Financial Management - Evaluation of Takeover Bids Under Different Version of EMH - Assignment Example

Financial Management - Behavior of Prices under Different Versions of EMH Introduction Market efficiency means that the market price of a security represents the market’s consensus estimate of the value of that security. If the market is efficient, it uses all information available to it in setting a price. Takeover bids often evaluate the efficiency sentiments of the market before rolling the deal. Various shades of Efficient Market Hypothesis have been studied in this paper in the light of takeover bids that succeeded as well as failed to capture this efficiency sentiment of markets. Behavior of prices under different versions of EMH Efficient Market Hypothesis (EMH) is a theory that assumes that market prices cannot be influenced by fresh information or happenings as prices in fact are reflections of all relevant information. As per EMH buying and selling is simply a game of chance and there is no involvement of skillful abilities. Takeno Trano (2001, Page 111)i explains the basic features of EMH theory as under: “Each market participant of a financial market takes in very quickly and exactly all the information related to the movement of a market price, and uses it for price expectation. The market price that determined by the dealings between such market participants is reflecting properly all the information that is available at present. Therefore there is no room for certain person to find out the new relation between a market price and the available information, and to become advantageous from other persons. That is the movement of a market price becomes a random walk driven only by new information, and nobody can predict it.” Three form of EMH has been envisaged, namely weak form, semi strong, and strong form of EMH. The more efficient the market, the less predictive it is as per efficient market hypothesis. Accordingly corporate take- overs do not undertake the effect of any influential tactics. In simple language, the take- over price is not at all affected by any maneuverings or market upheavals. It is like perfect competition in economics where other factors remaining the same, prices are settled by demand and supply forces. Take- over bid of companies is basically concerned with purchase and sales of controllable shares of the company to be taken over. The market price for take-over bid under different forms of efficient market hypothesis would have the following reactions: Weak form of EMH The weak form of EMH implies that “current share price reflects all the information that could be gleaned from the study of past share prices. If this holds good then no investor can earn above average returns by developing trading rules based on historical prices or return information.” (J.Ogilive, page 79)ii That means study of past events or past performances of the company to be taken over would not have any impact on settling the takeover price. Semi- strong form of EMH Takeover bids some time involve buying the lots or holdings of the company to be taken over. As per semi strong version of EMH theory, current prices not only contain the influence of historical events and happenings but also all published information. If the theory holds true no investor can make above average earnings by trading in stocks. The reason for this is that formulations of current prices are reflection of all public information. Therefore take- over bids cannot under or over value the holdings of scrips of the entity to be taken over. That is why “individual companies may be underpriced because management has failed to communicate its plan to investors and a price may be paid above the market, but these cases are atypical according to EMH in semi strong form.” (Larry J. Kasper, page 88)iii.But even such companies do not get anything more than market price of their shares. Strong form of EMH Strong form of EMH includes the effects on prices of all sorts of information, historical, published, and even non- published. This also includes the insider information as well as the information held by the directors or other senior officials of the company. Any sort of maneuverings of buyers and sellers will not impact prices, whatsoever. It is highly impossible to test this form of EMH even if acquirer has insider information. The only possibility available is to buy or sell the holdings before the information of takeover is published or leaked. So much so that creative accounting technique cannot influence the takeover bids under the strong form of EMH. Under this form current prices will reflect the present value of future cash flows. Any price exceeding the net value of assets based on market prices under strong form of EMH will entail goodwill value of the takeover deal. Evaluation of takeover bids under different version of EMH EMH theory was introduced in late sixties, and prior to that inefficiency was believed to exist in stock markets. Financial economists have claimed that no hypothesis has been so extensively tested as EMH in economics and finance deals. “In an efficient market, security prices behave as if they fully incorporate all existing information quickly and without bias. Market efficiency in EMH means that security prices reflect the aggregate impact of relevant information in an unbiased way and the adjustment to the new information is very rapid.”(L S Porwel, page 42)iv The EMH advocates that investors are rational and the new information immediately get reflected into stock prices. That way most investors or takeover bids cannot beat the market. But there is a behavior approach to this study as well that advocates that rationality play no role in takeover bids and investors are motivated by greed, fear, and other emotions. If EMH theory is to be believed then the fundamental mechanism of pricing does not seem to work. Weak form of EMH suggests that the movement of pricing takes into account the impacts of past movements of pricing and the historical information. Then why take overbids often result into failures under such circumstances when prices have been settled on basis of historical facts? Takeover failure itself is an event but that becomes history after the bid has failed. Logic says that after the failure of takeover bids the stock prices of entity to be taken over should not rise. But often the prices have increased after the termination announcement. A study undertaken by Alan J. Auerbach (1991, page 147)v states that “for all unsuccessful targets, market efficiency predicts zero abnormal returns following the termination announcement. Investigation could adopt a strategy of buying the shares on the day after the termination announcement and holding the shares for three years. Such an investment strategy should not, according to efficient market hypothesis, earn above average returns. But previous studies of post performance of takeovers do not uniformly support the efficient market hypothesis.” The semi strong form of EMH conveys that publicly available information gets quickly incorporated in the prices in such a manner that the acquirer cannot take advantage of it even after studying the relevant information. Under semi strong efficient market most of the abnormal returns will be earned before or on the day of announcement of takeover, as it will not be possible to use the news of takeover after the announcement of takeover. But practically this does not happen. According to Peter Howells and Keith Bain (p.581)vi several systematic tests undertaken in 1970s and 1980s found that in semi strong equity markets “the information was incorporated in prices so rapidly for investors to be able to make subsequent excess returns.” As stated earlier under strong form of EMH even the non public information reflects in current prices. In fact prices reflect all those information that can be acquired by researching the company details and records. The importance of strong form of EMH cannot be overstated but practically such a situation is difficult to assume. “In other words, one cannot assess whether a financial market fully and correctly reflects all relevant information in determining security prices without knowing what correctly and relevant mean.”(Marry O’Sullvan, page 170)vii That shows that strong form cannot be tested in its strict sense and price wise takeovers under such conditions are only auto market maneuverings. For testing strong form of EMH, the researchers analyzed the returns of certain groups like, insiders, specialist on stock exchanges, and mutual fund managers. They arrived at conclusions that corporate insiders and stock exchange specialists earn superior rate of return and that too after adjustments of risk factors. Takeovers under such form are based on gradual adjustments of stock prices. A study conducted by V.L.Bernard and J.K.Thomas (1989, pp 1-36)viii found that stock prices adjust gradually and not rapidly to the information of all sorts. Conclusion The efficient market hypothesis (EMH) emphasizes that arbitrage will rapidly eliminate any profit opportunity and drive market prices back to fair value. The efficient market hypothesis has three forms. Weak form reflects that prices efficiently reflect all the historical information in stock prices pattern. In this form it is difficult to earn superior returns simply by looking for patterns in stock prices. Prices will follow a random walk. The semi strong form states that prices reflect all published information. That means it is impossible to make superior takeover bids just by reading published information like newspapers, company’s annual accounts, and other information. The strong form of hypothesis states that stock prices effectively impound all available information. It tells us that superior information is hard to find because in pursuing it you are in competition with thousand, perhaps millions of active, intelligent, and greedy investors. The best you can do in this case is to assume that securities are fairly priced. This form is hard to find out and takeover bids face resistance from competitors. Takeover deals will be settled only at competitive prices, and this is far from practicalities. Word Count: 1753 References Read More