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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.

Gaming the Earnings/Accruals Gamers?

Do companies systematically manage earnings in attempts to smooth out the bumps? If so, can investors detect and exploit such gaming? In their January 2008 paper entitled “Reconciling the Market’s Underreaction to Earnings Changes and Overreaction to (Abnormal) Accruals: An Earnings Management Explanation”, Henock Louis and Amy Sun investigate whether earnings management accounts for anomalous market reactions to earnings and accruals surprises. Specifically, they test whether firms with accelerating (deteriorating) earnings systematically manage earnings downward to create reserves (upward to avoid reporting losses). Using firm financial data and associated stock prices over the period 1988-2005, they conclude that: Keep Reading

A Tradable Accruals Anomaly

Do firms that manage accruals conservatively (liberally) tend to be good (bad) investments? In their June 2007 paper entitled “Repairing the Accruals Anomaly”, Nader Hafzalla, Russell Lundholm and Matt Van Winkle test adjustments to prior studies of the accrual anomaly to determine whether accruals can reliably predict future stock returns without look-ahead bias. One improvement is the use of Joseph Piotroski’s financial health score to refine accrual signals. The other improvement is to define accruals as a fraction of earnings rather than as a fraction of total assets. Using a sample of 72,668 firm-years spanning 1988-2004, they find that: Keep Reading

Asset Growth and the Cross-Section of Stock Returns

Does strong (weak) past growth in a company’s total assets predict high (low) future stock returns? Or, does investor overreaction to past data predict the opposite? In the July 2007 update of their paper entitled “Asset Growth and the Cross-Section of Stock Returns”, flagged by a reader, Michael Cooper, Huseyin Gulen and Michael Schill examine the relationship between firm asset growth (year-on-year percentage change in total assets) and subsequent stock returns. Using firm fundamentals and stock return data for all non-financial U.S. public companies over the period 1968-2003, they conclude that: Keep Reading

The Little Book That Makes You Rich: A Proven Market-Beating Formula for Growth Investing (Chapter-by-Chapter Review)

In his 2007 book The Little Book That Makes You Rich: A Proven Market-Beating Formula for Growth Investing, Louis Navellier, Chairman of the Board, Chief Executive Officer and Chief Investment Officer of Navellier & Associates, Inc., outlines his systematic approach to investing in timely growth stocks. This approach derives from his analysis-based belief that the market does not efficiently incorporate key indicators of growth into stock prices. Here is a chapter-by-chapter review of some of the key points in this book, along with some links to relevant research summaries: Keep Reading

Using Firm Productivity Measures to Enhance Stock Returns

Investors ought to reward a company that employs capital productively. One measure of firm productivity is return on invested capital (ROIC), the ratio of operating income to invested capital (debt plus equity minus cash from the balance sheet). Do stocks of high-ROIC firms outperform those of low-ROIC firms? In their June 2007 paper entitled “The Productivity Premium in Equity Returns”, David Brown and Bradford Rowe examine the relationship between ROIC and stock returns for both value stocks and growth stocks. They define value (growth) companies as those with high (low) CTEV, the ratio of invested capital (book value of equity plus debt minus cash) to enterprise value (market value of equity plus debt minus cash). Using monthly stock price data and contemporaneously available accounting fundamentals for the 1,000 largest U.S. companies during 1970-2005, they conclude that: Keep Reading

Does Customer Satisfaction Translate to Excess Stock Returns?

Do companies with high marks for customer satisfaction outperform as investments? Or, instead, does making customers happy crimp profit margins and stock returns? In their January 2006 Journal of Marketing article entitled “Customer Satisfaction and Stock Prices: High Returns, Low Risk”, Claes Fornell, Sunil Mithas, Forrest Morgeson III and M.S. Krishnan investigate the relationship between customer satisfaction as measured by the American Customer Satisfaction Index (ACSI) and stock returns. ACSI measurements are updated annually for each company rated. Using ACSI ratings for publicly traded companies during 1994-2004 and associated firm accounting and stock price data, they find that: Keep Reading

Do Good Employers Make Good Investments?

Do companies famously known as good places to work outperform as investments? Or, contrarily, do they waste resources keeping employees happy? In his May 2007 paper entitled “Does the Stock Market Fully Value Intangibles? Employee Satisfaction and Equity Prices”, Alex Edmans analyzes the relationship between employee satisfaction and long-term stock performance. He identifies companies with exceptionally satisfied employees via Fortune magazine’s annual list of the “100 Best Companies to Work for in America.” Using these lists for 1998-2005 and monthly stock price data for the publicly traded companies in the lists (about 60 per year), he finds that: Keep Reading

Does Earnings Acceleration Mean Anything for Investors?

How does the second derivative (acceleration) of earnings relate to stock returns? In their March 2007 paper entitled “Does Earnings Acceleration Convey Information?”, Ying Cao, Linda Myers and Theodore Sougiannis investigate how the change in earnings growth rate (earnings acceleration) relates to stock returns. They examine separately conditions in which earnings growth rate and earnings acceleration have the same and opposite signs. Using a large sample of U.S. non-financial and non-utility firms over the period 1965 to 2002 (66,150 firm-year observations), they conclude that: Keep Reading

Testing Benjamin Graham Out of Sample

Does old-fashioned value investing still work? In their recent paper entitled “Testing Benjamin Graham’s Net Current Asset Value Strategy”, Ying Xiao and Glen Arnold test Benjamin Graham’s approach to valuation based on net current asset value to market value (NCAV/MV) to see whether it outperforms in a modern market environment. NCAV is current assets minus all current and long-term liabilities, divided by the number of shares outstanding. The strategy assumes that a stock is substantially undervalued when NCAV/MV is 1.5 or greater. Using accounting and return data for stocks listed on the London Stock Exchange during 1980-2005, they find that: Keep Reading

Enhancing the Value Premium Via P/E Analysis

Reader Richard Beddard, editor of Interactive Investor, flagged a series of three studies by Keith Anderson and Chris Brooks on approaches to enhancing the value premium via empirical analysis of the price-earnings ratio (P/E) calculated with lagged earnings. One study seeks to optimize value indication based on the extent and weighting of historical earnings used in the P/E calculation. The second study seeks to concentrate the value premium by decomposing P/E into components related to market, firm size, industry and company-specific factors. The third study combines the findings of the first two and examines the returns for the extreme tails of the enhanced P/E distribution. All three studies use earnings and stock return data for a broad range of UK companies (excluding the smallest) for the period 1975-2004. Summaries of the three studies follow. Keep Reading

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