Financial Theories Financial Theory General

¶ … 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.

Efficient Market Hypothesis -- EMH

EMH is a theory that believes in the fairness of the stock market. According to this theory, stock markets trade at fair value and it may be difficult to find under-valued or over-valued shares. "The accepted view was that when information arises, the news spreads very quickly and is incorporated into the prices of securities without delay." (Malkiel, 2003; p.3).

Though there is some evidence that stock markets are fairly predictable, EMH continues to be a controversial theory because of the studies that have proved it wrong. This is due to the psychological factors and irrational investing that exist in stock markets around the world.

Rozeff and Kinney (1976) discovered something called the January Effect. According to this study, the returns in January were much higher than in the other months in stock markets around the world. This theory coupled with other seasonal effects makes stock markets less predictable using EMH.

Behavioral Asset Pricing Model

The Behavioral Asset Pricing Model deals with the psychological factors that make investors use an information in a particular way. (Ball, 2001).

A good example of this model is the LSV Asset Management founded by Josef Lakonishok, Andrei Shleifer and Robert Vishny. They deal only with glamor stocks and stocks with a poor performance in the past. This is because markets reacts positively to any non-negative news from these companies.