Analysts' recommendations and rigorous valuation models

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.

Historical cost and comparability

Many of my former MAcc and MBA students will (hopefully) remember my discussions in class about how historical cost can potentially distort accounting-based rates of return (like return on assets - ROA) in my mind this lead to a possible comparability concern with accounting.

My coauthor, Melissa Lewis (also an Assistant professor at Utah) and I decided to test whether this is actually the case for a wide sample of firms - and we do indeed find evidence of an inflation in ROA for firms with older assets. More startling, even though we all know about historical cost, we find that investors appear to be unable to correctly estimate the level of this bias, leading to predictable negative future returns - you can read about our paper on SSRN.

Blockbuster's noose?

After reading the article "Netflix has Blockbuster on the ropes" I'm curious if it is more like Netflix has Blockbuster in a noose...

Can Blockbuster still compete with Netflix? What do we think of Blockbuster's ability to also compete against Red Box? Seems to me like a typical example of "Creative destruction"...

A check of BBI's financial statements and market price yields some interesting questions, what kind of growth rates would be required for BBI to pay "healthy" dividends?

Netflix Q4 results

Netflix announced their fourth quarter results, disclosing a 36% increase in profits, and a 31% increase in subscriber base (now over 12 Million) and saw a positive market response of a 13.24% increase in their stock price.

Macro-level news

This week in class we have been talking about "Top-down" analysis (which by the way, we will typically discard in favor of bottom-up analysis). This article mentions that the futures price is indicating an increase in overall market value (for the S& 500), while we didn't discuss these instruments in detail, we have been discussing interest rates (which are expected to be unchanged in the Fed's policy statement due this afternoon), there is also some discussion of additional factors and their expected impact. Note that Apple is set to announce a new product (the tablet) this afternoon, I'll write about this event separately after it occurs. This related article Before the bell: Futures higher amid upbeat earnings also notes some interesting factors and raises some additional points relating to the (expected) turn-around in the housing market.

So given the level of the S&P 500 closed at 1,092.17 yesterday, if we are expecting some possible impact on the market will it be long-term or will it be short-term? What is your estimate of the level of the S&P 500 in the final weeks of class? Moving to our firm level analysis, what tools do we have to incorporate any expected returns on the S&P 500 index into calculating value of the individual companies we are following?

Valuing facebook

Related to one of our class exercises is the question of how much can these social networking sites be worth?

As a starting point you will notice that all three of the commentators in this article "How much is facebook really worth?" are basing their estimates on multiples of revenue. Of course revenue growth without growth in earnings (and hopefully even residual earnings) tends not to add value in the long-run.

Another point of contention arises between the three authors on the selection of a suitable comparable firm, is it myspace (1st author)? or is it yahoo (last author)? Clearly the assumptions of the value of facebook are widely varied based on the selection of the comparable firm.

Is facebook worth 15 billion?

The hard(ware) and soft(ware) of it

Apple Inc, is involved in lawsuits relating to the use of its operating system software on computers with PC hardware. According to this article "German Mac clone maker claims immunity from Apple" is selling Intel loaded computers with Mac OS X operating system software pre-installed. An entry-level computer sells for about $643, relative to the entry-level iMac selling at $1199. The issue is that the end user license agreement (EULA) for the operating system 'forbids' the user from installing the software on non-Mac hardware.

But for Apple's valuation, we have a bigger issue in play, what happens if the anti-trust lawsuits prevent Apple from 'forbidding' the installation of their software on non-Mac hardware? Is the EULA an effective barrier to entry?

Clearly, Apple's strategy is likely to remain the same - product differentiation - rather than them trying to compete in low cost alternatives. Does this news, however, change your expectations of future ROE for Apple? How would you expect the profit margin and asset turnover ratios to change in the next few years? How would this affect your forecasts?