Robert Alan Hill
The 2007 global financial crisis ignited by reckless bankers and their flawed reward structures will be felt for years to come. Emerging from the wreckage, however, is renewed support for the over-arching objective of traditional finance theory, namely the long-run maximization of shareholder wealth using the current market value of ordinary shares (common stock) as a benchmark.
If capitalism is to survive, it is now widely agreed that conflicting managerial aims and short-term incentives, which now seem to characterize every business sector, must become entirely subordinate to the preservation of ownership wealth, future income and capital gains.
And as we shall discover, the key to resolving this principle-agency problem begins with a theoretical critique of how shares are valued. This not only underpins the practical measures of current and historical stock market performance published in the financial press (price, yield, cover, and the P/E ratio) used by market participants throughout the world. It also provides private individuals and the companies or financial institutions acting on their behalf with a common framework to analyze all their future investment decisions, whether it is an individual share transaction, a market placement, or corporate takeover activity.
Some Observations on Traditional Finance Theory
Based on the Separation Theorem of Irving Fisher (1930), traditional normative theory explains how corporate management should maximize shareholder wealth by maximizing the expected net present value (NPV) of all a firm’s investment projects.
According to Fisher, in a world of perfect capital markets, characterized by rational-risk averse investors, with no barriers to trade and a free flow of information, it is also irrelevant whether a company’s future project cash flows are distributed as dividends to match shareholders consumption preferences at any point in time. If a company decides to retain profits for reinvestment, shareholder wealth measured by share price will not fall, providing that….
Some Observations on Stock Market Volatility
Over the past decade, global capital markets have experienced one of the most volatile periods in their entire history.
For example, since the millennium, the index of Britain’s highest valued companies, the FT-SE 100 (Footsie) has often moved up and down by more than 100 points in a single day, fuelled by the extreme price fluctuations of risky internet or technology shares, the changing profitability of blue-chip companies at the expense of emerging markets, rising oil and commodity prices, interest rates, global financial crises, increased geo-political instability, military conflict, natural disasters and even nuclear fallout. Consequently, conventional methods of assessing stock market performance, premised on efficiency and stability, as well as the models upon which they are based, are now being seriously questioned by a new generation of academics and professional analysts….