There’s a well-known hypothesis about efficient markets, which I would say is not true – which is why we have thousands of portfolio managers out there telling us they can beat the market. The hypothesis says that by the time you can trade on any publicly available information, the information is already assimilated into stock prices, and you would not be able to make abnormal profits. However, we have good evidence that people can use public information in different ways and that public information isn’t communicated equally to everybody, so there are some investors who are able to make more profitable investment decisions.

Theory tells us the best way to value any asset is by looking at the present value of the cash-flow stream it generates. With business valuation, for example, many authors of paperback books advocate short-cut approaches, but most of those short-cut approaches are gross generalizations that over-simplify the valuation process. They have such illogical assumptions that if you step back and look at those assumptions, you would never use that approach in the first place.

Portfolio theory shows that by combining two assets with returns that have a correlation coefficient of less than 1.0, we can create a portfolio that has risk that is less than the weighted average of the risks of the two individual assets. This result is the basis for the recommended diversification that investors always hear from their financial advisors.

The Capital Asset Pricing Model is a theoretically-based model used to empirically estimate the rate of return an investor should expect to earn on a particular asset. This expected return is a function of the financial market conditions, as measured by the return that could be earned on a default risk-free asset and the return on the market in general, and the asset’s risk relative to the financial market. While this model has been criticized in the financial literature, it is still the most applicable and most widely used model to calculate these expected returns.

Long ago, the classic economists defined economic profit as the after-tax earnings reported on the income statement less the opportunity cost of the firm’s equity capital. This opportunity cost represents the cost to the firm of raising capital via equity. Sometimes too much attention is given to earnings and earnings growth at the expense of a focus on the firm’s economic profit. Economic profit is the ultimate measure of the firm’s performance because it shows the residual profit after all costs – operating costs, taxes, debt-financing costs, and equity-financing costs – are deducted from the firm’s revenues.

The field of finance deals with allocating scarce resources, and people should always view financial decision-making with a clear sense of fiduciary responsibility, recognizing that they are using the funds they have acquired from someone to do something. They always need to keep in mind that they should make the best possible use of those dollars, taking into consideration the finance issues, as well as ethical considerations, stakeholder concerns, and so on.

We make decisions on an incremental basis. That is, we look at the changes and the marginal effects of our decisions. We need to think of all the consequences of our decision-making, including possible impacts that may not appear in our immediate focus.

We must never forget that money has a time value, and the dollars of different time periods are different. In multi-period decisions, we try to draw a timeline that will show all the impacts of the decision and when those impacts will occur. Financial decisions have to be made in the context of other issues besides finance (ethics, regulatory issues, and so on), so every decision must be related to the impact on shareholder value. Notice that I didn’t say shareholder value must be maximized, but the impact must be recognized. Shareholder value should not be maximized to the disadvantage of other important stakeholders.

Finance is, broadly, about two things: one is what happens to decisions within firms in terms of how much value they create – decisions regarding corporate governance, capital budgeting, and investment; the other is how the capital market reacts to these decisions and how risk gets priced in the market.

In terms of what happens within the firm, the basic principles to remember are that if you want to use finance to create value, the first thing you need is a good strategy. The second thing you need is a good internal resource allocation system so that capital is flowing to the highest-value project. The third thing you need is the right performance metrics with which to judge people so that you maximize shareholder value on a day-to-day basis. Finally, you need the right corporate culture within the organization to make sure the implicit rules by which people are being judged and rewarded make sense.

From the external perspective, capital will flow to the highest- value user. The firms that will be valued more highly are the ones that are making positive net present value investments. The market will demand a higher risk premium for investing in firms that are riskier. If you are an investor and you hold a diversified portfolio, you don’t really have to care so much about what is happening in the firm because the capital market at an aggregate level is taking care of allocating resources to the best users. You have to make sure you hold a diversified portfolio so that if one out of the 200 firms in your portfolio disappoints, the whole portfolio doesn’t go down.