Ultimately, it represents an attempt to determine the present discounted value of all the pay- ments a stockholder will receive from each share of stock. If that value exceeds the stock price, the fundamental analyst would recommend purchasing the stock.

Fundamental analysts usually start with a study of past earnings and an examination of company balance sheets. They supplement this analysis with further detailed economic analysis, ordinarily including an evaluation of the quality of the firms management, the firms standing within its industry, and the prospects for the industry as a whole. The hope is to attain insight into future performance of the firm that is not yet recognized by the rest of the market. Chapters 17 through 19 provide a detailed discussion of the types of analy- ses that underlie fundamental analysis.

Once again, the efficient market hypothesis predicts that most fundamental analysis also is doomed to failure. If the analyst relies on publicly available earnings and industry infor- mation, his or her evaluation of the firms prospects is not likely to be significantly more accurate than those of rival analysts. There are many well-informed, well-financed firms conducting such market research, and in the face of such competition it will be difficult to uncover data not also available to other analysts. Only analysts with a unique insight will be rewarded.

Fundamental analysis is much more difficult than merely identifying well-run firms with good prospects. Discovery of good firms does an investor no good in and of itself if the rest of the market also knows those firms are good. If the knowledge is already public, the investor will be forced to pay a high price for those firms and will not realize a superior rate of return.

III. Equilibrium In Capital

Markets

12. Market Efficiency The McGraw−Hill

Companies, 2001

CHAPTER 12 Market Efficiency 349

The trick is not to identify firms that are good, but to find firms that are better than everyone elses estimate. Similarly, poorly run firms can be great bargains if they are not quite as bad as their stock prices suggest.

This is why fundamental analysis is difficult. It is not enough to do a good analysis of a firm; you can make money only if your analysis is better than that of your competitors be- cause the market price will already reflect all commonly available information.

Active versus Passive Portfolio Management

By now it is apparent that casual efforts to pick stocks are not likely to pay off. Competi- tion among investors ensures that any easily implemented stock evaluation technique will