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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.

Is ValueEngine’s Stock Market Mispricing Summary Predictive?

A reader suggested that we evaluate the usefulness of ValueEngine, self-described as “a stock valuation and forecasting service founded by Ivy League finance academics” utilizing “the most advanced quantitative techniques and analysis available.” ValueEngine offers a limited archive (20 weeks) of their free weekly newsletter that includes a “Summary of VE Stock Universe” within a section entitled “ValueEngine’s Market Overview.” This summary states the percentages of stocks undervalued and overvalued and the percentages of stocks undervalued and overvalued by at least 20%. If these summaries are meaningful, the net levels of mispricing they indicate should be to some degree predictive of future stock market behavior. Using the weekly mispricing summaries for 5/11/07-6/20/08 (a total 58 summaries, with none listed for 1/25/08) and contemporaneous weekly S&P 500 index data, we find that: Keep Reading

A Few Notes on The Halo Effect

In his 2007 book, The Halo Effect …and Eight Other Business Delusions That Deceive Managers, Phil Rosenzweig argues for distinguishing carefully between sentiments (halos) derived principally from past bottom-line performance and fundamentals independent from that performance when assessing the excellence of companies and managers. Sentiments are essentially opinions expressed via “managers’ ex post facto recollections, company statements, and articles from the business press.” The distinction between sentimental and fundamental is important for investors/traders, as are his related conclusions about the value of experts and the inherent unpredictability of firm performance. Based on his review of prominent past studies of business excellence, he finds that: Keep Reading

Regulations Suppressing Analysts’ Earnings Optimism?

Have Regulation FD (Fair Disclosure) of 2000 and the Global Analyst Research Settlements of 2002 effectively removed incentives for sell-side analysts to curry favor with their own and covered company management teams by issuing inflated earnings forecasts? In their May 2008 paper entitled “Conflicts of Interest and Analyst Behavior: Evidence from Recent Changes in Regulation”, Armen Hovakimian and Ekkachai Saenyasiri investigate whether these two regulatory actions reduced the average analyst earnings forecast bias found in prior studies. Based on the annual earnings forecasts of sell-side analysts and associated actual annual earnings over the period 1984-2006, they conclude that: Keep Reading

Macroeconomic Shocks and the Stock Market

How strong and persistent are the effects of inflation rate and interest rate shocks on the stock market? In the May 2008 draft of their paper entitled “Inflation, Monetary Policy and Stock Market Conditions”, Michael Bordo, Michael Dueker and David Wheelock quantify the extent to which various macroeconomic and policy shocks (industrial production, inflation, money supply growth, 10-year Treasury note yield and 3-month Treasury bill yield) explain the behavior of U.S. real stock prices and stock market conditions (trend) during the second half of the 20th century. Using monthly data for these variables and the S&P 500 index (as a proxy for stock prices) over the period August 1952 through December 2005, they conclude that: Keep Reading

Inflation as Fed Model Intermediator

Is the Fed Model an artifact of bad investor behavior (money illusion) or rational response? In the April 2008 draft of their paper entitled “Inflation and the Stock Market: Understanding the “Fed Model”, Geert Bekaert and Eric Engstrom carefully re-examine mechanisms that might explain why the Fed Model “works.” Using quarterly inputs for bond yield, S&P 500 index level and dividend yield, the economic forecast and a consumption-based measure of risk aversion spanning the fourth quarter of 1968 through 2007, they conclude that: Keep Reading

Cash Flow Trumps Discount Rate in Stock Valuations?

Are expected cash flows (earnings) or expected discount rates (risk tolerance) more important in determining stock valuations? In the April 2008 version of their paper entitled “What Drives Stock Price Movement?”, Long Chen and Xinlei Zhao investigate the relative importance of cash flows and discount rates in equity valuation by studying the relationships among proportional stock price change, cash flow news and discount rate news at firm and aggregate levels. They make a critical assumption that analyst earnings forecasts are accurate and timely measures of investor beliefs regarding future cash flows. Using quarterly stock price data and contemporaneous prevailing earnings forecasts over the period 1985 through 2006, they conclude that: Keep Reading

Outperformance of High-Yield Stocks in the UK

Does a high dividend yield translate on average to high total return? In the February 2008 version of their paper entitled “Dividend Yield Strategy in the British Stock Market: 1994-2007”, Janusz Brzeszczynski, Kathryn Archibald, Jerzy Gajdka and Joanna Brzeszczynska examine the recent performance of an equally-weighted portfolio of UK stocks with the highest dividend yields. Using total dividend-reinvested return data for portfolios of the Top Ten highest dividend yield stocks in the FTSE 100, reformed annually on the first trading day in March, and for the index itself over the period 1994-2007 (13 years), they conclude that: Keep Reading

Still Irrationally Exuberant?

Are asset prices still in a behavioral bubble, sustained at least in part by wrongly using nominal rather than real interest rates in valuation calculations? In his October 2007 paper entitled “Low Interest Rates and High Asset Prices: An Interpretation in Terms of Changing Popular Economic Models”, Robert Shiller examines the Fed model-like belief that that long-term asset prices are generally high because monetary authorities are keeping long-term interest rates low. Using interest rate and inflation data for 1871-2007 and more recent behavioral evidence, he argues that: Keep Reading

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

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