5.3 Theories on valuation of financial assets; fundamental theory, technical theory, random walk theory and the efficient market hypothesis

Theories on the valuation of financial assets provide different perspectives on how to determine the value of these assets. Here are explanations of some key theories:

1. Fundamental Theory: The fundamental theory of valuation focuses on assessing the intrinsic value of a financial asset based on its underlying fundamentals. This approach involves analyzing factors such as cash flows, earnings, growth prospects, risk, and other fundamental indicators to estimate the true worth of an asset. Fundamental analysis aims to identify assets that are undervalued or overvalued relative to their intrinsic value, allowing investors to make informed investment decisions.
2. Technical Theory: The technical theory of valuation, also known as technical analysis, takes a different approach by examining historical price patterns and market data to predict future price movements. Technical analysts believe that the market’s historical trading patterns and trends can provide insights into future price behavior. Techniques such as chart patterns, trends, and indicators are used to identify buying or selling signals. Technical analysis assumes that market participants’ behavior and emotions are reflected in the price and volume patterns, which can be used to anticipate future price movements.
3. Random Walk Theory: The random walk theory suggests that future price movements of financial assets are random and unpredictable. According to this theory, asset prices reflect all available information, and future price changes cannot be reliably predicted based on past prices or patterns. The random walk theory implies that it is not possible to consistently outperform the market by using historical price data or patterns.
4. Efficient Market Hypothesis (EMH): The efficient market hypothesis states that financial markets are efficient in reflecting all available information. It asserts that asset prices quickly and accurately incorporate any new information, making it difficult for investors to consistently achieve above-average returns by trading based on public information. The EMH has three forms: weak form efficiency, which suggests that past price and trading data cannot be used to predict future prices; semi-strong form efficiency, which posits that asset prices reflect all publicly available information; and strong form efficiency, which contends that asset prices reflect all information, including both public and private information.

These theories provide different perspectives on how to approach the valuation of financial assets. While fundamental analysis focuses on the intrinsic value of assets, technical analysis relies on historical price patterns. The random walk theory suggests that price movements are unpredictable, and the efficient market hypothesis implies that asset prices reflect all available information. Investors and analysts may employ a combination of these theories or adopt their preferred approach based on their investment philosophy and objectives.