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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.

Earnings, Inflation and Stock Returns

In their February 2003 paper entitled “Stock Returns, Aggregate Earnings Surprises, and Behavioral Finance”,  Jonathan Lewellen, S. Kothari and Jerold Warner explore the relationships between overall stock market behavior and aggregate corporate earnings, looking for parallels with firm-level price-earnings behavior. Using quarterly data for 1970-2000, they conclude that: Keep Reading

Focus on Return on Investment, Not P/E

Can one calculate what the return from the overall stock market, or from a specific stock, should be? In the never-ending quest to achieve this goal, Hollister Sykes presents his recent “An Equity Market Model and Its Implications”. This model calculates investor return as a function of four variables: (1) earnings yield; (2) return on equity; (3) ratio of dividend payout to earnings; and, (4) ratio of share repurchases or sales value to earnings. Model details and implications, and the results of testing it with 133 years of aggregate market data, are as follows: Keep Reading

Out-of-Sample Test for a Stock Market Model

In their April 2002 paper entitled “Solving the Price-Earnings Puzzle” Carl Chiarella and Shenhuai Gao investigate the interrelationships of stock prices (the S&P 500 index), earnings and interest rates (the Federal Funds Rate) during January 1979 to August 2001. They conclude that the stock index is proportional to aggregate earnings and inversely proportional to the interest rate. Using data for these variables since January 1990,  we find that: Keep Reading

Last Nail in the Coffin of the Fed Model?

Fed Model proponents argue that there is an equilibrium relationship between the earnings yield of a stock index and the 10-year government bond yield. When the earnings yield is below (above) the 10-year government bond yield, the stock market is overvalued (undervalued). In his January 2006 paper entitled “The Fed Model: The Bad, the Worse, and the Ugly”, Javier Estrada recaps the (lack of) theoretical basis for the Fed Model and tests its empirical support in the markets of 20 countries. Using both actual (trailing) and projected (forward) earnings for total market indices over various periods ending in June 2005, he concludes that: Keep Reading

Classic Research: Mean Reversion in Corporate Profitability

We have selected for retrospective review a few all-time “best selling” research papers of the past few years from the General Financial Markets category of the Social Science Research Network (SSRN). Here we summarize the February 1999 paper entitled “Forecasting Profitability and Earnings” (download count over 3,600) by Eugene Fama and Kenneth French. Is corporate profitability mean reverting due to competitive forces, as entrepreneurs exit relatively unprofitable industries and enter relatively profitable industries. Are there therefore predictable patterns in corporate earnings? Using a simple return-on-assets model applied to an average of 2304 firms per year over the period 1964-1995, the authors conclude that: Keep Reading

International Fed Model Test

Fed Model proponents argue that there is an equilibrium relationship between the earnings yield of a stock index and the 10-year government bond yield. When the earnings yield is below (above) the 10-year government bond yield, the stock market is overvalued (undervalued). In their August 2005 working paper entitled “An International Analysis of Earnings, Stock Prices and Bond Yields”, Alain Durré and Pierre Giot assess the relationships among stock index prices, earnings and long-term government bond yields for 13 countries (Australia, Austria, Belgium, Canada, Denmark, France, Germany, Italy, Japan, Switzerland, The Netherlands, United Kingdom and the United States) over a 30 year period. Using current earnings for total market indexes over the period 1973-2003, they conclude that: Keep Reading

Earnings Guidance Lags the Market?

In the June 2005 update of their paper entitled “Is Guidance a Macro Factor? The Nature and Information Content of Aggregate Earnings Guidance”, Carol Anilowski, Mei Feng and Douglas Skinner investigate whether aggregate management earnings guidance predicts future aggregate earnings news and overall stock market returns. Using a sample of 31,320 annual and quarterly management earnings forecasts for 1994-2003 from Thomson First Call, they find that: Keep Reading

Pricing Corporate News

In their May 2005 draft paper entitled “The Market Impact of Corporate News Stories”, Werner Antweiler and Murray Frank apply computational linguistics to 245,429 Wall Street Journal news stories published during 1973 to 2001 to examine how, and how quickly, stock prices fully reflect 43 different kinds of news. They find that: Keep Reading

Fed Model Versus P/E Model

Conventional wisdom says that high market P/E ratios forecast negative future stock returns. In their March 2005 paper entitled “The Market P/E Ratio: Stock Returns, Earnings, and Mean Reversion,” Robert Weigand and Robert Irons to test this conventional wisdom. Using data back to the 1880s, they pit the Fed Model against the P/E mean reversion model to determine which one better explains stock market behavior. They find that: Keep Reading

50-Year Fed Model Meme?

Is the Fed Model a useful market timing tool? In their March 2005 paper entitled “The Market P/E Ratio: Stock Returns, Earnings, and Mean Reversion”, Robert Weigand and Robert Irons investigate whether very high price/earnings (P/E) ratios foreshadow poor future stock market performance. Using data over the very long period from 1881 to 2002, they find that: Keep Reading

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