# Fundamental Valuation

What fundamental measures of business success best indicate the value of individual stocks and the aggregate stock market? How can investors apply these measures to estimate valuations and identify misvaluations? These blog entries address valuation based on accounting fundamentals, including the conventional value premium.

**November 13, 2017** - Animal Spirits, Calendar Effects, Fundamental Valuation, Sentiment Indicators

Should investors view stock returns around recurring firm events in aggregate as an exploitable anomaly? In their October 2017 paper entitled “Recurring Firm Events and Predictable Returns: The Within-Firm Time-Series”, Samuel Hartzmark and David Solomon review the body of research on relationships between recurring firm events and future stock returns. They classify events as predictable (1) releases of information or (2) corporate distributions, with some overlap. Information releases include earnings announcements, dividend announcements, earnings seasonality and predictable increases in dividends. Corporate distributions cover dividend ex-days, stock splits and stock dividends. They specify a general trading strategy to exploit these events that is long (short) stocks of applicable firms during months with (without) predictable events. They use market capitalization weighting but, since there are often more stocks in the short side, they scale short side weights downward so that overall long and short sides are equal in dollar value. Based on the body of research and updated analyses based on firm event data and associated stock prices from initial availabilities through December 2016, *they conclude that:*

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**November 3, 2017** - Fundamental Valuation, Strategic Allocation

Are there stock return forecasts good enough to make mean-variance optimization work as a stock portfolio allocation strategy? In their October 2017 paper entitled “Mean-Variance Optimization Using Forward-Looking Return Estimates”, Patrick Bielstein and Matthias Hanauer test whether firm implied cost of capital (ICC) based on analyst earnings forecasts is effective as a stock return forecast for mean-variance portfolio optimization. They derive ICC annually for each stock as the internal rate of return (discount rate) implied by a valuation model that equates forecasted cash flows, derived from analyst earnings forecasts, to market valuation. To refine ICC estimates, they correct predictable analyst forecast errors (slow reactions to news) by including a standardized, rescaled momentum variable based on return from 12 months ago to one month ago (ICC_{adj}). They then employ ICC_{adj} to specify annual (each June 30) mean-variance optimized (maximum Sharpe ratio) long-only stock allocations (with maximum weight 5%) based on stock return covariances calculated from returns over the last 60 months. For benchmarks, they consider the value-weighted market portfolio (VW), the equal-weighted market portfolio (EW), the minimum variance portfolio (MVP) and a maximum Sharpe ratio portfolio based on 5-year moving average actual returns (HIST). They focus on U.S. stocks, which have relatively broad analyst coverage. They test robustness of findings with data from selected international developed markets, different return variable specifications, different subperiods and impact of transaction costs. Using monthly data for the 1,000 U.S. common stocks with the biggest prior-month market capitalizations since June 1985 and the 250 biggest stocks in each of Europe, UK and Japan since 1990, all through June 2015, *they find that:*

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**September 20, 2017** - Fundamental Valuation, Momentum Investing

Does uncertainty about future firm earnings underlie stock factor returns? In their August 2017 paper entitled “Uncertainty, Momentum, and Profitability”, Claire Liang, Zhenyang Tang and Xiaowei Xu examine relationships between analyst uncertainty about current-year firm earnings and four U.S. stock return anomalies. They each month estimate uncertainty for each stock as square root of the average squared differences between individual analyst forecasts for current-year earnings and reported earnings per share, divided by stock price. They then each month sort firms into fifths (quintiles) by:

- Uncertainty – as specified.
- Price momentum – stock returns from 12 months ago to one month ago.
- Earnings momentum – most recently announced quarterly earnings minus earnings from the same quarter one year ago, divided by the standard deviation of seasonal differences in earnings for the previous eight quarters.
- Operating profitability – annual revenue minus cost of goods sold, interest expense and selling, general, and administrative expenses, divided by book equity for the last fiscal year.
- Return on equity – earnings before extraordinary items from the most recent quarter divided by prior-quarter book equity.

