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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

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