In my Financial Statement Analysis and Valuation class we talk about how the "residual income model" is a rigorous approach to valuing a company and possibly spotting mispriced stocks. Specifically, we can compare the valuation model estimate we come up with using our forecasts and compare them to price (see my earlier post on value-to-price here). This would lead us to being able to recommend whether we believed that the stock was currently under- or overvalued... just as sell-side analysts do!
A curious result in the academic literature was presented by Mark Bradshaw who finds that analysts' don't seem to use the residual income model in generating their stock recommendations but instead appear to use their estimates of expected growth. Now this may seem reasonable until we notice that trading on expected growth would have us lose money, while trading on the residual income model would make us a nice return!
In a paper that I coauthored with Andreas Simon, we were interested in whether this finding was true of the very best analysts, so we investigated whether analysts who are good at forecasting appear to use the residual income model in generating their stock recommendations. We find that those analysts who are "putting in the effort" to produce better forecasts are also more likely to be generating their recommendations from a model "like" the residual income model and have more profitable recommendations (note I say "like" because even this group of analysts appear to be aligning their recommendations with their growth expectations than would be suggested by theory). Our paper can be found at ssrn and has been accepted for publication at the Journal of Business Finance and Accounting.
