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AFM 492 FINANCIAL STATEMENT ANALYSIS

Professor: Changling Chen School of Accounting and Financing Class 1

MOTTO FOR THE CLASS

Tell me, I forget. Teach me, I remember. Involve me, I learn.

AGENDA
Syllabus and course plan A warm-up contest Course framework Market efficiency

GROUP AND CASE CHOICES (NEXT WEEK DUE)


Group Members Names Voluntary; Section 001 (Mon): 4~5 in each group; Section 002 (Wed): 5~6 in each group Cases Case 1 Case 2 Case 3 Preference rank

Find your group ASAP; Rank your choice of Case 4 in-class group cases. Note confliction, if Case 5 there is any.

CONTEST
This is a contest. The winner of this contest will receive a Gift (ties are broken by lottery). Rule: Pick a number (an integer) between 0 and 100, inclusive. The person whose number is closest to 2/3 of the average number for the class is the winner. We will check the results towards the end of the class. Name: My pick is:
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WINNER OF THE CONTEST?

BEAUTY CONTEST GAME

Pick up the most beautiful (popular) faces It is not a case of choosing those [faces] that, to the best of ones judgment, are really the prettiest, nor even those that average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practice the fourth, fifth and higher degrees. (Keynes, General Theory of Employment Interest and Money, 1936).
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BEAUTY CONTEST GAME


Investor rationality: Keynes believed that similar behavior was at work within the stock market. This would have people pricing shares not based on what they think their fundamental value is, but rather on what they think everyone else thinks their value is, or what everybody else would predict the average assessment of value is.

WHO ANALYZES FINANCIAL STATEMENTS?


Security analysts Investors Bankers Management consultants Corporate managers Other stakeholders

WHAT IS THE ROLE OF FINANCIAL REPORTING IN CAPITAL MARKETS?

Savings

Financial Intermediaries Business Ideas

Information Intermediaries

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HOW TO CONDUCT ANALYSIS USING FINANCIAL STATEMENTS?


Business Environment and Strategy Analysis

Accounting Analysis

Financial Analysis

Prospective Analysis

Cost of Capital

Intrinsic Value
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WHAT IS EMH?

Fama (1970): Security prices always fully reflect the available information.

How? Immediately and Without bias. What information set?


In past price (weak) In public domain (semi-strong) Both public and private (strong)

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EQUITY SECURITY ANALYSIS AND EMH

Perfectly efficient markets would make it impossible to identify mispriced stocks using public information. If markets are extremely efficient, the few who receive newly announced financial information could trade advantageously on it before it is fully disseminated to the rest of the market.

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WHY DO WE BELIEVE MARKETS ARE EFFICIENT?


Stock prices are hard to predict Stock prices adjust quickly to new information Stock prices do not react to noninformation No one consistently outperforms the market:
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is no consistent evidence that actively managed mutual funds produce superior returns for investors.

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S SUN-TIMES STOCK-PICKING CONTEST

In the four years since Mr. Monk, wearing an NFL shirt in support of the Bears, has chaired and inspired the Sun-Times stock-picking contest, his stocks have posted annual returns that beat the major indexes each time. (Rich Hein/Sun-Times)
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THEORETICAL CHALLENGES TO THE EMH (I)

The theoretical case for the EMH:


Investors are rational Some investors are irrational, but their biases can go both directions and their trades cancel out Some systematic irrationality, but it is eliminated by rational arbitrageurs

Investors could be biased in a systematic manner. The faith is in the process of arbitrage. But the faith may not be well founded. 16

THEORETICAL CHALLENGES TO THE EMH (II)

Arbitrage is almost always costly and risky.


Lack of substitutes Fundamental risk of substitutes Noise trader risk

It requires sufficient mispricing to function properly. Arbitrage and mispricing must co-exist. (Lee, JAE, 2001)

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EMPIRICALLY EVIDENCE OF MARKET INEFFICIENCY

Excess volatility in returns

Returns are too volatile to be explained by a discounted dividend model

Stock prices react to non-information

1987 market crash

Returns predictability

Cross-sectional returns exhibit predictable patterns


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LONG-RUN REVERSALS: DEBONDT AND THALER (1985)

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POST-EARNINGS-ANNOUNCEMENT DRIFT: BALL AND BROWN (1968)

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PEAD AND EARNINGS PERSISTENCE (CHEN 2012)

Persistence HIGH PEAD hedge return HIGH

Investors appear to not fully understand earnings persistence.


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MARKET EFFICIENCY IS A JOURNEY.


[Market] efficiency is a journey, not a destination. Therefore, the pertinent questions on the matter of market efficiency are not yes or no, because strictly speaking the answer is always no. Price discovery is an on-going process and the current price of a security is best regarded as a noisy (or incomplete) proxy for a securitys true fundamental value. --Charles M. C. Lee, Journal of Accounting and Economics (2001)

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