Fundamental Analysis: Combining the Search for Quality with the Search for Value

Using cross‐sectional forecasts, we combine fundamental analysis strategies based on quality, such as the FSCORE from Piotroski (2000) and the GSCORE from Mohanram (2005), with strategies based on value, such as the V/P ratio from Frankel and Lee (1998) and the PEG ratio. While all four strategies generate significant hedge returns, combining quality‐driven and value‐driven approaches substantially improves the efficacy of fundamental analysis. Our parsimonious two‐dimensional approach can be applied to a wide cross section of stocks and outperforms common practitioner approaches that require a lengthy time series of data. The improvements in hedge returns hold for a variety of partitions and are robust to controls for risk factors and other determinants of stock returns. While the efficacy of fundamental analysis has declined in recent years, this can partially be attributed to investors arbitraging away excess returns by investing in fundamental strategies.     

Are CEOs compensated for value destroying growth in earnings?

Prior research shows that firms generating earnings growth by improving profitability create shareholder value, while firms generating earnings growth through investment destroy value. This paper examines whether compensation committees consider this while determining CEO compensation. We first confirm prior results that growth from increased profitability is perceived by markets to add value while growth from investment does not. While growth from increased profitability is positively associated with compensation, so is growth from investment. The presence of institutional ownership increases the weight on growth from increased profitability, but does not reduce the weight on growth from investment. Further, value-oriented institutional ownership increases the sensitivity of compensation growth to growth from increased profitability and reduces the sensitivity to growth from investment. Contrarily, growth-oriented institutional ownership increases the sensitivity of compensation growth to growth from investment. Our results highlight the importance of understanding the nature of earnings growth in determining executive compensation.     

Valuation of Internet Stocks—An IPO Perspective

We empirically investigate valuations of Internet firms at various stages of the initial public offering (IPO) from two perspectives. First, we examine the association between the valuation of Internet IPOs and a set of financial and nonfinancial variables, which prior anecdotal or empirical evidence suggests may serve as value drivers. Second, we document differences in IPO valuations between Internet and non-Internet firms as well as across different stages in the IPO process—i.e., initial prospectus price, final offer price, and first trading day price—within each set of firms. Our primary two conclusions are as follows. First, there are noticeable differences between valuations of Internet and non-Internet firms, especially at the prospectus and final IPO stage. Specifically, the valuation of non-Internet firms generally follows the conventional wisdom regarding valuation: positive earnings and cash flows are priced, while negative earnings and negative cash flows are not. The valuation of Internet firms, however, departs from conventional wisdom, with earnings not being priced, and negative cash flows being priced perhaps because they are viewed as investments. This difference between the two classes of firms may be expected, given the age and unique nature of the Internet industry. Second, there are significant differences between the initial valuation of firms at the prospectus and IPO stage and their valuation by the stock market at the end of the first trading day. For non-Internet firms, the difference is largely ascribed to the relative offering size. For Internet firms, however, the differences are with respect to positive cash flows, sales growth, R&D, and high-risk warnings, in addition to the relative offering size.     

Removing predictable analyst forecast errors to improve implied cost of equity estimates

Prior research documents a weak association between the implied cost of equity inferred from analyst forecasts and realized returns. It points to predictable errors in analyst forecasts as a possible cause. We show that removing predictable errors from analyst forecasts leads to a much stronger association between implied cost of equity estimates obtained from adjusted forecasts and realized returns after controlling for cash flow news and discount rate news. An estimate of implied risk premium based on the average of four commonly used methods after making adjustments for predictable errors exhibits strong correlations with future realized returns as well as the lowest measurement error. Overall, our results confirm the validity of implied cost of equity estimates as measures of expected returns. Future research using implied cost of equity should remove predictable errors from implied cost of capital estimates and then average across multiple metrics.     

Fundamental analysis of banks: the use of financial statement information to screen winners from losers

This study investigates the efficacy of a fundamental analysis-based approach to screen U.S. bank stocks. We construct an index (BSCORE) based on fourteen bank–specific valuation signals. We document a positive association between BSCORE and future profitability changes, as well as current and one-year-ahead stock returns, implying that BSCORE captures forward looking information that the markets are yet to impound. A hedge strategy based on BSCORE yields positive hedge returns for all but two years during our 1994–2014 sample period. Results are robust to partitions of size, analyst following, and exchange listing, and persist after adjusting for risk factors. We further document a positive relation between BSCORE and future analyst forecast surprises as well as earnings announcement period returns, and a negative relation between BSCORE and future performance-based delistings. Overall, our results show that a fundamental analysis-based approach can provide useful insights for analyzing banks.     

Is PIN priced risk?

Several recent papers assume that private information (PIN), proposed by Easley et al. [2002. Is information risk a determinant of asset returns? Journal of Finance 57, 2185–2221; 2004. Factoring information into returns. Working Paper, Cornell University], is a determinant of stock returns. We replicate Easley et al. (2002) and show that while PIN does predict future returns in the sample they analyze, the effect is not robust to alternative specifications and time periods. There is no evidence that PIN factor loadings predict returns or that PIN factor returns reflect future GDP growth. PIN exhibits no association with implied cost of capital derived from analysts’ earnings forecasts. Overall, our findings cast doubt on whether PIN reflects information risk systematically priced by investors.     

How Has Regulation FD Affected the Operations of Financial Analysts?*

In this paper, we analyze how financial analysts generate information, make decisions about firm coverage, and try to maintain their forecasting accuracy after the passage of Regulation Fair Disclosure (“Reg FD”). Using the model developed by Barron, Kim, Lim, and Stevens 1998, we find that analysts are investing more effort in idiosyncratic information discovery. In order to do this, individual analysts appear to be reducing coverage for well‐followed firms while increasing coverage of firms that were less followed prior to Reg FD. Analysts who had preferential links with firms that they covered, such as analysts from large brokerage houses, tend to have greater forecast accuracy in the pre‐FD period. However, these analysts are unable to sustain their forecasting superiority in the post‐FD period, which suggests that there has been a leveling of the information playing field among analysts. Overall, our results reflect a trend toward greater reliance on idiosyncratic information discovery on part of the financial analysts.     

Separating Winners from Losers among LowBook-to-Market Stocks using Financial Statement Analysis

This paper combines traditional fundamentals, such as earnings and cash flows, with measures tailored for growth firms, such as earnings stability, growth stability and intensity of R&D, capital expenditure and advertising, to create an index – GSCORE. A long–short strategy based on GSCORE earns significant excess returns, though most of the returns come from the short side. Results are robust in partitions of size, analyst following and liquidity and persist after controlling for momentum, book-to-market, accruals and size. High GSCORE firms have greater market reaction and analyst forecast surprises with respect to future earnings announcements. Further, the results are inconsistent with a risk-based explanation as returns are positive in most years, and firms with lower risk earn higher returns. Finally, a contextual approach towards fundamental analysis works best, with traditional analysis appropriate for high BM stocks and growth oriented fundamental analysis appropriate for low BM stocks.This revised version was published online in August 2005 with a corrected cover date.     

Stock-based compensation,financial analysts,and equity overvaluation

Review of Accounting Studies - Stock-based compensation (SBC) reduces the value of shareholder equity, ceteris paribus, and is a significant and growing expense for many firms. Despite its...