Blog - Investing Notes

Blog Synthesis: Valuation Based on Fundamentals

What fundamental measures of business success best indicate the value of individual stocks and the aggregate stock market? How can investors apply these measures to estimate valuations and identify misvaluations? Here is a listing of past blog entries that address valuation based on accounting fundamentals:

Stock Market Value Ratio Trends ...operating and reported P/Es are close to their 18-year averages, but they are above their three-year averages. Earnings forecasts indicate a persistent operating-reported divergence, anticipating further write-downs in the value of booked assets.

Perspectives on Earnings Growth Forecasts ...assessing the valuation implications of earnings growth requires delving into the sources of that growth (investments in new products/capabilities versus improvements in efficiency).

An International Test of Common Stock Return Indicators ...there is solid evidence that stock returns have a predictable component, captured at least partially by interest rate variables, across international markets.

Room for More Gloom in Earnings? ...S&P 500 operating earnings growth forecasts exhibit considerable (mostly downward) variability since October 2007.

Real Earnings Yield Model Scenarios ...fundamental stock market valuation forecasts are sensitive to beliefs about future corporate earnings and future inflation.

Cash Flow Trumps Discount Rate in Stock Valuations? ...cash flow expectations represent a significant positively correlated component of stock returns at both firm and aggregate levels. Their importance grows with investment horizon, dominating discount rate expectations for horizons over three years.

Outperformance of High-Yield Stocks in the UK ...evidence from this UK study supports a belief that a portfolio of stocks with high dividend yields outperforms the broad market most of the time.

Gaming the Earnings/Accruals Gamers? ...investors may be able to generate substantial abnormal returns by combining the effects of earnings and accruals surprises, qualified by overall firm operating performance.

A Tradable Accruals Anomaly ...firm accruals may be a good indicator of future stock returns when combined with a broader measure of firm financial health, or when defined as a fraction of earnings rather than assets.

Asset Growth Rate as a Return Indicator ...consistent with the interpretation that investors over-extrapolate past trends, last-year change in firm assets is among the most economically and statistically significant predictors of next-year returns for individual U.S. stocks. On average, stocks of companies with low growth last year consistently outperform stocks of companies with high growth last year.

Why Rational Asset Pricing Models Don't Work Well ...the authors find that both market friction and investor irrationality play substantial roles in the pricing of stocks.

The Accuracies of Different Valuation Multiples (Ratios) ...P/E using two-year forward earnings estimates is among the best indicators of firm market value. For technology firms, adjusting earnings to include investments in intellectual property enhances valuation accuracy.

Aggregate Earnings and Stock Market Returns ...surprisingly strong (weak) aggregate earnings news, as an indicator of high (low) future inflation, may portend relatively low (high) future stock returns.

Stock Valuation Indicator Flyoff ...over the last 80 years, a few price-normalized variables (price-dividend, price-earnings, price-output and price-consumption ratios) and the approximate consumption-aggregate wealth ratio have been the best stock market indicators.

Predicting Stock Returns Using Accounting Fundamentals ...investors may want to examine a range of accounting indicators, not just earnings and earnings growth rate, to identify stocks likely to outperform over the long term.

Which Financial Performance Measure Best Fits Stock Valuation? ...operating earnings forecasts are the best simple indicator of market valuation.

Classic Paper: Company Valuation Methods ...the value of a company's equity depends on its future cash flows (derived from the company's growth rate and return on investment) and on the required return on equity (derived from the risk-free rate and the company's operating and financial risks). Investors who are stock pickers should understand how the companies they choose stand with respect to these drivers.

Earnings, Inflation and Stock Returns ...neither change in aggregate earnings nor the inflation rate alone is a good concurrent indicator for the overall stock market returns on a quarterly basis. However, because earnings growth and inflation are interrelated, they may together help forecast stock market behavior.

An Equity Market Model: Focus on Return on Investment, Not P/E ...investors should focus on return on investment as the driver of investment returns and earnings yield as the indicator of how large the returns should be.

Mean Reversion in Corporate Profitability ...corporate profitability and earnings growth exhibit non-linear mean reversion.

Understating P/E? ...calling for lower P/Es for years and years makes their forecasts less than useful from a market timing perspective.

What Bubble? ...the Internet Bubble is very much a technology stock phenomenon. Except for Energy recently, investing in other sectors over the past few years has been unexciting. Most sectors are trading near all-time highs.

Is Irrational Exuberance Over Yet? ...mean reversions of fundamental ratios are key predictors of future stock market returns.

For detailed examples of aggregate market valuation models, see the Real Earnings Yield Model and the Reversion-to-Value Model.