Market Efficiency & Valuation

• Topic 01

  Market Efficiency & Valuation

  90 questions

A few questions from this unit, with the answer and a full explanation. The complete bank is available when you start practising.

1. In the context of the Efficient Market Hypothesis, what does the widespread use of technical analysis tools like moving averages imply?

   • A
     In a weak-form efficient market, technical analysis should not generate consistent abnormal returns because past price information is already reflected in current prices; however, markets may not be perfectly efficient, and momentum effects provide some empirical support
     Correct answer
   • B
     Technical analysis is inconsistent with all forms of EMH; any analyst using moving averages accepts that markets are completely inefficient
   • C
     Widespread use of technical analysis confirms that markets are strong-form efficient, because all technical patterns must be publicly known
   • D
     Moving averages confirm semi-strong efficiency because they are based on publicly available price data that is fully and instantly reflected in prices
   Explanation

   Weak-form EMH holds that all past price and volume data is reflected in current prices, implying technical analysis cannot generate consistent alpha. However, empirical evidence for the momentum anomaly (Jegadeesh and Titman) shows that past winners tend to continue outperforming in the short term, which is inconsistent with weak-form efficiency. Many practitioners use technical analysis as one input alongside fundamentals. The majority of academic evidence suggests technical analysis alone does not consistently outperform after transaction costs, consistent with approximate weak-form efficiency.

2. What are the three forms of the Efficient Market Hypothesis (EMH)?

   • A
     Price efficiency, information efficiency, and allocational efficiency
   • B
     Weak form, semi-strong form, and strong form
     Correct answer
   • C
     Narrow form, broad form, and complete form
   • D
     Passive form, active form, and absolute form
   Explanation

   The Efficient Market Hypothesis (EMH), formalised by Eugene Fama (1970), has three forms: (1) Weak form — prices reflect all past price and volume data; (2) Semi-strong form — prices reflect all publicly available information; (3) Strong form — prices reflect all information including private/insider information. Each form has different implications for the usefulness of technical analysis, fundamental analysis, and insider trading as strategies for generating abnormal returns.

3. A firm has free cash flow to the firm of £50m, a WACC of 9%, and net debt of £200m. The firm also has £150m of FCFE, and its cost of equity is 12%. Assuming constant perpetual growth of 3%, calculate the equity value using the FCFF/WACC approach.

   • A
     Equity Value = 150m ÷ (0.09 − 0.03) = £2,500m (using FCFE and WACC)
   • B
     Enterprise Value = 50m ÷ (0.09 − 0.03) = £833m; Equity Value = £833m − £200m = £633m
     Correct answer
   • C
     Enterprise Value = 50m ÷ (0.12 − 0.03) = £556m; Equity Value = £356m
   • D
     Enterprise Value = 50m ÷ 0.09 = £556m; Equity Value = £556m − £200m = £356m
   Explanation

   FCFF approach: EV = FCFF ÷ (WACC − g) = 50m ÷ (0.09 − 0.03) = 50m ÷ 0.06 = £833m. Equity Value = EV − Net Debt = £833m − £200m = £633m. The FCFE approach would give: £150m ÷ (0.12 − 0.03) = £150m ÷ 0.09 = £1,667m directly as equity value. If both approaches are correctly applied, they should yield the same result; the discrepancy here suggests the FCFE and FCFF figures are inconsistent as given. The key is never to mix WACC with FCFE or cost of equity with FCFF.