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Markets: Can You Trust Them?

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How do managers know whether they are managing the company in the best interests of the owners? If financial markets are efficient, the answer is simple: Managers should monitor the share price of the company's common stock to find out what public investors think about the company, its future prospects, and its management decisions. And what should managers do to maximize share price? Well, they need to understand how investors value common stock so that they can identify and implement value-maximizing operating and financing policies. Let's consider the notion of financial market efficiency first-perhaps the most critical requirement for relying on market prices for allocating resources and evaluating management. For if markets are not efficient, the case for a market-based governance system all but disappears. We'll take up the valuation story in the next chapter.

Market prices must reflect the true value of a company and its economic prospects if a market-based corporate governance system based on shareholder wealth maximization is to work as intended. But what do we mean by the true value? How do we measure it? And how do we know that the markets (investors) are pricing the company properly?

Financial economists believe that the true value of a company is what investors will pay for that company based on all of its expected future returns to its owners. By all, we mean not only today's and tomorrow's returns, but also returns ten, twenty, or fifty years from now. What this definition means for stock prices is that in efficient financial markets, all information about the company that is presently available must be embedded in the price of the company's common stock. Thus, financial markets are deemed efficient if all information about the company is reflected in its stock price, thereby eliminating any opportunities for investors to earn returns greater than a fair risk-adjusted return on investment. In other words, no money trees or free lunches exist. But how do you know whether all the information about the company is embedded in the stock's price and, if it is, that the price reflects the true value? Well, with respect to the information question, financial market efficiency is typically divided into three categories: weak-form or informational efficiency, semistrong-form efficiency, and strong-form efficiency.
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Document Type: Research Article

Publication date: February 25, 2003

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