Stock Market Efficiency

There are three types of stock market efficiency, these are said to be; operational, allocational and pricing.

Operational efficiency relates to the speed, cost and reliability of transactions on the exchange. The market tries to carry out its operations as quick, reliably and as cheaply as possible. In order to do this competition is created between brokers so they can earn only normal profits not excessively high profits.

Allocational efficiency - Firms with the greatest potential to investment funds need a method to channel their funds their way. Stock markets help in allocating resources between competing investments. For example, an efficient market provides vast funds for the growth of the electronics, pharmaceuticals and biotechnology industries but allocates only small amounts to slow growth industries.

Pricing efficiency - the investor can expect to earn merely a risk adjusted return from an investment as prices move instantaneously in an unbiased manner.

In order to see how efficient the market is, there are three different forms of efficiency (Arnold, 2008)

1. Weak form efficiency - This is where the share price reflects all the PAST information, and therefore this past information reflects the price today.

2. Semi-strong form efficency - This focuses on the question of whether it is worthwhile acquiring and analysing publicly available information. This form of efficiency reflects all historic and publicly available information whilst being able to react quickly and rationally to new information

 

3. Strong form efficiency - where the share price reflects all known information, whether that be publicly available or not. This type of efficiency would however suggest that everyone knows everything about the company at any one time, which cannot be the case, as businesses regularly make company announcements that were unexpected to the shareholders and at the same time information can be leaked and cause controversy amongst shareholders as it was not news they were expecting.

On the other hand, stock markets can surprise investors and shareholders regularly which is why they are deemed to be unpredictable and why companies and investors lose and gain vast amount of profits.

This in turn leads on to Kendal (1953) and his Random Walks theory, whereby price changes are completely random based on all information that is known by the shareholders at the time of change, and changes in turn occur when new information enters the market. This thoery seems to me the most reasonable thoery because of the unpredictability of the market and how the shareholders will react.

Raising company capital - Equity vs. Debt

In order for a company to keep expanding it is vitally important for them to raise capital especially in the ever changing competitive business environment. There are two main ways of raising capital for a company and they are either debt or equity. However, it is possible to have a combination of the both in some circumstances.

Equity is where companies issue shares through a number of ways such as ordinary shares, preference shares or deferred ordinary shares. This is a way of attracting shareholders in a goal to get them to invest. Shareholders in turn will consider the rate of return that the company is offering compared to other investments with an equal amount of risk. One advantage of using equity as a source of capital is that the company are not required to pay back the full amount invested or pay back dividends. On the other hand, shareholder activism could result in a loss of shareholders if the return is not satisfactory to the shareholders. Even though the company are under no obligation to return the payment through dividends, in order to satisfy the shareholders it is necessary to compensate them with the satisfactory return.

The Dividend Policy must be considered if equity is being used as a means of raising capital. As discussed in a previous blog, shareholder wealth will be maximised if profits are treated in a certain way to benefit the shareholder, which can only be an advantage to the company. Miller and Modigilani (1958), state that companies must take into account what they issue in the form of dividend which may impact their share price on the stock market, and even more so the impact this change in share price may have on future investors. The Clientele Effect is a result of this because where the share price of a company can move in reaction to a change in policy, in this instance it would be a dividend change, and therefore the use of raising capital through Equity would require constant examination of the company, in relation to shareholder wealth maximisation.

The cost of satisfying these shareholders can be high and can result in a business losing control however maximising shareholder wealth and gaining shareholder funds is a good way to enhance profit and the business, which links to the agency theory problem and managerialism. However, holding managers accountable for their actions can only benefit a company, for example BP have been recently held accountable to their shareholders, through the legal system, due to two oil spillages that occurred in 2006. The voice of the shareholders here is vital to hold the necessary people responsible for their actions that have impacted not only the company and its stakeholders but many others, increasing a company’s awareness of its corporate social responsibility.

Another way to raise capital is by the use debt. In this case lenders have no official control over the business and are unable to vote at meetings which mean they cannot choose the directors or make major strategic decisions. Usually companies cannot last on the stock market at such an early stage in their life but with the funding of debt they can benefit greatly on the stock exchange. Debt has a much lower cost than equity, but still requires repayments to the investor, with interest included as part of the repayment, and these repayments will be required regardless of how the business has performed during the year. Businesses can also use their secured assets to finance their debt, which can cause complications if the business were unable to sustain the repayments on their loans and may even result in losing the business entirely.

Both equity and debt have their advantages and disadvantages in relation to raising capital, however if a business were to use a mixture of both they would not only benefit from increased business exposure and accountability, but will also be able to use finance and repay it without having to worry about a lifelong connection to their investor.


