Financial Analysis questions
1
Chapter 01:
Discussion Questions
1. Qian, who has just completed his first finance course, is unsure whether he should take acourse in business analysis and valuation using financial statements, because he believes that financial analysis adds little value, given the efficiency of capital markets. Explain to Qianwhen 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 buysor sells. The efficient market hypothesis implies that there is no further need for analysisinvolving 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 theremust be just enough mispricing to provide incentives for the investment of resources in securityanalysis.Even in an extremely efficient market, where information is fully impounded in prices withinminutes of its revelation (i.e., where mispricing exists only for minutes), John can get rewardswith strong financial analysis skills:1. John can interpret the newly announced financial data faster than others and trade on itwithin minutes; and2. Financial analysis helps John to understand the firm better, placing him in a better position tointerpret other news more accurately as it arrives.Markets may be not efficient under certain circumstances. Mispricing of securities may existdays or even months after the public revelation of a financial statement when the followingthree 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
Chapter 01:
Discussion Questions
1. Qian, who has just completed his first finance course, is unsure whether he should take acourse in business analysis and valuation using financial statements, because he believes that financial analysis adds little value, given the efficiency of capital markets. Explain to Qianwhen 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 buysor sells. The efficient market hypothesis implies that there is no further need for analysisinvolving 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 theremust be just enough mispricing to provide incentives for the investment of resources in securityanalysis.Even in an extremely efficient market, where information is fully impounded in prices withinminutes of its revelation (i.e., where mispricing exists only for minutes), John can get rewardswith strong financial analysis skills:1. John can interpret the newly announced financial data faster than others and trade on itwithin minutes; and2. Financial analysis helps John to understand the firm better, placing him in a better position tointerpret other news more accurately as it arrives.Markets may be not efficient under certain circumstances. Mispricing of securities may existdays or even months after the public revelation of a financial statement when the followingthree 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