ACCA Applied Skills · Financial Management

Efficient market hypothesis (EMH) and practical considerations in the valuation of shares: formula sheet

Full chapter guide

Key formulas

Weak form: Price reflects: past prices and trading data; Technical (chart) analysis cannot give abnormal returns. Fundamental analysis and insider information still might.
Semi-strong form: Price reflects: past data + all public information; Technical and fundamental analysis cannot give abnormal returns. Insider information still might.
Strong form: Price reflects: past data + public + private information; No one can consistently earn abnormal returns, not even insiders.
Abnormal return: Abnormal return = actual return − expected (required) return; An efficient market gives no consistent positive abnormal return from information already in the price.
Order of forms: Weak ⊂ Semi-strong ⊂ Strong; Each form includes all information of the weaker form. Strong form efficiency implies the other two.
Abnormal return: Abnormal return = Actual return − Expected return; Expected return is usually based on the market return and the share's beta. Used in event studies.
Weak form: Prices reflect all past price and trading information; If true, technical analysis cannot give consistent abnormal returns.
Semi-strong form: Prices reflect all publicly available information; If true, fundamental analysis of public data cannot give consistent abnormal returns.
Strong form: Prices reflect all information, public and private; If true, even insiders cannot make abnormal gains. Evidence generally rejects this.
Weak form efficiency: Price reflects all past price and trading data; Technical (chart) analysis cannot give consistent excess returns. Fundamental analysis and insider information still could.
Semi-strong form efficiency: Price reflects all publicly available information; Fundamental analysis of published data cannot give consistent excess returns. Insiders could still gain.
Strong form efficiency: Price reflects all information, public and private; No one, including insiders, could make consistent excess returns. Few believe it holds in practice.
Value created by a project: Change in shareholder wealth = NPV of project (in an efficient market); Wealth comes from positive NPV decisions, not from timing or accounting presentation.
Intrinsic value versus market price: Over/undervaluation = Market price − Model value; Positive means the market price is above your model value (apparently overvalued). Negative means apparently undervalued. It only holds if the model inputs are reliable.
Dividend valuation model (constant growth): P₀ = D₀ × (1 + g) ÷ (Ke − g); Valid only if Ke > g and growth is constant. Very sensitive to g, a key limitation.
P/E valuation: Value per share = EPS × P/E ratio; The P/E must come from a comparable company. Unquoted firms usually get a discounted P/E because of lower marketability.
Earnings yield: Earnings yield = EPS ÷ Share price × 100%; The inverse of the P/E ratio.

Quick revision

EMH: share prices reflect available information and adjust quickly to new information.
Weak form: prices reflect all past price information, so charts cannot give consistent excess returns.
Semi-strong form: prices reflect all public information, so fundamental analysis of public data cannot beat the market.
Strong form: prices reflect all information, public and private, so even insiders cannot gain.
Each stronger form includes the information of the weaker forms.
Insider trading gains would contradict the strong form.
Market anomalies and bubbles are used as evidence against efficiency.
In an efficient market, managers cannot fool investors with cosmetic accounting changes.
A rational price reacts when new information arrives, not when the event later happens.
Models give estimates; thin trading, poor information and sentiment can cause price and value to differ.
Valuation inputs such as growth and cost of equity are estimates, so outputs are ranges, not facts.
In objective tests, read the scenario for which information is used before choosing the form.

Common mistakes

Saying weak form means the market is inefficient or prices are wrong. Fix: Weak form is the lowest level of efficiency. Prices still reflect past price data. It just does not claim to reflect public or private information.
Thinking semi-strong form means only half of public information is reflected. Fix: Semi-strong reflects all public information. The gap from strong form is private information.
Saying anomalies prove the market is inefficient. Fix: Say anomalies challenge the EMH, but may reflect risk, costs or chance, and may disappear once widely known.
Linking event studies to weak form. Fix: Event studies test reaction to public news, so they test semi-strong form.
Saying managers can raise the share price by changing accounting policies. Fix: State that in a semi-strong market, investors look at the full disclosures and cash flows, so cosmetic changes do not add value.
Confusing weak and semi-strong forms. Fix: Link weak form to past prices only and semi-strong to all public information. Weak form is the least demanding.
Saying the market price is always right and the model is always wrong, or the reverse. Fix: Say both are estimates. The market reflects what buyers and sellers agree now, and the model reflects stated assumptions.
Listing generic points that ignore the scenario. Fix: Tie each point to a fact in the question, such as an unquoted company, a small stake or an uncertain growth rate.

Exam tips

Link each form to one kind of analysis: weak with charts, semi-strong with published information, strong with insiders. Examiners test this link often.
In written answers, say forms are cumulative and give an example of information for each form.
Always say whether information is a surprise. An expected announcement gives no price move.
In short objective cases, a scenario about a director trading or unpublished news points to strong form.
If asked about implications for managers, discuss the points in the scenario rather than a memorised list.
Always state which form of the EMH the evidence relates to. This is often the key mark.
In discussion questions, give evidence for and against, then a conclusion. A one-sided answer loses marks.
Know three or four anomalies by name, and one counter-argument for each.