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Fundamental Valuation

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? These blog entries address valuation based on accounting fundamentals, including the conventional value premium.

Weak Guidance vs. Beating Consensus

Conventional wisdom is that company management can maximize stock price by issuing weak guidance for future earnings that sets low expectations, and then reporting earnings that beat the low expectations. Does evidence support this belief? In their September 2010 paper entitled “The Stock Price Effects from Downward Earnings Guidance Versus Beating Analysts’ Forecasts: Which Effect Dominates?”, Lynn Rees and Brady Twedt investigate the net effect on stock price of downward earnings guidance that enables a subsequent positive earnings surprise. Using a sample of 8,635 guidance-earnings observations for 2,751 firms during 1993 through 2006, along with a matched control sample, they find that: Keep Reading

Combining Momentum and Asset Growth

Both stock price momentum and asset growth rate exhibit empirical value as return predictors for individual stocks. Does combining these indicators offer enhanced value to investors? In their September 2010 paper entitled “Firm Expansion and Stock Price Momentum”, Peter Nyberg and Salla Pöyry investigate the interaction between firm-level asset growth (change in balance sheet total assets) and stock price momentum. Specifically, they measure returns for a monthly strategy that buys (sells) the prior winners (losers) within groups of stocks sorted first on on asset growth rates and then on 11-month past returns with skip-month. Using data for a broad sample of U.S. firms listed on NYSE, AMEX and NASDAQ over the period 1964-2006, they find that: Keep Reading

Market Models Summary Augmentation

Two charts added to “Market Models”, a backtest of the 6-month forecasts and a current valuation map, offer context for the projections from the Reversion-to-Value (RTV) Model and the Real Earnings Yield (REY) Model of the U.S. stock market.

Simple Versus Complex Valuation Metrics

Do complex valuation metrics outperform simple ones in predicting stock returns? In their July 2010 paper entitled “The Sophisticated and the Simple: The Profitability of Contrarian Strategies from a Portfolio Manager’s Perspective”, Daniel Giamouridis and Chris Montagu compare and contrast several simple and sophisticated valuation metrics, with focus on those of interest to equity portfolio managers. They consider three simple metrics: (1) forward price-earnings ratio (PE); (2) Book Yield (book price per share divide by share price); and, (3) Fair PE, derived from expected earnings growth and market capitalization. They consider sophisticated metrics as generated by two models: (1) the Residual Income Model (RIM), a function of current book value plus residual income; and, (2) the real options model (ROM), a convex function of earnings and book value. Using monthly firm fundamentals and return data for approximately 450 stocks that have been or are constituents of the MSCI Europe Index during January 1990 to April 2010, they find that: Keep Reading

Accrual Volatility as a Stock Return Predictor

Does unreliability of the relationship between reported earnings and cash flow affect stock valuation? In the July 2010 version of their paper entitled “The Accrual Volatility Anomaly”, Sati Bandyopadhyay, Alan Huang and Tony Wirjanto investigate whether the market penalizes firms that consistently report earnings that are different from cash flows, as measured by accrual volatility. They define accrual volatility as the standard deviation of the ratio of accruals to sales over the past 16 quarters. They focus on total accruals, defined as changes in working capital minus deprecation and amortization.Using quarterly accounting data and monthly stock returns for a broad sample of U.S. stocks over the period 1976-2008, they find that: Keep Reading

A Few Notes on Capital Rising

In their June 2010 book Capital Rising: How Capital Flows Are change Business Systems All Over the World, authors Peter Cohan and Srinivasa Rangan mine lessons from 47 case studies to “describe the phenomenon of capital flows, present new ways to think about what causes them to rise and fall, and describe ways that our readers can profit from this framework.” Specifically, in Chapter 7 (“Implications for Capital Providers”) they argue “that analyzing a country’s EE [Entrepreneurial Ecosystem] is essential for capital providers to maximize investment returns” and provide a six-step methodology to “help capital providers to sniff out the best opportunities…” The six steps are: Keep Reading

A Few Notes on Buying at the Point of Maximum Pessimism

In his May 2010 book Buying at the Point of Maximum Pessimism: Six Value Investing Trends from China to Oil to Agriculture, author Scott Phillips “introduces a half dozen investment themes that should maintain their fundamental appeal over the next five to ten years. The purpose of this book is to answer the question of what to buy during future bouts of market volatility. In sum, these themes could be thought of as CliffsNotes to be used in preparation for future tests in the stock market. These themes should help investors, at a minimum, inventory a list of investment ideas that may be applied over the years to come.” Some notable ideas from the book are: Keep Reading

Valuation Metric Map and Critique

Aggregate operating earnings as an indicator of future cash flows and the inflation rate as a fundamental wealth discount rate suggest a set of equity market valuation metrics, such as:

  • Lagged earnings yield [Lagged E/P], where E is 12-month lagged aggregate operating earnings and P is the level of a corresponding index.
  • Forward E/P, using a forecast of aggregate operating earnings for the next 12 months rather than lagged earnings. This metric underlies  the Reversion-to-Value Model.
  • Lagged E/P minus the lagged inflation rate [Lagged (E/P – I)], where I is the lagged 12-month inflation rate.
  • Forward (E/PI), using forecasts for both aggregate operating earnings and the inflation rate. This metric underlies the Real Earnings Yield (REY) Model.
  • Forward E/PLagged I, because earnings forecasts arguably get much more attention than inflation rate forecasts. This metric underlies an alternate version of the REY Model.

How much have these metrics varied for the U.S. stock market, and where do they stand now? Using monthly estimates of actual and forecasted aggregate S&P 500 operating earnings, actual and forecasted inflation rates and monthly closes of the S&P 500 Index since March 1989, we find that: Keep Reading

Bubbles: Ride, Watch or Play the Pop?

Should investors go with or against asset pricing bubbles? Or, should they step aside and await a “Return to Normalcy?” In their December 2009 paper entitled “Riding Bubbles”, Nadja Guenster, Erik Kole and Ben Jacobsen investigate empirically the best approach for investors to take regarding active asset bubbles. They detect bubbles within rolling historical 10-year intervals based on two criteria: (1) price advances faster than growth rates of fundamental value based on three widely used asset pricing models; and, (2) sudden accelerations in price unexplained by these models. More descriptively, a bubble is a structural break followed by abnormally positive returns, and ended with a crash. Using monthly returns and contemporaneous fundamentals for 48 value-weighted industry indexes spanning July 1926 to December 2006, they conclude that: Keep Reading

Gross Profitability as a Stock Return Predictor

Is level of profitability alone, and in combination with other firm/stock characteristics, a useful indicator of future stock returns? In his April 2010 paper entitled “The Other Side of Value: Good Growth and the Gross Profitability Premium”, Robert Novy-Marx investigates the power of the gross profits-to-assets ratio to predict returns for individual stocks as a standalone indicator and in combination with the book-to-market ratio. Using annual firm characteristics and stock price data for a broad sample of U.S. companies spanning 1962-2009, he concludes that: Keep Reading

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