Market Efficiency — EMH
The Efficient Market Hypothesis (EMH) holds that security prices fully reflect available information.
- Weak Form: Prices reflect all past price and volume data. Technical analysis cannot generate persistent alpha. Tests: autocorrelation tests, filter rules.
- Semi-Strong Form: Prices reflect all publicly available information (financial statements, news, analyst reports). Fundamental analysis cannot generate persistent excess returns. Tests: event studies.
- Strong Form: Prices reflect all public AND private information (including insider information). Even insiders cannot consistently earn abnormal returns. Tests: performance of insiders, mutual fund managers.
Exam insight: Most empirical evidence supports weak and semi-strong forms. Strong form is generally rejected — insider trading laws exist precisely because insiders can profit from MNPI.
Anomalies that challenge EMH: momentum (contradicts weak form), post-earnings announcement drift (contradicts semi-strong), calendar effects (January effect).
Dividend Discount Model (DDM)
Value = Present Value of all future dividends.
Gordon Growth Model (Constant Growth DDM)
P₀ = D₁ / (k − g)
- D₁ = Next period's dividend = D₀ × (1 + g)
- k = Required rate of return (from CAPM: k = Rf + β × Market Risk Premium)
- g = Sustainable growth rate = ROE × Retention ratio = ROE × (1 − Payout ratio)
- Condition: k > g (model breaks down if g ≥ k)
Example: D₀ = ₹10, g = 8%, k = 12%. P₀ = 10 × 1.08 / (0.12 − 0.08) = 10.80 / 0.04 = ₹270
Two-Stage DDM
For firms with high growth that then normalises:
- Calculate PV of dividends in high-growth period (each year separately)
- At end of high-growth period, apply Gordon Growth Model for terminal value
- PV total = PV of high-growth dividends + PV of terminal value
Free Cash Flow to Equity (FCFE)
FCFE = Net Income + D&A − CapEx − Change in Working Capital + Net Borrowing
Or: FCFE = CFO − CapEx + Net Borrowing
Valuation: P₀ = FCFE₁ / (k − g)
When to use FCFE vs DDM: FCFE when dividends don't reflect firm's cash generation capacity (company retains a lot, or pays special dividends). DDM when dividends are stable and reflect payout policy. FCFE is more useful for non-dividend-paying firms.
Price Multiples
P/E Ratio (Price-to-Earnings)
| Type | Formula | Use |
|---|---|---|
| Trailing P/E | Price / EPS (last 12 months) | Based on known earnings — more stable |
| Leading P/E | Price / Forecasted EPS (next 12 months) | Forward-looking; used in DCF context |
| Justified P/E | D₁/E₁ / (k − g) = Payout / (k − g) | What P/E should be given fundamentals |
P/E limitations: Not useful when EPS is negative. Cyclical businesses have misleading P/E at earnings extremes. Different accounting choices affect comparability.
P/B Ratio (Price-to-Book)
P/B = Market Price per Share / Book Value per Share
Useful for: financial firms (banks, insurance) where book value closely tracks asset values.
P/B < 1.0: Market values firm below net assets — could be undervalued or signal structural problems (low ROE, write-off risk).
Justified P/B = (ROE − g) / (k − g)
EV/EBITDA
Enterprise Value (EV) = Market Cap + Total Debt − Cash and Cash Equivalents
EV/EBITDA is capital-structure neutral — unaffected by leverage differences between firms. Useful for comparing firms with different debt levels or in leveraged buyout (LBO) analysis.
Limitation: EBITDA ignores CapEx — a capital-intensive firm with high EBITDA but also high CapEx is less valuable than it appears.
Industry Analysis Framework
Five Forces (Porter) — used in CFA Level 1 industry analysis:
- Threat of new entrants (barriers to entry: capital, regulation, brand, economies of scale)
- Bargaining power of buyers
- Bargaining power of suppliers
- Threat of substitutes
- Rivalry among existing competitors
Industry life cycle: Embryonic → Growth → Shakeout → Mature → Decline. Mature industries are most amenable to dividend-paying analysis; embryonic/growth firms use FCFE or P/S multiples.