxes are 35% of taxable
income; Dividends are 60% of Net income. Suppose the company makes sufficient
Capital expenditures during 2526 so that it holds PP&E constant. It finances these
Capital expenditures by issuing 10 shares during 2526 for $7 per share. The remainder
of the Capital expenditures is financed internally. All else remains the same. Find all
the different cash flow measures as well as the price-to-earnings, price-to-book, and
price-to-cash flow.
Lessons about the Structure of Finance
SOLUTION
For convenience forecast the income statement from the preceding facts.
Company Income Statement, Jan. 1 — Dec. 31, 2526
Sales revenue
$2,100
- Other costs (see discussion)
....
- Depreciation (@ 15% of PPE)
102
= EBIT (@ 14% of sales)
$294
- Interest (@ 10% of debt)
18
= Taxable income
$276
- Taxes (@ 35% tax rate)
97
= Net income
$179
- Dividends (@ 60% payout)
108
= New Retained Earnings
$ 71
The operating margin allows computation of EBIT from Sales. It is unnecessary to
compute Other costs. Notice that the income statement does not show in any way the
Capital expenditures nor equity issues. These latter items, however, affect the balance
sheet for year-end 2526. Apply formula 2.11 to compute that SE2526 equals $832 (= 690
+ 72 + 70). For convenience show all that is known about the balance sheet for yearend 2526:
Cash
Other current assets
PP&E
Balance Sheet, 12/31/2526
$ ?
$200
Current liabilities
300
180
Debt
680
832
Stockholders equity (80 shares)
$1,212
$1,212
Total
Cash is found such that it equalizes the bottom line. That is, Cash2526 equals $232 (=
$1,212 – 300 – 680). Now apply the cash flow formulas and find that CF to creditors equals
interest paid on debt and equals $18 (no new loans are taken out); CF to shareholders
equals Dividends minus new issues and equals $38 (= $108 – $70); CF from assets equals
the sum of CF to creditors plus CF to shareholders and is $56. The Cash surplus is the change
in Cash
CF
from assets
and Cash surplus are consistent with formulas 3.9 and 3.12, respectively.
One final comment about this example pertains to the source of the $102 Capital
expenditure that the Company pays to the capital goods supplier. The Company sells
new shares and raises $70; the remaining $32 is paid in cash. Confirm that if Capital
expenditures were zero and no shares were issued, Cash is $32 higher at $264, and
Total assets is $1,142.
Lessons about the Structure of Finance
EXERCISES 3.3
11. Find below the Company’s balance sheet for year-end 2525.
Balance Sheet, 12/31/2525
Cash $345
$750
Inventory $795
$790
PP&E $4,000
$3,600
$5,140
$5,140
Current liabilities
Debt
Stockholders equity
Total
For 2525 the Company’s asset turnover ratio (Sales2525  Total assets2525) is 3.6.
Depreciation equals 18% of PP&E, and the operating profit margin (= earnings before
interest and taxes  Sales) is 9.70%. Interest expense equals 9.60% of Debt. Taxes
equal 35% of taxable income, and the payout ratio (=DividendsNet income) is 45%.
There are no other items on the income statement for 2525. There are 180 shares
outstanding.
As a prospective investor in the Company’s shares, you are especially interested in
their financial ratios. You know the price-to-earnings ratio at year-end 2525 equals
28.3. More significant to you, however, is the price-to-cash-flow ratio (= shareprice 
operating cash flow per share). What is the company’s price-to-cash-flow ratio?
©CF3a
ANSWER: First, find CFfrom operations . EBIT is $1,795 (= 3.6 x $5,140 x 0.0970); Taxes
equal $601 (= {$1,795 – (.0970 x $790)} x 0.35); and CFfrom operations equals $1,913 (=
$1,795 + (.18 x $4,000) – $601). Now find market capitalization: Net income is $1,117
(= {$1,795 – (.0970 x $790)} x {1 – 0.35}); market cap equals $31,607 (= 28.3 x
$1,117). The ratio of market cap to CFfrom operations is identical to the ratio of shareprice to
operating cash flow per share and equals 16.5 (= $31,607 / $1,913).
Lessons about the Structure of Finance