Objective research to aid investing decisions

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Allocations for January 2022 (Final)

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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.

Predicting Stock Returns Using Accounting Fundamentals

Which accounting data is most important in predicting future stock returns? In their July 2006 paper entitled “How Do Accounting Variables Explain Stock Price Movements? Theory and Evidence”, Peter Chen and Guochang Zhang test the predictive power of a model that combines the discount rate with four indicators of company cash flow: (1) earnings yield; (2) capital investment; (3) changes in profitability; and, (4) changes in growth opportunities. Earnings yield indicates current cash flow generation, while the other three factors indicate future changes in cash flow generation. Using annual company-level accounting data and analyst growth forecasts for cash flow indicators (27,897 firm-year observations over the period 1983-2001) and the yield on 10-year Treasury notes for the discount rate, they conclude that: Keep Reading

An Equity Risk Premium Opus

What excess return have you gotten, do you expect, should you require, does the market imply for taking the risk of owning stocks? In his September 2006 paper entitled “Equity Premium: Historical, Expected, Required and Implied”, Pablo Fernandez addresses all these questions in a comprehensive overview/history and analysis of the equity risk premium in the U.S. and other countries. He begins with definitions of four perspectives on the equity premium, the first equal for all investors and the other three varying among investors: Keep Reading

Stock Price Impacts of Management Changes

A reader observed and asked: “I read today that Peter Dolan, the CEO of Bristol-Myers Squibb (BMY), left the company…BMY was up nearly 4% at the open. How many other times have CEOs of unprofitable/unloved publicly traded companies gotten sacked and the share price rises on the news? Could this be a market inefficiency that market makers and traders (i.e., hedge funds) exploit to the chagrin of individual and institutional investors (mutual funds)? Does a publicly traded company with a stock price stagnant for years get a trader’s premium when a management change occurs?” Keep Reading

Which Financial Performance Measure Best Fits Stock Valuation?

Is cash flow or earnings a better indicator of stock valuation? In their August 2006 paper entitled “Cash Flow is King? Comparing Valuations Based on Cash Flow Versus Earnings Multiples”, Jing Liu, Doron Nissim and Jacob Thomas extend their prior work on comparing cash flow and earnings as indicators of firm market valuation. The authors assume that financial markets efficiently price stocks and compare the accuracies with which different simple valuation ratios predict stock prices. They hypothesize that: (1) earnings should outperform cash flows as predictors of valuation because earnings include information about both cash flow and accruals; and, (2) forecasts should outperform historical results as predictors of valuation because forecasts typically exclude non-recurring events. Using data from the prior study for the U.S. (1992-1999) and for a large sample of firms across ten international markets (1987-2004), they conclude that: Keep Reading

Classic Paper: Company Valuation Methods

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 March 2004 update of the paper entitled “Company Valuation Methods: The Most Common Errors in Valuations” (download count over 6,000) by Pablo Fernandez. In this paper, the author describes the four most widely used company valuation methods: (1) balance sheet-based; (2) income statement-based; (3) goodwill-based; and, (4) cash flow discounting-based. He also illustrates a break-up value calculation and summarizes the valuation errors he has most commonly encountered. He states that: Keep Reading

Are the Returns for IBD’s New America Index for Real?

A reader asked whether IBD’s New America Index, which IBD claims has trounced that of the S&P 500 index by over 160% since late 1998 is “for real.” There is little publicly available information on the New American Index. Using what we can find, we conclude that: Keep Reading

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

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