Archive for the 'Valuation' Category

Risk Based Theories and the Value Premium

The value premium refers to the fact that stocks with priced at a low multiple of book value tend to perform better than would be explained by the Capital Asset Pricing Model. Proponents of the Efficient Market Hypothesis (EMH) argue that the value premium results from a risk factor not captured by Beta. Opponents argue that the value premium is evidence that the EMH is not valid.

Fama and French, among others, have developed models that attribute the value premium to risk factors. Typically these studies use company size as a proxy for liquidity risk. In the Review of Finance, Phalippou replicates these studies in their original form, and then using institutional ownership as an alternative liquidity proxy. In this second iteration, the value premium persists and cannot be explained by the risk factor models.

Phalippou concludes that if the value premium is attributable to risk factors, the risk factors are not the ones identified in previous research.

Posted on 3rd July 2008
Under: Behavioral Finance, Investing in Stocks, Passive Management, Portfolio Management, Research, Valuation | No Comments »

Where is the Value Premium?

The value premium refers to the well-documented outperformance of value stocks (those with high book value relative to market value) over gorwth stocks (those with high market-book ratios.) This outperformance is not explained by systematic Beta as defined in the CAPM, though it does represent one of the three/four factors used in the Fama-French model.

In the March/April 2008 Financial Analysts Journal, Phalippou finds that the value premium is driven by stocks with low institutional ownership – a group that represents just 7% of the total stock market capitalization. Since individual investors may be less sophisticated than institutional investors, such stocks may have a higher tendency to be mispriced. The low institutional ownership may also signal that the mispricing opportunities are difficult to arbitrage.

Posted on 3rd July 2008
Under: Active Management, Fundamental Analysis, Institutional Investing, Investing in Stocks, Investment Returns, Security Selection, Valuation | No Comments »

Affect in a Behavioral Asset Pricing Model

“Affect” is the term used in behavioral finance to refer to automatic feelings investors feel toward a specific company or investment. It is, in a sense, the gut reaction one has to the company itself.

Affect is known to play a role in the pricing of many assets such as cars, houses and watches. In a Perspective presented in the March/April 2008 Financial Analysts Journal Statman, Fisher and Anginer examine the role of affect in investment valuation.

Using the Fortune magazine list of most admired companies, the authors form two portfolios: one consisting of “Admired” companies and the other consisting of “Spurned” companies. They found that the spurned companies generated higher returns than admired companies, even after adjusting for CAPM risk.

The authors also find that subjective risk is associated with negative affect. While objective risk factors such as those used in the CAPM or the Fama-French 3 factor model typically assume that higher risk will lead to higher returns, the authors posit that higher perceived risk, manifest as low affect, is also associated with higher return.

Posted on 5th June 2008
Under: Behavioral Finance, Investing in Stocks, Investment Returns, Valuation | No Comments »

The Pros and Cons of Fundamental Indexing

Fundamental indexing strategies attempt to form benchmarks based on fundamental factors such as book value, dividends or earnings rather than market capitalization. Proponents claim that the fundamentals provide a less biased estimate of a security’s fair value, and thus explain the value premium. Detractors claim that the strategies are simply “value investing in a shiny new wrapper.”

In the January/February 2008 Financial Analysts Journal,  Kaplan argues both fundamental and market-cap weightings provide valuable information, and argues in favor of approaches that combine both.

Posted on 4th April 2008
Under: Active Management, Fundamental Analysis, Investing in Stocks, Investment Returns, Passive Management, Portfolio Management, Quantitative Analysis, Valuation | No Comments »

Selling Short

Investors typically think of buying stocks that they believe will go up, and selling those (holding no position) in those they believe have poor prospects. Short selling takes this one step further, allowing an investor to have a negative position in a stock they believe will go down in value.

A short sale is accomplished by selling stock that was borrowed from another investor. In exchange for this privilege, the short seller must pay interest on the borrowed stock, as well as any dividends paid by the stock while it is sold short. At an unspecified future point, the short seller buys back the stock and returns it to the original investor.

Short sales are profitable if the stock declines in value while the seller is short, and lose money if the stock increases in value.

Posted on 1st April 2008
Under: Investing in Stocks, Security Selection, Trading Execution, Valuation | No Comments »

Adjusted Earnings Yield

The earnings yield is a company’s earnings per share divided by its price per share. Earnings yield has frequently been used to predict real return for stocks. Since earnings are not reported on a real basis, Stephen Wilcox presented a technique in the September/October 2007 Financial Analysts Journal to adjust earnings yield to better represent real return. Statistical tests show that this measure better predicts future real returns than other popular valuation measures.

