Finance theory as a foundation for superior investment analysis

Had an insight while I was reading some academic papers and wanted to write it down and invite a discussion, so here it goes. The idea is that finance theory, on its own, can help one find opportunities.

This comes as a counterargument to the saying that what is thought in the classroom isn’t useful in practice, so just focus on going through but don’t delve to deep into theory. But let me present you a different case: What we’re doing in real life, in finance, is analyzing a wide spectrum of investment opportunities through the lens of what finance thought us. The issue and main critique is that analyzing investment opportunities and filling the analysis with theories is a recipe for disaster – which I agree with. However, when you shift the approach, that is, you analyze the investment landscape based on what the theory told us should be, and then we start to go from theory downstream into reality by removing the most extreme academic assumptions, then that's provides a superior understanding of the asset. In other words, when we remove all the assumptions, then the investment is taken naked as what it really is: An asset priced based on a semi-EMH approach. But there is more to it. 

In finance, we analyze investment opportunities through the lens of theory, which provides a structured framework for understanding the mechanics of value creation. Consider the MM Capital Structure Theorem. In its pure form, it offers an elegant but idealized view of the factors influencing capital structure. By systematically stripping away its assumptions, we begin to approximate real-world conditions, identifying which factors hold and which diverge from theoretical expectations. From thereon, you can again go upstream and ask yourself: Taken from the current price, if we were to add the assumption, what value should it have? Leading to the idea than in almost all cases the final value in an upstream and downstream scenario would be different than what the current market is pricing it by a wide margin and not decimals. 

Thus, then it begs the question: Why is this happening? And information asymmetry isn’t enough. There is more behind it, there is an inefficiency and not always explained by economic forecasts. 

This is contrary to the discussion of undervalued or overvalued because of the behavioral factors in the market or that the market missed something. This approach analyzes the ratio existendi of an asset in its pure, ideal form distanced from any sort of influence that impacts its value. The analysis, then, of those "assumptions" in theory (that equal the "influences" in practice) allows us to analyze what should hold, why it doesn't hold, and to what degree it influences the price - which is completely different from a valuation approach because you're analyzing the concept of the asset, and not its potential for generating cash flows.