Identifying Overvalued Equity

here's an interesting paper by Daniel Beneish of Indiana U. and Craig Nichols of Cornell titled "Identifying Overvalued Equity."

Here's the abstract:

Jensen (2005) argues that overvaluation changes the behavior of managers in ways that increase agency costs, but suggests that overvaluation is difficult to identify. We show that observable characteristics of changes in managers' accounting, operating, investing and financing decisions can be used to predict two likely consequences of overvalued equity: future stock price declines and overstatement of accounting earnings. In particular, we show that an overvaluation score (O-Score) that combines proxies for earnings overstatement, prior merger activity, excessive stock issuance, and the manipulation of real operating activities identifies firms with one-year-ahead abnormal price declines averaging -27%. We also estimate a model that integrates these various attributes to predict accounting restatements associated with fraud. In light of the costs associated with overvalued equity, the findings that firm characteristics can be used to identify overvalued equity should interest researchers who study overvaluation and professionals who oversee management on behalf of investors.

RTWT here.

It's an interesting paper, because it uses publicly available information to identify firms with high probabilities of negative returns. While it's probably not that applicable to individual investors, I can see their approach being of use to short-sellers (or those running long-short funds).

Earnings Before Everything

Earnings and cash flows are two of the recurring themes in my classes (Securities analysis, corporate finance, and my student-managed fund). But, unfortunately, there are multiple "flavors" of each. For earnings (profits), there's gross, operating, and net, and for cash flows , there's free cash flow to equity (or to the firm), cash from operations, free cash flow from operations, and (for some folks), EBITDA.

Now I have a new one: "EBITDAGSAC", or "Earnings before Depreciation, Amortization, General , Sales, and Administrative, and Cost of goods sold". It's got a nice ring to it.

Or, as we used to call it, Sales (or Revenue).

HT: Long or Short Capital.

More on The Accrual Anomaly

Here's another paper on "tradable" patterns in stock returns. The CXO Advisory Group recently put up a summary of the study titled "Repairing the Accruals Anomaly" by Hafzalla, Lundholm and Van Winkle. The paper examines the pattern that stock market performance of firms with low accruals (i.e. the difference between the firm's earnings and cash flows) is significantly greater than the performance of their higher accrual counterparts. It does a pretty good job of examining Sloan's "Accrual Anomaly" with a few tweaks:

• It corrects for the extent to which the firm is financially healthy, using Piotrowski's "financial health" indicator.
• It measures accruals in relation to earnings rather than to assets
  

Their findings are that the accrual anomaly does a better job of sorting out investment performance for financially healthy firms. Their results are pretty strong (note- the following is CXO's summary):

• A hedge strategy that is long (short) firms of high (low) financial health (ignoring accruals) generates an average size-adjusted annual return of 9.36% across the entire sample.
• After excluding firms with the lowest financial health scores, a hedge strategy that is long (short) the 10% of firms with the lowest (highest) traditional accruals generates an average size-adjusted annual return of 13.64%, with 7.98% coming from the long side
• Using the total sample, a hedge strategy that is long (short) low-accrual, high financial health (high-accrual, low financial health) firms produces an average size-adjusted annual return of 22.93%, with a 14.92% from the long side. (See the first chart below.)

Here's a pretty good grapic of size adjusted abnormal returns on the various portfolios. Note that financially healthy firms with low accruals earn a size-adjusted abnormal return of about 15% annually, while those in the "financially unhealthy/high accruals" group have negative size adjusted returns of about almost 10% a year.





Read the paper here.

It looks like my students in Unknown University's Student Managed Fund will have another indicator to look at next semester.

And They Say Accounting Doesn't Make Sense

As a person who's trained primarily in finance, accounting rules sometimes look like they were designed by Monty Python. Here's the latest installment - your company's credit rating drops, so the market value of your liabilities fall. As a result, you show a profit. This is what happened to some Wall Street firms recently. Read the whole story here. IMO, the best line in the article is:

But Moody’s Investors Service said buyers should beware of gains booked when brokers mark down their own debt liabilities. “Moody’s does not consider such gains to be high-quality, core earnings,” it said in a report issued Friday.

Ya think?

This is why we make all our Finance students take four accounting classes before they graduate. That way, they'll see these things often enough that they won't break out laughing.