Fundamental Valuation

Do earnings surprises work differently for value and growth stocks? If so, can investors exploit the difference? In the September 2009 draft of their paper entitled “When Two Anomalies meet: Post-Earnings Announcement Drift and Value-Glamour Anomaly”, Zhipeng Yan and Yan Zhao investigate the combined effects of the value premium and the post-earnings announcement drift anomaly. They first sort stocks into quintiles according to some measure of value (book-to-market ratio, earnings-to-price ratio, cash-flow-to-price ratio or three-year average sales growth) and then allocate firms within these quintiles to six categories according to sign of the most recent quarterly earnings surprise (+/-/0) and the direction of the most recent earnings announcement abnormal return (+/-). Using stock price, earnings estimate and accounting data for a broad sample of firms over the period June 1984 through December 2008, they find that: Keep Reading

In the 2009 second edition of his book, The Dark Side of Valuation: Valuing Young, Distressed, and Complex Businesses, Professor of Finance Aswath Damodaran, investigates and offers remedies for “dark practices and flawed methods in valuation.” He emphasizes “the importance of first principles in valuation and how they should guide us when we’re faced with estimation questions and issues.” As summarized in the closing chapter, the key enlightening propositions of the book are: Keep Reading

A reader asked: “Have you ever investigated: (1) the work of R. G. Sloan on the predictive power of accruals (both negative and positive); and, (2) the web site www.valuedog.com? It’s not kept up-to-date anymore, but the ‘earnings torpedo’ and ‘value screen’ parts of the web site are still maintained on a monthly basis, complete with charts. It claims to be ‘based on work at the University of Michigan Business School.’ They used to publish a monthly list of companies with positive or negative accrual attributes, but don’t anymore. I can’t find anyone else that does.” Keep Reading

The Value Line Select ETF (VLSE) Index “is an equal-dollar weighted index comprised of between 30 and 100 U.S. traded ETFs ranked #1 by Value Line Publishing, Inc… The Value Line ETF Ranking System seeks to select the ‘best-for-investment’ ETFs among all U.S. traded ETFs…approximately 10% of all traded ETFs but no more than 100 ETFs. The Value Line Select ETF Index is rebalanced and reconstituted once per quarter… Upon Value Line Select ETF Index’s introduction in 2008, the index values were computed on a daily basis dating back to 2003 to provide a historical frame of reference.” Does this approach to ETF investing beat the market? Using self-reported daily performance data for the VLSE Index over the period 10/21/02 through 8/14/09 (almost seven years), and contemporaneous daily returns for S&P Depository Receipts (SPY) for benchmarking , we find that: Keep Reading

Do aggregate earnings (for example, for the S&P 500) predict stock market behavior? In their 2008 paper entitled “Aggregate Earnings, Firm-Level Earnings and Expected Stock Returns”, Turan Bali, Ozgur Demirtas and Hassan Tehranian analyze the predictability of stock returns using market, industry and firm-level earnings. Using monthly stock return data and quarterly fundamentals data for a broad range of U.S. stocks focused mostly on the period from mid-1972 through 2002, they conclude that: Keep Reading

In the 2009 edition of his book, Full of Bull, author Stephen McClellan seeks to “expose the puzzling and deceptive behavior of Wall Street that so disadvantages individual investors, tripping them up in their attempts to invest properly and rationally. It unscrambles the confounding practices of the Street in terms a layperson can comprehend. …Once armed with an insider’s understanding of all the Street’s subtleties, you can be your own investment analyst.” Stephen McClellan was a securities analyst for 32 years. The principal messages of the book are: Keep Reading

In his 2009 book, Quantitative Strategies for Achieving Alpha, flagged by Jeff Partlow, author Richard Tortoriello “seeks to determine empirically the major fundamental and market-based drivers of future stock market returns” by testing over 1,200 alternative investment strategies. He believes “that the quantitative approaches outlined in this book can provide a proven way to generate investment ideas for the qualitative investor as well as a discipline that can help improve investment results.” Richard Tortoriello is an equity research analyst with Standard & Poor’s. The principal elements of the book are: Keep Reading

What aggregate return thresholds are critical to investors in deciding whether to accept or reject equity and bonds for investment portfolios? In their December 2008 paper entitled “A Required Yield Theory of Stock Market Valuation and Treasury Yield Determination”, Christophe Faugere and Julian Van Erlach argue that investors first require that U.S. stocks and bonds in aggregate prospectively provide a real after-tax earnings yield directly related to real long-term GDP per capita growth. Investors then decide between stocks and bonds based on the better after-tax real return. Applying this Required Yield Theory (RYT) to quarterly data over the period 1953-2006, they find that: Keep Reading

Can investors tell when management is unsustainably propping up the stock price of a company? In their June 2008 paper entitled “Identifying Overvalued Equity”, Craig Nichols and M. D. Beneish devise and test a method for predicting stock price declines that integrates observable accounting, operating, investing and financing data indicative of management efforts to sustain overvaluation. Specifically, they relate future stock returns to an overvaluation score (O-Score, ranging from zero to five points) calculated by assigning one point each for the following indications: (1) likely earnings overstatement; (2) high sales growth; (3) low operating cash flow to total assets; (4) an acquisition in the last five years; and, (5) unusual amounts of equity issuance in the past two years. Using 27,427 firm-year observations over the period 1993-2004 (with financial services and very small companies excluded), they conclude that: Keep Reading

Is the discounted cash flow (DCF) method or the comparables method more accurate in forecasting equity valuations? In their April 2009 preliminary paper entitled “Exploring the Accuracy of DCF and Comparables Valuation Methods by Using Ex-Post Market Data as Forecasts”, Friedrich Sommer, Arnt Woehrmann and Andreas Wömpener use both truly historical data and “best” forecasts of basic firm fundamentals (such as earnings) to compare the forecasting power of the DCF and comparables methods. They define “best” forecasts of input data as actual results inserted retroactively (see the chart below). They consider multiple variations of both the DCF and comparables methods. Using fundamentals and stock price data for the period 1998 through 2006 to support truly historical and retroactive valuation calculations as of 12/31/2001 for 89 U.S. public companies via DCF and over 200 U.S. public companies via comparables, they conclude that: Keep Reading