Valuation: Measuring and Managing the Value of Companies, Fifth Edition

18

Investors and Managers in Efficient Markets

The evidence presented in Chapter 15 demonstrated that stock markets are efficient, in the sense that share prices typically reflect the economic fundamentals of the companies whose shares are traded on those markets.²⁷⁰ In this chapter, we explain how markets manage to generate efficient prices even though not all investors act rationally, as Chapter 17 explored. It is the interaction between investors with different strategies—some rational, some not—that can result in the observable market pattern of volatile prices that are still generally in line with intrinsic values.

We use a straightforward model to illustrate how market trading by both rational and irrational investors will produce markets that are both generally efficient and volatile. Empirical research using a new investor classification confirms that real investors do indeed fall into rational and less rational categories, but the more rational type—those who are well informed and focused on companies’ economic fundamentals—are the ones who ultimately set market prices.

The implications of market efficiency for managers are clear.

• Managers should focus on driving return on invested capital (ROIC) and growth to create maximum value for shareholders, because ultimately stock market values are driven by those fundamental measures, too. As Chapter 16 demonstrates, market efficiency means there is no point in managers pursuing quarterly earnings growth or making share repurchases ...