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.

Valuing Netflix earnings and growth

At the time of this post, the market was valuing Netflix at $37 per share, one year ago the share price was $26.89. The raw return for the stock over the past year was( ($37-26.89)/26.89) = 37.6%

One question to ask was how did Netflix beat the expectations set at the end of last year...?

One interesting article that discusses some of these expectations (at the time) is the article "Netflix looks like a bargain again" written about a year ago, along with expectations about 2008 written in the companion piece "Netflix 2008 Outlook" where the author discusses expected growth rates in subscriptions.

What do you believe the Outlook for 2009 will look like?

Cyber Monday

A big day for Internet retail firms, many of the companies posted sales increases over the prior period this time last year. Overstock, however, didn't post an increase in sales.

From an article on internet retailer:

At Overstock.com, sales fell 3% yesterday compared with the same Monday last year. “Last year Cyber Monday was in November. In November we had gunned marketing, which gave us a bigger November than we should have had, and a weaker December,” says CEO Patrick Byrne. “So our expectation has been to have a hard time matching November’s days this year, but then to make up some ground in December.” read the rest of the article here.

How may this affect your forecast?

What other macro-economic factors may affect your forecast?