There are two primary adjustments considered:

  • An accounting adjustment to convert historical cost measures to current value
  • An adjustment to liabilities to reflect the real cost of capital as principal values erode due to inflation

Posted on 12th March 2008
Under: Fundamental Analysis, Investing in Stocks, Investment Returns, Ratio Analysis, Research, Valuation | No Comments »

How Value and Growth Stocks Deliver Returns to Investors

In the November/December 2007 Financial Analysts Jounal Fama and French break down the returns historically delivered by growth and value stocks into dividends and three components of capital gain: growth in book value, primarily through retained earnings; convergence in price/book ratios due to mean reversion in profitability and expected returns; and the general upward drift in P/B ratios experienced over the last century.

For value stocks, the capital gains arise primarily from convergence. P/B reverts to the mean (increases) and many of the companies that were cheap due to lack of profitability become more profitable.

For growth stocks, the growth in book value is the primary positive factor for returns and convergence is a negative one.

Drift has had a negligible effect on average returns, regardless of the growth or value profile.

Posted on 17th February 2008
Under: Active Management, Fundamental Analysis, Institutional Investing, Investing in Stocks, Performance Measurement, Portfolio Management, Research, Security Selection, Valuation | No Comments »

Money-Weighted Rate of Return

Time weighted rate of return measures the compound rate of return over a given period for one unit of money.  Money-weighted rate of return, by contrast, measures the compound growth rate in the value of all funds invested in the account over the evaluation period.

Money-weighted rate of return is equivalent to a portfolio’s internal rate of return (IRR). It is the growth rate that solves the equation:

MV1 = MV0(1+R)^m + CF(1+R)^m-L(1) + … + CFn(1+R)^m-L(n)


  • m is the number of time units in a given subperiod
  • L(i) is the number of time units by which the ith cash flow is separated from the beginning of the evaluation period

Posted on 6th February 2008
Under: Investment Returns, Portfolio Management, Valuation | No Comments »

Calculating Returns in a Portfolio

One would think that determining the return in a portfolio would be simple: divide the change in value by the beginning value. In the most simple of cases, this can be true. But external cash flows (cash flows in and out of a portfolio, rather than those generated by the investments themselves) can make things more difficult.

Whenever there is an external cash flow such as a deposit to or withdrawal from the portfolio, the return should be measured. Then, each period between cash flows (or ending at specified dates such as year-end) can be linked together in a process called chain-linking. This process is used to determine the time weighted rate of return (TWR).

Consider the following exhibit, which shows the change in portfolio value before and after cash flows.


The portfolio starts the year at $100,000 and ends at $118,000 – so its return is 18%, right? Not so fast! All during the year (for simplicity it is assumed to be on the last day of the month after the ending value is calculated) there are deposits and withdrawals. The 118,000 reflects not only the investment return, but these external cash flows as well.

The proper way to calculate return in this case is to take the change in value from the beginning to the end of each month (before the cash flow). So, in the first month the return is (110,000 – 100,000)/100,000 = 10%.

Next, the cash flow is added or subtracted from the ending value to arrive at the following month’s beginning value, and that month’s return is calculated the same way.

Returns can be linked geometrically. To do this, 1 is added to each return and they are multiplied together. At the end, 1 is subtracted from the final product. So the linked return for the three months ending in March are (1.10 X 1.043 X 0.965)  – 1 = 10.7% (which is slightly off from the 10.8% in the exhibit due to rounding).

Posted on 6th January 2008
Under: Active Management, Investment Returns, Passive Management, Portfolio Management, Valuation | 3 Comments »

Standardized Unexpected Earnings (SUE)

Standardized unexpected earnings is a means of comparing earnings surprise to the company’s track record of earnings surprise. For example, Cisco was once said to consistently beat earnings estimates by a penny. Thus, if the company did beat by a penny it was hardly unexpected. A method frequently used in academic research to adjust for this factor is the standardized unexpected earnings, or SUE.

SUE = the earnings surprise at a given time divided by the standard deviation of earnings surprises measured over some historic period such as the previous 20 quarters.

Consider a stock that had a $0.03 earnings surprise, and that the standard deviation of past earnings surprises is $0.05. The surprise is smaller than normal, and the standardized earnings surprise would be $0.03/$0.05 = 0.6.

Posted on 5th January 2008
Under: Investing in Stocks, Momentum Strategies, Technical Analysis, Valuation | No Comments »