They calculate gross monthly returns for each factor via an equal-weighted or value-weighted hedge portfolio that is each month long (short) the quintile of stocks with the highest (lowest) factor values. They test the power of uncertainty to explain other factor returns via regressions against uncertainty factor returns. Since some stocks may not have analyst coverage, they test whether idiosyncratic volatility and earnings forecast dispersion are effective substitutes for uncertainty. Using the specified monthly data for all NYSE/AMEX/NASDAQ stocks priced at least $1 during 1983 through 2013, *they find that:*

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**August 18, 2017** - Fundamental Valuation

Do markets exploitably misprice stocks? In their July 2017 paper entitled “Global Market Inefficiencies”, Söhnke Bartram and Mark Grinblatt assess the exploitability of deviations from fair stock prices worldwide based on publicly known accounting data. Specifically, they each month:

- Regress market capitalizations of all stocks sampled on 21 annual accounting variables from most recently disclosed balance sheets and income/cash flow statements. Returns play no role, suppressing potential snooping bias.
- Calculate percentage mispricings of stocks as regression residuals (unexplained by accounting variables) divided by market capitalization.
- Rank stocks into fifths (quintiles) based on within-country percentage mispricings.
- Group stocks in the same quintile across countries globally, by developed or emerging, or by region (Europe, Asia Pacific, Americas, and Africa/Middle East).
- Calculate next-month equal-weighted and value-weighted gross returns and alphas by quintile and for a hedge portfolio that is long (short) the most underpriced (overpriced) quintiles. Alphas derive from eight risk factors (market, size, book-to-market, investment, profitability, momentum, short-term reversal, and long-term reversal) calculated by region.
- Estimate the impact of quintile portfolio rebalancing frictions on gross returns/alphas.

To suppress rebalancing frictions, they also consider a holding interval of 12 months (averaging returns of 12 overlapping portfolios formed each month and held for a year). They run tests controlling for past returns, earnings surprises, country effects and other possible sources of abnormal returns. Using monthly values of 21 annual accounting variables for more than 25,000 non-financial firms, associated stock returns and stock trading frictions from 36 countries during March 1993 through December 2016, *they find that:* Keep Reading

**August 8, 2017** - Fundamental Valuation, Value Premium

Are high-quality stocks worth the price? In the June 2017 update of their paper entitled “Quality Minus Junk”, Clifford Asness, Andrea Frazzini and Lasse Pedersen investigate whether high-quality stocks outperform low-quality stocks. They define high-quality stocks as those that are profitable, growing, safe and well-managed. Specifically, they compute a single quality score for each stock by averaging scores for three components calculated as follows:

- Profitability – average of rankings for (high) gross profits/assets, return on equity, return on assets, cash flow/assets, gross margin and fraction of earnings that is cash.
- Growth – average of rankings for (high) prior five-year growth rates for each of the six profitability measures.
- Safety – average of rankings for (low) market beta, idiosyncratic volatility, leverage, bankruptcy risk and volatility of return on equity.

They consider two modes of analysis: quality-sorted portfolios and quality-minus-junk (QMJ) long-short factor portfolios. Quality-sorted portfolios are by value-weighted tenths (deciles), reformed at the end of each calendar month. QMJ factor portfolio return is the average return on two value-weighted top 30% of quality portfolios (big stocks and small stocks separately) minus the average return on two value-weighted bottom 30% of quality portfolios (big stocks and small stocks separately), reformed monthly by sorting first on size and then on quality. For both modes, global portfolios are value-weighted composites of country portfolios in U.S. dollars. Using characteristics and returns for a broad sample of U.S. stocks since June 1957 and samples of stocks from 24 developed markets (including the U.S.) since June 1989, and contemporaneous U.S. Treasury bill yield as the risk-free rate, all through December 2016, *they find that:*

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**July 26, 2017** - Fundamental Valuation, Value Premium

Do investors fixate on price-to-earnings ratio (P/E) and thereby create trading opportunities as P/Es change? In his June 2017 paper entitled “P/E Ratios and Value Investor Attention”, Jordan Moore examines market responses to U.S. common stocks sorted by earnings yield (inverse of P/E). He defines P/E as the ratio of stock price to the sum of the last available four quarters of net earnings excluding extraordinary items divided by current shares outstanding. For monthly tests, he assumes that earnings become available at the close of the last trading day of the reporting month. For daily and weekly tests, he assumes that earnings become available at the close of the first trading after earnings release date. He separately analyzes stocks with (published) positive and (generally unpublished) negative earnings yields. For comparison, he similarly calculates current monthly book-to-market ratios and sorts stocks by that alternative valuation metric. Using the specified accounting and price data for a broad sample of U.S. common stocks during 1973 through 2015, *he finds that:* Keep Reading

