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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.

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

One Up on the Fed Model?

In their June 2003 paper entitled “A General Theory of Stock Market Valuation and Return”, Christophe Faugere and Julian Van Erlach contend that past stock returns are overstated and develop a market valuation formula that out-fits the Fed Model. Specifically, they show that: Keep Reading

Earnings Yield-Interest Rate Spread

In his May 2002 paper entitled “Market Timing Strategies that Worked”, Pu Shen evaluates the effectiveness of the spreads between the S&P 500 index earnings yield (the earnings/price ratio or E/P) and the yields on 10-year Treasury notes (T-note) and 3-month Treasury bills (T-bill) as market timing indicators. By constructing “horse races” between switching strategies that call for investing in the stock market index unless spreads are lower than predefined thresholds during 1970-2000, he concludes that: Keep Reading

Classic Paper: Piotroski’s Efficient Value Investing

We occasionally select for retrospective review an all-time “best selling” research paper of the past few years from the General Financial Markets category of the Social Science Research Network (SSRN). In his January 2002 paper entitled “Value Investing: The Use of Historical Financial Statement Information to Separate Winners from Losers”, Joseph Piotroski applies a simple accounting-based fundamental analysis strategy to a broad portfolio of high (top 20%) book-to-market firms to enhance returns. His stock scoring system (FSCORE) consists of nine binary signals based on profitability and value-specific financial measures (see the list below). Using stock returns and fundamentals for a broad sample of U.S. stocks during 1976 through 1996, he finds that: Keep Reading

Fed Model: Predictive or Not?

Many investors monitor the Fed Model, based on the relationship between the earnings yield of stocks and the bond yield, for long-term stock market timing signals. Does this model really work? Notable contrary arguments are found in the December 2002 paper entitled “Fight the Fed Model: The Relationship Between Stock Market Yields, Bond Market Yields, and Future Returns” by Clifford S. Asness and the 2004 paper entitled “A Tactical Implication of Predictability: Fighting the Fed Model” by Roelof Salomons. These two papers present similar analyses and conclusions, as follows: Keep Reading

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