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When
Sell Means Buy
A
stock analyst’s rating downgrade, say from “buy” to “hold,”
which most market participants understand means “sell,” usually drives
a stock price down. But if the reason for the rating change was solely
valuation, the downgrade could be a buying opportunity.
Last
week, I tracked the returns of all the stocks I could pinpoint that had
been downgraded roughly six months earlier, from April 22 through April
30, only because the analyst thought they were overvalued. I chose six
months because that seemed like a reasonable timeframe for a stock to
recover from the downgrade. I started with April 22 and worked forward
until I had spotted enough qualifying downgrades to draw some conclusions.
I ignored downgrades where the analyst cited additional reasons besides
valuation.
I
found 13 qualifying downgrades, but two of them later reported
disappointing earnings, which dropped their share prices. I dropped those
two from the study because their problems were unrelated to valuation and
unforeseen by the analyst making the downgrade.
The
remaining 11 “over valued” stocks gained 12 percent, on average, from
the date of the analyst downgrade through October 25, trouncing the
S&P 500’s 3 percent during the same period. Better, despite the
rough market, 9 of the 11 “overvalued” stocks produced positive
returns while the other two broke even. None dropped.
The
results suggest that analysts’ valuation downgrades might be buying
opportunities. Here’s why.
Buying
Opportunity?
Perhaps due to the well-publicized shenanigans of some during the
bubble days, analysts now follow a fairly rigorous approach to
establishing their buy/sell ratings. First they set a target price. Then,
their buy/sell rating depends on the relationship between the stock’s
current and target prices. For example, a stock trading substantially
below its target is a “buy.” Stocks trading near or above their
targets are rated “hold” or “sell.”
Thus,
the value of an analysts’ buy/sell rating depends on setting the right
target price, and that’s the problem.
Many
analysts rely on a formula developed years ago, known as “discounted
cash flow,” to calculate a stock’s “fair value,” which becomes
their target price. The DCF formula calculates the present value of
expected future cash flows or earnings.
What's
Google Worth?
Unfortunately, small changes in required assumptions can substantially
change the result. For example, using the DCF formula, I first calculated
Google’s fair value at $922. Then, by making moderate changes to my
assumptions, I cut Google’s fair value down to $136. Sounds
unbelievable? Here are the details.
I
used the free fair value calculator available on the Money Chimp financial
education site (www.moneychimp.com)
to run the numbers (from Money Chimp’s homepage, select Stock Valuation
and then DCF
Calculator).
You
use the calculator by first entering your stock’s last 12-month’s
per-share earnings. Then estimate its earnings growth rate while the
company is in its early fast growth stage, say over the next five years.
Next, estimate its annual growth in later years when the company has
matured and earnings growth has slowed.
Finally,
you must specify a “discount rate,” which is the return that you or
other investors require, given the risk of owning that particular stock.
Money Chimp suggests using an appropriate market benchmark, such as the
S&P 500’s historical return for the discount rate.
Yahoo
Has Info
I found Google’s last 12-month’s earnings and next five-years forecast
annual earnings growth on Yahoo’s Key
Statistics and Analysts
Estimates reports. Find them from the Yahoo Finance homepage (finance.yahoo.com)
after getting a price quote. According to Yahoo, Google’s last
12-months’ earnings were $3.41 per share and it’s expected to grow
earnings at a 32 percent annual clip over the next five years.
I
used those numbers, and estimated that after the first five years,
Google’s growth would slow to a 10 percent annual rate. I used Money
Chimp’s suggested 11 percent discount rate, which corresponds to the
S&P 500’s long-term average annual return.
Based
on those numbers, Money Chimp said Google’s fair value was $922 per
share.
Then,
I recalculated Google’s fair value making two relatively modest changes.
I
cut my forecasted next five-years’ annual earnings growth to 25 percent,
and I increased my annual return requirement (discount rate) to 15
percent. Surprisingly, those changes cut Google’s fair value down to
only $136 per share.
Guessing
Game
Analysts probably use more sophisticated calculators than Money Chimp
offers. But they must still guess at earnings growth rates far into the
future and arbitrarily pick a discount rate. As you can see, small changes
in these assumptions produce vastly different results.
In
my experience, Google or any other stock’s share price will only
temporarily sink because an analyst thinks it’s overvalued. In the end,
stock prices reflect changes in future earnings growth expectations. They
move up when expectations increase and plunge when growth falters.
Finding
Valuation Downgrades
MarketWatch’s Upgrades/Downgrade
report (www.marketwatch.com) is a
good resource for spotting stocks downgraded based on valuation. For each
market day, the report lists pertinent information about downgraded
stocks, including, in most cases, the reason for the downgrade. You can
find the report in the Investor Tools section. Click “next” near the
bottom of the page to see earlier reports.
MarketWatch
archives its Upgrades/Downgrades reports going back years, so you can do
your own research by picking a week several months back and see how
downgraded stocks fared in the ensuing months.
Just
because a stock was downgraded based on valuation doesn’t mean that it
won’t run into fundamental problems. You still have to do your due
diligence. The more you know about your stocks, the better your results.
Published 10/30/05 & 11/6/05 |
