Dr Shamol Miah

In a takeover situation, if a company wants to take over another company, it normally has to acquire at least 50 percent of the shares. The company can make a formal offer to the remaining shareholders if they acquire 30 percent of the shares. In takeover situations, share prices change very rapidly (Oxborrow and Winnifrith, 1998). In an efficient market, it is not possible to develop trading rules that can beat the market, as systematic undervaluing and overvaluing of shares do not occur (Arnold, 2008). According to the efficient market hypothesis (EMH), if any new information is released about a company, it is incorporated into the share price rapidly and rationally with respect to share price movement and the size of that movement. There is a well-known story that is used in an efficient market: A lecturer is walking along a busy corridor with a student on his way to a lecture on the efficient market hypothesis. The student notices a £20 note lying on the floor and stops to pick it up. The lecturer stops him, saying, ‘If it were really there, someone would have picked it up by now.’

Similarly, Jones and Netter (1993) state that as soon as any information is revealed about a firm in the expected direction, stock market prices react very quickly. The market often anticipates and reacts to news before it is officially made available. For example, on the day of a bidding announcement (19th of May), AstraZeneca’s share price falls by 13% because the market has already incorporated expectations about restructuring into its price. They also state that today’s markets are more efficient than in the past due to technological innovation, which makes information available in the share market at low cost.

Mergers occur more frequently when bidders approach are overvalued towards bidding (Shleifer and Vishny, 2003). On the other hand, Rosen (2006) suggests that merger decisions can be affected if the market reaction to a merger announcement is not based on fundamentals. Mergers are based on the initial market reaction to the merger announcement (Asquith, Bruner, and Mullins, 1983). Manager’s motivation is also involved in takeover situations, as stated in the managerial motivation theory, rational shareholders react very quickly when new information is released in a merger announcement (Gorton, Kahl, Matthias, and Rosen, 2009).

Capital market efficiency observes how available information is assimilated into security prices and also observes how much, how fast, and how accurately that information is incorporated. Fama also suggests that stock prices reflect when past prices, public information, and private information are available. Jones and Netter (1993) state that the efficient market hypothesis is divided into three stages: the weak form, semi-strong form, and the strong form, based on the availability of information.

Capital market efficiency observes how available information is assimilated into security prices and also observes how much, how fast, and how accurately that information is incorporated (Fama, 1991). Fama also suggests that stock prices reflect when past prices, public information, and private information are available. EMH is divided into three stages: the weak form, semi-strong form, and the strong form based on the availability of information.

Weak-form efficiency exists if security prices fully reflect all the information contained in the history of past prices and returns. The return is the profit on the security calculated as a percentage of an initial price. If capital markets are weak-form efficient, then investors cannot earn excess profits from trading rules based on past prices or returns. Therefore, stock returns are not predictable (Jones and Netter, 1993).

Under semi-strong form efficiency, security prices fully reflect all public information. Thus, only traders with access to non-public information, such as some corporate insiders, can earn excess profits. Under weak-form efficiency, some public information about fundamentals may not yet be reflected in prices. Thus, a superior analyst can profit from trading on the discovery of, or a better interpretation of, public information. Under semi-strong form efficiency, the market reacts quickly to the release of new information so that there are no profitable trading opportunities based on public information (Jones and Netter, 1993). However, in semi-strong efficiency markets, inside traders can make superior profits (Dixon and Holmes, 1992).

Finally, under strong-form efficiency, all information, even apparent company secrets, is incorporated in security prices. Thus, no investor can earn excess profit trading on public or non-public information. Even inside traders, technical and fundamental analysts cannot beat the market to make abnormal returns (Brealey, Myers, and Marcus, 1999).

According to the efficient market theory, it is impossible to predict the future path of security prices using the available information on the market. The random walk theory suggests that security price changes are independent and do not follow past movements or past stock price changes. More specifically, tomorrow’s price can change tomorrow and cannot be predicted today (Rutterford,1993). Thaler (1999) argues that it may be possible to predict future prices by utilizing dividend yields, price-earnings ratios, earning announcements, etc. However, there would be an abnormal return if the reaction is delayed for the first time to the earning announcement (Ball and Brown, 1968). Watson and Head (2013) recommend that anomalies in the behavior of share prices cannot be ignored, as they could be the causes of abnormal returns. The potential effect of anomalies should also be considered, as their influences might be long on the movements of share prices in a takeover condition.

In summary, there is a lot of research available that suggests stock markets react very quickly as soon as new information is revealed. As the market incorporates information excessively and reacts rapidly, it becomes very difficult to value stock prices. We must consider these problems more seriously to face new information and future challenges.

References

Asquith, P., Bruner R.F, & Mullins JR, D.W. (1983). The Gains to Bidding Firms from Mergers, Journal of Financial Economics, 11(1), 121-139.

Arnold, G ., 2008. Corporate Financial Management (4^th ed.). Harlow: Pearson Education Ltd.

Ball, R.; Brown, P. (1968). An Empirical Evaluation of Accounting Income Numbers. Journal of  Accounting Research,  6(2), 159-178.

Bealey, R.A., Myers, S.C, & Marcus, A.J.( 1999). Fundamental corporate Finance (2^nd ed.).London: McGraw- Hill.

Dixon, R, & Holmes. (1992). Financial Market: An Introduction.London: Chapman Hall.

Fama, E. (1991). Efficient Capital Market II. Journal of Finance, 46(5), 1775-1617.

Gorton, Gary B. and Kahl, Matthias and Rosen, Richard J. (2009). Eat or Be Eaten: A Theory of   Mergers and Mergers  Waves. Available at SSRN: http://ssrn.com/abstract=713769 or        http://dx.doi.org/10.2139/ssrn.713769

Oxborrow, J, & Winnifrith, T.(1998). The What Investment a-z Guide to the Stock Exchange. London: B T Batsford Ltd.

Rhodes-Kropf, M.; Robinson, D.T, & S. Vishanathan, S. (2005). Valuation Waves and Merger Activity: The Empirical Evidence. Journal of Financial Economics, 77(3), 561-603.

Rosen, R.J. (2006). Merger Momentum and Investor Sentiment: the Stock Market Reaction to  Merger Announcements. Journal of Business, 79(2), 987-1071.

Rutterford, J. (1993). Introduction to stock Exchange Investment (2^nd .). Hampshire: Palgrave.

Shleifer, A. and Vishny, R.W., (2003). Stock Market Driven Acquisitions. Journal of Financial  Economics, 70(3), 295-311.

Thaler, R. (1999). The End of Behavioural Finance. Financial Analysts Journal, 55(6), 12-17.

Watson, D., Head, A. (2013). Corporate Finance: Principles and Practice (6^th ed.). Edinburgh Gate: Pearson Education Ltd.