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.

Value-to-price

I will post some results from relevant accounting studies over the course of the semester. The first I'd like to highlight relates to today's discussion of the residual income model. The paper I want to highlight examines the predictive ability of the residual income value to price ratio over future stock returns. The paper is by Rich Frankel and Charles Lee, who published "Accounting valuation, market expectation, and cross-sectional stock returns" in the Journal of Accounting Research in 1998.


In their paper they find that over holding periods of 36 months, a strategy based on buying high value to price stocks (i.e., stocks the market undervalues relative to the model of fundamental value) and selling stocks low value to price stocks (i.e., stocks the market overvalues relative to the model of fundamental value) earns over a 45% return.

Do you think that these results are likely to hold in our current economy?

Overstock's new debt agreements

This article discusses the debt covenants engaged in by Overstock.com in their loan with Wells Fargo.

A debt covenant is basically an agreement over a loan that restricts some of the actions a borrower may engage in. If the covenant is violated then the lender has the right to repossess their loan. Often these covenants will refer to accounting information, including restrictions on leverage ratios. An academic study by Illa Dichev and Doug Skinner found that debt covenants that are violated by healthy firms are not always repossessed, however, if we were to believe Gary Weiss, if Overstock violates their covenant it might be because they are heading to bankruptcy...

Do you agree with Gary Weiss on Overstock's impending doom?

How might the loan affect your forecasts of overstocks operating performance?