Finance Chapter 5 Inefficient Markets And Corporate Decisions Inefficient Markets And Corporate Decisions

Chapter 05 – Inefficient Markets and Corporate Decisions

CHAPTER 5

Inefficient Markets and Corporate Decisions

1. Judging whether a single stock was mispriced at some specific time relative to intrinsic

value, in light of subsequent events, is a difficult exercise. It is possible to argue that the

It is also possible to point to particular behavioral phenomena described in the chapter

that might have played a role in eBay’s subsequent stock performance. Three relevant

phenomena are:

turned out to have been reasonably accurate for the intermediate horizon but too high for the

terminal period. The short term performance of eBay’s stock for the period mentioned in the

Chapter 05 – Inefficient Markets and Corporate Decisions

The market price in April 2003, and especially its forward P/E ratio, suggested that

most of eBay’s value resided in its growth opportunities. In terms of fundamentals, growth

opportunities require that the expected return on equity exceed the required return on equity.

Yet, as was pointed out in Chapter 3, eBay’s historical return on equity was close to, or

2. Walker’s remark points to the question of how reasonable managers should make

decisions when prices are inefficient. The quotation in the question involves two errors by

“the market.” The first error is that in the year 2000, the market was overvaluing the stocks

of dot.com firms. In this respect, the market treated negative earnings as investments in

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3. Applying Main Street skills to Wall Street means that managers provide analysts with

internal forecasts of what the firm’s earnings are likely to be, and then deliver an actual

earnings stream that grows at a predictable rate. In others words, financial managers provide

analysts with reasonable earnings guidance about what to expect. Analysts who develop

4. Perhaps some investors were irrational. An investor who was willing to pay $110 a share

the day before the IPO could have registered to participate, and paid $85 instead of $100.

5. One of the pros of declining to offer guidance is that markets might not react as harshly to

earnings falling below analysts’ consensus forecast, as happens to firms who offer guidance.

One of the cons of declining to offer guidance are that analysts might be reluctant to

Chapter 05 – Inefficient Markets and Corporate Decisions

recommend the stock highly, because the lack of guidance makes them view the stock as

being more risky than comparable firms who do offer guidance.

6. All three phenomena apply. Palm went IPO in a hot issue market at the tail end of the

super bull market of the 1990s. It was initially underpriced, in that its opening price was over

7. At the close of its first day of trading, Palm was worth $53.4 billion, more than 3Com’s

value of $28 billion. And 3Com still held 94 percent of Palm. Therefore, 3Com should have

been worth 94 percent the value of Palm plus the value of its non-Palm businesses.

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sophisticated investors from borrowing Palm shares in order to short them. There were too

few shares traded, and finding shares to borrow was nearly impossible.

8. Sagawa appears to have relied on a combination of familiarity bias (stemming from

availability) and representativeness to judge Palm’s stock, after he purchased a Palm for his

Chapter 05 – Inefficient Markets and Corporate Decisions

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Minicase

Case Analysis Questions

1. In 2010, Google offered to pay $5.7 billion for Groupon. The next best alternative for

Groupon’s board was to maintain control of the firm and take it public through an IPO.

Doing so would require estimating its market value, based on its past sales growth and

information in their possession about its growth opportunities. Indeed, in less than a year the

firm’s sales went from $25 million per month to more than $400 million per month.

On the face of it, Groupon’s board made the right decision. At the same time, given

the evidence about long-term underperformance of IPOs, the board might also have

considered the degree to which the firm’s shares were overvalued at the time of the IPO, and

if so how long it would take for the market value of those shares to revert to intrinsic value.

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2. Transaction utility is generated when a consumer derives psychological benefit from

believing that they acquired an item at a bargain price. Groupon’s product is centered on

3. All three IPOs took place in hot issue markets. In fact, Groupon’s IPO took place just after

LinkedIn’s IPO.

The IPOs of Groupon and Twitter displayed initial underperformance, but not the IPO

of Facebook. Groupon’s IPO took place on November 4, 2011, at an offer price of $20 per

share, in which the company sold 5 percent of its shares. During its first trading day, the

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4. Groupon engaged in catering behavior by timing its IPO to coincide with very rapid sales

growth, perhaps relying on investors succumbing to hot hand fallacy. Although its reported

earnings were negative, it also engaged in accounting practices that overstated earnings, an

activity which also qualifies as catering. Twitter’s GAAP earnings and free cash flow were

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on November 4, 2011. On May 18, 2012 Facebook had its IPO. Twitter’s IPO took place on

November 7, 2013. These IPOs occurred at least two and a half years after the stock market

had bottomed during the global financial crisis, when the S&P 500 fell to 683. In November,

2011, the S&P had almost doubled in value to 1253, increased to 1353 in May 2012, and to

1804 in November 2013.

5. The chapter states that when sentiment rises, investors increase the riskiness of their

portfolios by holding a higher proportion of stocks and by shifting into more speculative

stocks. The primary example of a speculative stock is a company that is young, currently

unprofitable but potentially very profitable, has no earnings history and a highly uncertain

future. Twitter qualifies on all counts. Speculative stocks are difficult to value, likely to

Conversely, when investors are excessively pessimistic, stocks with high and positive

sentiment betas tend to be undervalued, leading their subsequent returns to be superior.

Chapter 05 – Inefficient Markets and Corporate Decisions

Evidence provided by Baker and Wurgler indicates that subsequent abnormal returns