Fundamental Valuation

Proponents of rational markets build on a common-sense foundation of reward for risk, with price variability (beta) as the fundamental risk. Since this single source of risk does not predict asset prices very well, rationalists have empirically appended to their models other sources of risk (proxied by size, value and momentum factors) in search of better predictions. Proponents of behavioral finance counter with innate cognitive and emotional biases (irrationality) as causes of rational model failures. Is there a way to prove one of these two views more correct? Should rationalists look for additional risk factors? Does some third perspective offer insight? In their January 2007 preliminary paper entitled “Failure of Asset Pricing Models: Transaction Cost, Irrationality, or Missing Factors” Joon Chae and Cheol-Won Yang tackle these questions. Using monthly stock return data for 700 Korean firms over the period December 1997 to November 2004 (84 months), along with associated measures for both potential degree of trader rationality (sophistication) and transaction costs, they conclude that: Keep Reading

Is the Fed Model fit only for statistics-challenged practitioners, or does it offer some trading intelligence? In the January 2007 version of his paper entitled “A Behavioral Defense of the Fed Model”, Michael Clemens combines the concepts of mean reversion of key financial variables and confidence intervals to present a behavioral defense of the Fed model. He examines the version of the model based on the spread between the S&P 500 forward earnings yield (E/P) and the yield on the 10-year Treasury note. His defense includes identification of ten potential chinks in the armor of model detractors. Using monthly data for the period January 1979 through August 2006 (322 monthly observations over 26 years) , he finds that: Keep Reading

How well do commonly used valuation multiples align with actual stock prices? In their January 2007 paper entitled “Multiples and Their Valuation Accuracy in European Equity Markets”, Andreas Schreiner and Klaus Spremann investigate the accuracy of the valuation multiple method in general and the properties of 50 different multiples (see the figure below). They define a valuation multiple as a market price variable (e.g., stock price) divided by a particular value driver (e.g., earnings). Using stock price and firm financial data over the period 1996-2005 primarily for the Dow Jones STOXX 600 (ten industries, 18 supersectors, 39 sectors, and 104 subsectors) and secondarily for the S&P 500 index, they find that: Keep Reading

ave accounting scandals (e.g., Enron, WorldCom and Global Crossing) and the 2002 Sarbanes-Oxley Act (SOX) changed management-analyst earnings dynamics? In their December 2006 paper entitled “Mechanisms to Meet/Beat Analyst Earnings Expectations in the Pre- and Post-Sarbanes-Oxley Eras”, Eli Bartov and Daniel Cohen examine whether companies have changed behaviors post-SOX with respect to accrual earnings management, real (transaction-based) earnings management and earnings expectations management. Using earnings forecast and financial data for thousands of companies during 1987-2005, they conclude that: Keep Reading

Do aggregate earnings guidance and actual aggregate earnings predict overall stock market returns? In his September 2006 paper entitled “Aggregate Earnings, Stock Market Returns and Macroeconomic Activity”, Lakshmanan Shivakumar discusses the relationships among aggregate earnings, stock market returns and the economy. He frames his discussion as commentary on prior research on earnings guidance, earnings news and stock returns. Using earnings, inflation and gross domestic product (GDP) data for 1972-2004, he finds and suggests that: Keep Reading

Deterioration over the past decade in the forecasting power of traditional indicators (such as price-dividend and price-earnings ratios) have stimulated searches for better ones, with recent emphasis on macroeconomic variables. Which financial and economic variables best predict stock returns over the short, intermediate and long terms? Is “best” good enough for market timing? In her October 2006 paper entitled “How Well Do Financial and Macroeconomic Variables Predict Stock Returns: Time-series and Cross-sectional Evidence”, Anne-Sofie Reng Rasmussen evaluates the relative performance of a wide range of variables in forecasting excess stock returns (above the one-month T-bill rate) over horizons from one quarter to eight years. Using annual data for periods as long as 1930-2005 and quarterly data for periods as long as 1926-2005, she concludes that: Keep Reading

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

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

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

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