The market price per share of common stock varies from day to day and even it varies considerably in a single day’s transactions as buy and sell orders arise. For example, we can see that price of EBL stock varied in a range of Rs 58 (from the minimum Rs 2,324 to the maximum Rs 2,382) on the same trading day, Such variations in stock prices are observed due to the fact that not all investors in the stock market have equal access to market information. If all investors had all knowable information, the stock would have sold at a relatively fair price with negligible variations. The fair price of the stock is called the intrinsic value, which reflects all expected future cash flows and risks associated with the stock investment. The market price actually tends to 1 fluctuate around the intrinsic value as the buy and sell orders arise. The market price that balances buy and sell orders at any given point in time is called the equilibrium price. In an efficient stock market market, prices remain close to the intrinsic value and the market is said to be in equilibrium.
When stock markets are efficient, investors can be confident that they can get a fair price on buying and selling stocks. Conversely, in an inefficient market, investors feel reluctant to invest and therefore capital allocation becomes poor. Thus market efficiency is essentially a good phenomenon from an economic point of view.
Academics and scholars in financial markets have extensively studied stock market efficiency. Most of the earlier evidence related to stock market efficiency was based on the random walk hypothesis, which contended that changes in stock prices occurred randomly. In other words, common stock prices evolve randomly. They were as likely to increase as they were to decrease on any particular day regardless of past performance. Then, the essence of the argument that stock prices should follow a random walk is that price changes should be random and unpredictable. A large number of studies related to stock price behavior are based on this fact. The notion that stocks already reflect all available information is referred to as the efficient market hypothesis (EMH). Hence, an efficient stock market is one in which stock prices fully reflect all available information about the economy, about stock markets, and about the specific company involved. In other words, in an efficient stock market, stock prices adjust rapidly to the arrival of new information. The efficient markets hypothesis (EDIFI) has implications for investors and for firms – because the information is reflected in prices immediately, (that is, stocks are always in equilibrium), investors should only expect to obtain a normal rate of return. It is not possible for an investor to consistently beat the market. Firms should expect to receive fair value for securities that they offer to the public.
Forms of Market Efficiency and Stock Price Behavior
Eugene Fama, a pioneer in efficient market research, has described three forms, also called three levels, of market efficiency: weak-form efficiency, semi-strong form efficiency, and strong-form efficiency.
The weak-form of market efficiency assumes that all information contained in past price movements is fully reflected in current stock prices. Information contained in past price movement includes a historical sequence of prices, rate of return, trading volume data, and other market-generated information, such as odd-lot transactions, block trades, and transactions by exchange specialists. Therefore, this hypothesis implies that no investor can expect to earn an excess return based on an investment strategy using such historical information.
SEMI STRONG-FORM EFFICIENCY.
The semi-strong form of market efficiency assumes that stock price adjusts rapidly to the release of all public information; that is, the current prices fully reflect all public information. Public information includes market information such as historical stock price, rate of return, trading volume, etc., and non-market information such as earnings and dividend announcement, price-to-earning ratios, dividend yield, stock split, right offerings announcement, news about the economy, the political news, etc. This hypothesis implies that no investor can expect to earn excess returns based on an investment strategy using any publicly available information.
The strong form of market efficiency states that current market prices reflect all pertinent information, whether publicly available or privately held (information known only to insiders). This means that no individual or group of investors has monopolistic access to information relevant to the formation of prices. Therefore, this hypothesis contends that no group of investors (even insiders) should be able to consistently derive profit above the normal level.
To sum up, in an efficient stock market, stock prices reflect all publically available information so stocks are fairly priced. Thus, it is a waste of time for most investors to seek bargains by analyzing published data on stocks. In such a case, investors can win only with chance or inside information.