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I am confused by the relation between stocks market prices and fundamental (or intrinsic) values stated by Efficient Market Hypothesis. How these deviates regarding to efficient market theory or are these the same according to EMH?

Why I am asking this is because among the literature, there can be found two kind of statements.

This is the very general statement that can be found from here and there:

Investopedia: This principle is called the Efficient Market Hypothesis (EMH), which asserts that the market is able to correctly price securities in a timely manner based on the latest information available. Based on this principle, there are no undervalued stocks to be had, since every stock is always trading at a price equal to its intrinsic value **.

The another one what can be found from academic literature and books, states:

Fama (1965) In other words, in an efficient market at any point in time the actual price of a security will be a good estimate of its intrinsic value.

and line with previous, other source states :

Market efficiency does not require that the market price be equal to true value at every point in time. All it requires is that errors in the market price be unbiased, i.e., that prices can be greater than or less than true value, as long as these deviations are random

I also saw algebraig illustration where it was shown that the market price estimates the fundamental value of security better any individual trader can estimate it. (with certain assumptions)

So the question is, why here and these is stated, that in efficient market, the market price of stock is trading at a price equal to fundamental (or intrinsic) value? Which is right?

And if the market price is at the best good estimate of intrinsic value, how can it be stated that in efficient market there are not under- or overvalued stocks, if the market price is only best estimate of instrinsic value?

I am not very familiar with algebraig definitions, but some kind of clarification behind this issue would be appreciated.

Thank you for clarification.

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The fundamental value of an asset over an infinite horizon is the sum of dividends discounted over time.

You are stumbling into the literature on rational and irrational bubbles. In general, the difference between the fundamental value of an asset and its market price constitutes, to some degree, bubble behavior.

Edit — I can probably expand this for clarity. Each of those definitions tries to get at the same thing — there is no room for systematic bias in the prices of assets traded on the market. Markets, more or less, are powerful because they aggregate massive amounts of information. They incorporate ever trader’s wants, fears, expectations, etc. and distill it all into a single thing — a price. And markets do this very quickly. We can see this, for example, when markets adjust to incorporate information shocks that occur around FOMC statements. Because of this, it should be true that prices do not deviate systematically from fundamentals. The argument boils down to one of arbitrage opportunities, I suppose.

However, many economists (many people, really) openly discuss bubbles. A bubble, rather loosely stated, exists if prices deviate systematically from fundamentals. The common theme of each definition above is that we should see systematic deviations on prices away from fundamentals. They just vary a bit in how emphatically they say this. Nevertheless, we all talk about bubbles.

Also — how do we know if prices have deviated from fundamentals? Well, there is a nice literature built around this idea, but I am not convinced this is possible to do with empirical data. However, economists have used the laboratory to show that this happens in markets. In fact, generating bubbles in an asset market is probably among the most reproducible laboratory phenomena I can think of.

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  • $\begingroup$ Sorry, but i do not get the point here. Both of definitions are based on Efficient Market Hypothesis literature. No discussion about bubbles there, just a basics behind the efficient market theory. $\endgroup$ – Lothilla Nov 22 '19 at 17:39
  • $\begingroup$ The question asks about the difference between market price and the fundamental value of an asset. That is, definitely, about bubbles. $\endgroup$ – 123 Nov 23 '19 at 21:08
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There are many valuation models. These models take fundamental or technical data as input and specify value as the output. Each model specifies how to calculate value. Different models give different values. Which value is true value?

The efficient market hypothesis is a tautology which says the market value is the intrinsic value and the intrinsic value is the market value at any point in time. Don't get confused by the words used to describe EMH. It is a tautology. It means the market price is always right and your valuation model, if it deviates from market price at the time of trade, is wrong, according to those who advocate EMH.

I challenge anyone who is tempted to vote down this answer to provide an objective model for "intrinsic value" of a stock or equity trading on the secondary market. If one uses discounted cash flow models then future earnings and revenue are forecast projections, subject to uncertainty and therefore not objective, and one has a choice of discount factor, subject to judgment of the person making the DCF analysis, so there is no objective model for intrinsic value.

This 53 page paper describes how discounted cash flows are used to make estimates of instrinsic value in a context of uncertainty:

http://people.stern.nyu.edu/adamodar/pdfiles/DSV2/Ch2.pdf

where there is no one objective way to predict future cash flows, to specify risk, or to apply a uniform discount factor during the discounted cash flow analysis. Everyone who is honest with self and others must recognize that there is no intrinsic value.

This is a quote from the link above, at the end of Chapter 2, the book title is The Dark Side of Valuations

What do intrinsic valuation models tell us?

All of the approaches described in this chapter try to estimate the intrinsic value of an asset or a business. However, it is important that we understand exactly what we are doing in the process. We are estimating what an asset or business is worth, given its cash flows and the risk in those cash flows. To the extent that the value is dependent upon the assumptions we make about cash flows, growth and risk, it represents what we think the intrinsic value is at any point in time.

So, what if the intrinsic value that we derive is very different from the market price? There are several possible explanations. One is that we have made erroneous or unrealistic assumptions about a company’s future growth potential or riskiness. A second and related explanation is that we have made incorrect assessments of risk premiums for the entire market. A third is that the market is, in fact, making a mistake in its assessment of value.

Even in the last scenario, where our assessment of value is right and the market price is wrong, there is no guarantee that we can make money of our valuations. For that to occur, markets have to correct their mistakes and that may not happen in the near future. In fact, we can buy stocks that we believe are under valued and find them become more under valued over time. That is why a long time horizon is almost a pre-requisite for using intrinsic valuation models. Giving the market more time (say 3 to 5 years) to fix its mistakes provides better odds than hoping that it will happen in the next quarter or the next six months.

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