Role of financial statement analysis in an efficient capital market

ADS

Role of Financial Statement Analysis inan Efficient Capital Market 

Security prices represent the aggregate information known by the capital markets about a firm. Market efficiency describes the degree to which the capital market impounds information into security prices. The larger the set of information that is priced and the

greater the speed with which security prices reflect new information, the higher the degree of market efficiency. A highly efficient capital market would impound all publicly available value-relevant information (such as an announcement of surprisingly good or poor earnings in a particular period) quickly, completely, and without bias into share prices. In a less efficient market, share prices would react more slowly to value-relevant information. In the U.S. capital markets, the performance of large firms tends to have a wide following of buy-side and sell-side analysts, many institutional investors, and the financial press. The market is more efficient in adjusting the share prices of these large firms than those of smaller market firms, which have no analyst following, no institutional investors, and rare press coverage.

There are differing views as to the benefits of analyzing a set of financial statements in the context of market efficiency. One view is that stock market prices react with such a high degree of efficiency to published information about a firm that analysts and investors have more difficulty finding ‘‘undervalued’’ or ‘‘overvalued’’ securities by analyzing financial statements because the capital market quickly impounds new financial statement information into security prices. However, consider the following:

•  For markets to be efficient, analysts and investors must actually perform the analysis to bring about the appropriate prices. With their expertise and access to information about firms, financial analysts do the analysis quickly and engage in the trading necessary to achieve efficient pricing. They are agents of market efficiency.
•  Research on capital market efficiency aggregates financial data for individual firms and studies the average reaction of the market to earnings and other financial statement information. A finding that the market is efficient on average does not preclude temporary mispricing of individual firms’ shares
•  Research has shown that equity markets are not perfectly efficient. Anomalies include the tendency for market prices to adjust with a lag to new earnings information, systematic underreaction to the information contained in earnings announcements, and the ability to use a combination of financial ratios to detect under- and overpriced securities.
• Management has incentives related to job security and compensation to report as favorable a picture as possible in the financial statements within the constraints of U.S. GAAP. Therefore, these reports may represent biased indicators of the economic performance and financial position of firms. Analysts must analyze and adjust these financial statements to remove such biases if market prices are to reflect underlying economic values.

Financial statement analysis is valuable in numerous settings outside equity capital markets, including credit analysis by a bank to support corporate lending, competitor analysis to identify competitive advantages, and merger and acquisition analysis to identify buyout candidates

ADS