Thisis a small case study with data from 2015. This demonstrates the failure ofefficient market hypothesis in the light of behavioral finance. EMH focuses on therational best interests of an investor and that the current valuation of thecompany is incorporated in the public information available. It also statesthat any new information which is public will be immediately incorporated inthe stock prices of the company.
In the light of such theories I choose Amazonand Berkshire Hathaway to compare the efficient market hypothesis withbehavioral finance theories.Amazon vs Berkshire Hathaway ComparisonAmazon had surpassed Berkshire Hathaway in market value in around July2016 to become the largest U.S listed company.
Amazon had a market cap of $356billion while Berkshire stood at $355 billion. The market has now determinedthat Amazon with a slighter edge is now nearly equivalent to Berkshire. A smallcomparative analysis is shown as follows: Name of Company Amazon Berkshire Hathaway Market Cap: $356 billion $355 billion Annual Profit: $0.59 billion (2015), Loss of $0.
24 billion (2014), $274 billion (2013), Loss of $0.03 billion (2012), $0.63 billion (2011) $24.08 billion (2015), $19.87 billion (2014), $19.47 billion (2013), $14.82 billion (2012), $10.
25 billion (2011) Price to Earnings Ratio: 306 14.5 Consensus Earnings Growth Rate (5 years): 49.4% per year Not available Trailing 5 years Earnings Growth Rate: – 13.15% per year Analysis:A quickanalysis reveals that Berkshire which a company based on strong fundamentalshave profits in billions of dollars whereas Amazon, the e-commerce giant hasconsistently lower profits and has losses that are far more than the profit itgenerated. This is a classic example where behavioral finance theory comes intoplay. Amazon’s huge market capitalization has been built on the positiveacceptance of ecommerce by the people thus leading to huge positive sentimentsthat leads to asset over valuation.
Since market prices fully incorporate allinformation in the past hence it should be no different that we invest inAmazon or Berkshire.Assumptions:1. Amazon’s growth: Estimates are assumed to be true: 2.
Berkshire growth: The growth rate of previous 5 years If we calculatethe profit for Amazon discounted to present value it turns out that it hasaccrued a profit of $4.4 billion by 2020 in the meantime Berkshire Hathaway endswith $44.5 billion profit. If we assume that both company are valued on thebasis of fundamental data and take the P/E ratio of 15, we see that Amazonreaches a valuation of $66bn and Berkshire $667.
5 billion by 2020.Investor performanceThe analysis above shows thatwe would earn 10 times more if we invest in Berkshire than in Amazon. But clearlythat is not the case. Both the efficient market and behavarial hypothesis failin such cases. Efficient theory suggests that both the companies would have earnednearly the same whereas behavior suggest that Amazon would have given betterreturn owing to huge positive sentiments. It is conceivable to outflank the market bylegitimate choice of stocks through fundamental analysis and behavior theory.Let’s look at the market todayto derive at better conclusions on the theories. If we see the market today,Amazon has surpassed Berkshire by a near 100 billion dollars in market capitalization.
Let’s dig a little deeper to understand the basic theories and explain it.Amazon has surpassed all expectations due to solid behavioral theory. Amazonhas diversified its business from only ecommerce to a portfolio of ecommerce,hyperlocal services, video streaming services, web services , payment andwallet services, machine learning services, etc which has led to a considerableincrease in revenue. The additional new services leading to growth can beattributed to fundamental analysis of the stock. But this is not enough todouble the market capitalization only by increasing services you offer. The overvaluation can be attributed to behavior theory where the general goodwill ofthe company has increased as people as started terming Amazon as a good companybecause of its large inventory, provide jobs to a lot of people, provideservices at affordable rates(like Amazon prime) and web services at cheaperprices to emerging small businesses.
This has led to positive sentiment in theentire community restoring faith on people’s mind that the emerging giant isgoing to do a lot of business and better growth.Implications of the Efficient Market Hypothesisfor InvestorsOn a concluding note, the current Market capitalization ofAmazon has hugely surpassed Berkshire. The most important reason attributed tosuch an event is the market sentiment relating to Amazon.
The positive vibeabout ecommerce making life simpler and the readiness of people investing inthe technology perspective has hugely helped Amazon to amass nearly double thecapitalization in just 3 years. It is quintessential to observe that the marketsentiment, investor confidence and the general goodwill of the people acceptingecommerce technology and putting their trust in it has led to huge gains forAmazon. This case study is a classic example of the traditional finance vsbehavioral finance anomaly.