**June 26, 2017** - Fundamental Valuation, Strategic Allocation

Is there a way to enhance the ability of the cyclically-adjusted price-to-earnings ratio (P/E10 or CAPE) to predict U.S. stock market returns by incorporating real interest rates? In their June 2017 paper entitled “Improving U.S. Stock Return Forecasts: A ‘Fair-Value’ Cape Approach”, Joseph Davis, Roger Aliaga-Diaz, Harshdeep Ahluwalia and Ravi Tolani introduce “fair-value” CAPE that accounts for a dynamic, positive relationship between real 10-year U.S. Treasury note (T-note) yield (cost of capital) and real earnings yield (return on equity). They hypothesize that a lower real T-note yield should imply a lower earnings yield and thus a higher fair-value CAPE. Their use of fair-value CAPE to forecast stock market return involves:

- Each month, execute a multiple vector autoregression of the logarithms of the following five variables separately for each of the last 12 months: (1) inverse of CAPE; (2) expected real T-note yield based on a 10-year U.S. inflation forecast; (3) U.S. inflation; (4) realized S&P 500 Index price volatility over the last 12 months; and, (5) realized volatility of changes in real T-note yield over the last 12 months. Their 10-year inflation forecast is the average of 120 monthly forecasts generated via autoregression of the U.S. consumer price index over a 30-year rolling window.
- Each month, forecast 10-year stock market return (see the chart below) by summing: (1) percentage change in CAPE from the preceding vector autoregression; (2) constant earnings growth equal to its long-term average; and, (3) dividend yield calculated as earnings yield times the historical payout ratio.

They then compare out-of-sample forecasts of 10-year U.S. stock market returns for 1960 through 2016 and 1985 through 2016 generated by fair-value CAPE and two conventional CAPEs: Shiller CAPE based on Generally Accepted Accounting Principles (GAAP); and, Siegel CAPE based on National Income and Product Accounts (NIPA) earnings. Using Shiller’s data and NIPA earnings during 1950 through 2016, *they find that:* Keep Reading

**June 6, 2017** - Fundamental Valuation

Which firm profitability metric best predicts stock returns? In their May 2017 paper entitled “Alternative Profitability Measures and Cross Section of Expected Stock Returns: International Evidence”, Nusret Cakici, Sris Chatterjee and Yi Tang compare abilities of 12 profitability ratios to predict stock returns across four regions (North America, Europe, Japan and Asia-Pacific). They consider three measures of profitability: gross profit (GP); operating income (OI); and, earnings before interest and taxes (EBIT). They consider four scaling variables: enterprise value (EV); book value of assets (BA); market value of equity (ME); and, book value of equity (BE). Specifically, at the end of June each year, they rank stocks by region into fifths (quintiles) based on each of the 12 profitability metrics and hold the quintiles for one year. They measure the predictive power of each metric as average monthly return to a portfolio that is annually long (short) the top (bottom) quintile. Using firm accounting data and monthly stock returns for 23 developed country equity markets allocated to one of the four regions during January 1991 through December 2016, *they find that:* Keep Reading

**May 24, 2017** - Fundamental Valuation, Investing Expertise

How accurate are consensus firm earnings forecasts worldwide at a 12-month horizon? In his May 2016 paper entitled “An Empirical Study of Financial Analysts Earnings Forecast Accuracy”, Andrew Stotz measures accuracy of consensus 12-month earnings forecasts by financial analysts for the companies they cover around the world. He defines consensus as the average for analysts coverings a specific stock. He prepares data by starting with all stocks listed in all equity markets and sequentially discarding:

- Stocks with market capitalizations less than $50 million (U.S. dollars) as of December 2014 or the last day traded before delisting during the sample period.
- Stocks with no analyst coverage.
- Stocks without at least one target price and recommendation.
- The 2.1% of stocks with extremely small earnings, which may results in extremely large percentage errors.
- All observations of errors outside ±500% as outliers.
- Stocks without at least three analysts, one target price and one recommendation.

He focuses on scaled forecast error (SFE), 12-month consensus forecasted earnings minus actual earnings, divided by absolute value of actual earnings, as the key accuracy metric. Using monthly analyst earnings forecasts and subsequent actual earnings for all listed firms around the world during January 2003 through December 2014, *he finds that:* Keep Reading

**April 27, 2017** - Fundamental Valuation, Momentum Investing, Strategic Allocation

We developed the Simple Asset Class ETF Momentum Strategy (SACEMS) about six years ago and the Simple Asset Class ETF Value Strategy (SACEVS) about two years ago independently, focusing on the separate logic of asset choices for each. As tested in “SACEMS-SACEVS Mutual Diversification”, these two strategies are mutually diversifying, so combining them works better in some ways than using one or the other. Beginning May 2017, we are making four changes to these strategies for ease of implementation and combination, with modest compromises in logic. Specifically, *we are:* Keep Reading