Arbitrage pricing theory, agency cost theory, and stock market efficiency

¶ … Financial Theories

Financial Theory

General Description of Theory

Current Examples of Theory

Significant Attributes of Theory

Arbitrage Pricing Theory

Arbitrage Pricing theory (APT) was developed by Ross in 1976 to be used as a basis in asset pricing. It brings out the relation between the expected return of assets and the random variables that can play a role in determining the value of an asset. "It is a one-period model in which every investor believes that the stochastic properties of returns of capital assets are consistent with a factor structure." (Huberman & Wang, 2005, p.2)

Today, it is widely used in calculating stock prices. It evaluates the random variables that can increase the risk factor for any investment. Based on this theory, any potential investor can design a portfolio that has minimal risk.

It is based on the idea that something is better than nothing for an investor. "The central insight of APT is that if investors understand the generating processes of security returns they can use this information to design portfolios in which net wealth is zero (because short and long positions are equal) and in which all risk has been completely diversified away. The familiar arbitrage condition suggests that the expected return on such portfolios should be zero for otherwise infinite wealth could be arbitrarily accumulated without any net investment or exposure to risk." (Beenstock & Kam-Fai, 1986, p.131).

Agency Cost Theory

This theory was developed by Michael Jensen and William Meckling. The aim of this theory is to focus on the conflicts between different groups of people who have a stake in the company and its impact on the share price of that company. (Chew, 2001).

A good example of this theory is a family business. The need to control and manage operations can disintegrate the business, especially after the death of the patriarch or the head of the business. This sibling-rivalry can bring about the collapse of the business. (Poza, Hanlon & Kishida, 2004).

This theory helps to explain why preferred stock is issued, why the companies send voluntary financial reports to creditors and shareholders, why a company has a mixed financial structure and why regulated industries have a higher debt-equity ratio than non-regulated ones. (Jensen & Meckling, 1976).

The Theory of Stock Market Efficiency

This theory was put forth by Fama, Jensen, French and Roll in 1969. It is based on the fact that competition will drive market efficiency. Fama coined the word "efficient market" and described it as a market with numerous people whose intention is to maximize profits and at the same time they try to predict the value of future market with information that is readily available. (Chew, 1994).

Fama had his doubts about the theory when he published his article in 1995. The nature of market today and its unpredictability and volatility makes it difficult to calculate the real value of stocks based on this theory. (Fama, 1995).

Ball came up with many anomalies in this theory (Ball, 2001). The basic assumption that information cost is zero is incorrect because there is a cost associated with getting that inform and this should be incorporated in the total costs. He also mentions that analysts will reduce uncertainties by analyzing the actions of others as well as by doing research about the stock.

Cash Flow Return on investment -- CFROI

It is a valuation model that is based on the assumption that the value of stock prices reflects the cash flow of the company and not the performance or earnings of the company. "Economic performance, displayed in the CFROI framework, provides company-specific insights and helpful comparability of performance over time and across companies, both domestic and foreign." (Madden, 1991. p. 9).

Companies use this model because it adjusts inflation and gives the real magnitudes. It provides better consistency and makes global research easier. (Madden, 1999).

To forecast a company's financial future, it is important that a specific rate is assigned to the company as its discount rate that will help investors to calculate the forecasted net cash receipt. This discount rate is the market rate as well as the risk differential. (Madden, 1998).

Economic Value Added (EVA)

Economic Value Added is similar to the idea of residual income. The aim of this valuation is to add more value to the shareholders' income over the cost of capital invested in the company. (Salmi, Timo & Virtanen, 2001).

Lin and Zhilin (2008) have used the concept of EVA to create a new idea called the integrated EVA Performance and they have used this to measure the valuations of companies in China and their associated drawbacks.

Application of EVA is a lot more difficult because measuring the value of a firm as well as the components that make up the cost of capital is difficult. "A central question concerning EVA is how sensitive this management tool is to the changes in its various components, management policies and external economic factors." (Salmi, Timo & Virtanen, 2001, p.2).

Capital Asset Pricing Model (CAPM).

CAPM is an important model for calculating the price of different kinds of securities and it describes the relationship between the expected rate of return and the risk involved. It was formulated by William Sharpe and John Lintner. (Ball, 2001).

CAPM is slowly being replaced by more advanced methodologies like Arbitrage Pricing Theory (APT) and the Option pricing model (OPM) for derivatives.

Extensive studies show that stocks with small capitalization tend to earn higher than the returns predicted by CAPM. "The results reported in these studies support the view that it is possible to construct a set of portfolios such that the static CAPM is unable to explain the cross-sectional variation in average returns among them." (Jagannathan & Wang, 1996. p. 4).

Discounted Cash Flow (DCF)

Discounted Cash Flow helps investors to value a company and its resulting stock value. "This approach is categorized by a higher level of objectiveness. It uses cash flow figures, so the argument goes, instead of accounting numbers (e.g., net deposits) that do not focus on legal frameworks such as accounting rules and concepts (depreciation policies or estimated bad debts which give management sufficient space." (Nowak, 2000 as cited in Schon, 2007, p.6)

One of the best uses is to determine the value of a company. It is calculated by forecasting the future cash flows for the next few years and discounting it to the current year to understand whether the company's stock is under-valued or over-valued. This gives good results because cash flow can determine the financial strength of a company as well as its stability.

Despite its usefulness, there is also a fundamental drawback in this method. (Chew, 2001). It is difficult to ascertain the value of companies that are involved in high and risky investments like those in the real-estate. This is because it is difficult to calculate the value of real-estate prices.

Miller-Modigliani Theory of Corporate Financial Policy

This theory states that in an efficient market and devoid of taxes and bankruptcy costs, the value of a company does not change because of its financing structure. In other words, the value will remain the same irrespective of the debt, equity and dividend policy of the company.

"The influence of the Modigliani-Miller (1958) propositions on capital structure and the Miller-Modigliani (1961) theses on dividend policy permeates almost all aspects of financial economics to this day." Bhattacharya (1988). It is used to calculate the value of a company based on its total cash flow. (Ross, 1988).

Bhattacharya (1998) states that this theory assumed that lower dividends will lead to reduced levels of new equity and this will bring about a balance between the debt and equity of a company. This is not ture for utilities companies and other monopolistic firms where new equities are rare.

For the "Current Examples" in our table, do we need to find specific company examples that exist today or have happened in the last 2-3 years? Or will it suffice to give a theoretical example of a measurement in a firm that fits the model.

For example, would this be OK.

Efficiency Theory Example

- Production returns based on shared, variable, and per unit costs divided by the total output of a factory in a given period of time.

Instructor Response: I am ok with any example which shows that you understand the theory / concept.