Miller, M. H. & Modigliani, F. (1958). Dividend policy, growth, and the valuation of shares. The Journal Of Business, 34 (4), pp. 411--433.

Stock Markets: The company risk of listing

Stock markets are where the government and the industries businesses can raise long term capital and investors can buy and sell securities. To be listed on the stock market is vital for any business who intends to grow and provide funds for the business and increase the status of the company.

Not only does it help the business continue with its growth, it also makes the business accountable to its stakeholders, thus helping society through systems such as Corporate Social Responsibility (CSR); whilst also allowing benefits to its employees through share reward schemes. Which in turn even makes it easier for shareholders to move between companies if they are unhappy with the business. Listing on the stock market offers liquidity to the investor while encouraging flow of funds to firms.

Such companies like Toyota aimed to enlist its shares on the London and New York stock exchange in order to attract international investors, while meeting the needs of the increasingly global industry and increasing their image. Another reason to enlist globally is to be able to judge whether the company can meet global standards. An example of a company who is enlisted on the London Stock Exchange but their headquarters are in Mexico is Fresnillo. Fresnillo is the world's largest producer of silver from ore (primary silver) and Mexico's second-largest gold miner. The first Mexican firm to have its primary listing on the LSE, they are a constituent of the FTSE 100. The reason they are enlisted on the LSE is because of better liquidity and corporate governance.

However, listing on the stock exchange isn't always great for businesses. As the stock market and share prices are influenced a great deal by the news, share prices are subject to volatile changes if the shareholders are not happy.

Word of mouth can affect the stock market and share price, even if shareholders are happy that the company are making profits and improving, looming talks of the company being unable to keep up with expansion will set back the share price.

The stock market is therefore not always a great place for businesses to be, despite its many advantages to the company, we can see through Twitter that increasing profits are not always enough to satisfy the shareholders and in turn keep the share price level.

Profit maximisation vs Shareholder wealth maximisation

Profit maximisation refers to how much profit the company makes. It is a short term approach as the business is mostly concerned with short term benefits. But short term it can fulfill the objective of earning profit but may not help in creating wealth. Wealth creation needs to be longer term; therefore financial management emphasises on wealth maximisation rather than profit maximisation. Profit maximisation can be expressed in such a way that it depends on relative prices only. However, the choice of such an objective function need not be in the interest of the shareholders. This problem is overcome by relating the profits of a firm to the expenditure of its shareholders. Profit maximisation also has the disadvantages of being unable to predict future prospects and can be subject to risk, as accounting only goes on a periodic basis may cause accounting problems.

Therefore, to reduce the risk of this managerialism and the problems caused by profit maximisation, companies need to seek a value creating goal; such as a shareholder value maximisation. Maximising wealth can be defined as maximising purchasing power. Owners pay shareholders dividends which is the main reason why shareholders indulge in purchasing a part of that company. Shareholders are interested in the flow of dividends over a long time period and not necessarily a quick payback.

Maximisation of shareholders' real wealth is the main objective of a firm. This concept is based on profits and on shareholders' expenditures. Moreover, it depends on relative prices only rather than on arbitrary price normalisations.

Shareholders won't be the only ones to benefit from this type of value creation, stakeholders such as debtors and employees will also benefit from the increased value. By maximising the flow of discounted cash, all the stakeholders will be satisfied, and finally the shareholders will be satisfied, creating a domino effect that helps all aspects of the businesses interests. This system of value creation is also better for society, as the business will become more accountable for its actions based upon their shareholders and stakeholders.

There are many reasons why accounting profit may not be a good proxy for shareholder wealth such as:

· Prospects – One firm may fail to reflect the relative potential of the two firms.

· Risk – Greater variability means years of losses and possibly bankruptcy.

· Accounting problems – Mistakes by the accountant may be made.

· Communication – shareholders need to know as much as they can about the firm before investing so communication between them and the firm is crucial.

· Additional capital – profits can be increased by making use of more shareholders’ money.  

Profit maximisation and wealth maximisation are not two mutually exclusive events. In fact, profit maximisation can lead to wealth maximisation ultimately. The point is whether a firm should stop at short term target of profit making or long term target of sustained profit, which may ultimately lead to wealth maximisation. 

Jensen and Meckling 1976, focus almost entirely on the positive aspects of the theory as they see how to structure the contractual relation between the principal and agent to provide appropriate incentives for the agent to make choices which will maximize the principal’s welfare, given that uncertainty and imperfect monitoring exist.

However, Jensen and Meckling 2010 further go on to say they do not know whether or not firms are committed to 'maximizing shareholder wealth.' They believe it is 'puzzling,' however, state that the agent does not at least state the intention of benefiting the alleged principal.

Conclusively, I believe the advantages to shareholder wealth maximisation outweigh those of profit maximisation