CELG

Understanding the amount of accruals a company has on its books and the quality of its reported earnings is especially important during earnings season, as poor earnings quality companies are more likely to have negative earnings surprises and underperform as a result. With so many companies reporting earnings this week, we wanted to share an analysis of their earnings quality based on The Applied Finance Group’s Earnings Quality score. AFG’s Earnings Quality variable is based on the concept of accruals and is an important indicator, which helps to differentiate between companies with poor and high quality of reported earnings. Watch out for firms with poor EQ score – make sure they are not trying to pad their sales numbers through channel stuffing, for example.

*Source: www.afgview.com

Two ways to approach accruals:

1. Cash Flow Statement
•Difference between Net Income and Cash Flow

2. Balance Sheet
•Change in Net Operating Assets from Period t-1 to t
•Net Operating Asset equals Total Assets Less Cash, Less Non-Debt Liabilities (excl. Minority Interest)
• Our studies show that the Balance Sheet approach is superior to the Cash Flow Statement approach.
• We found the Balance Sheet approach is also easier to expand to international companies.
• Low Accrual companies outperform high accrual companies
 

 Here is a look at how well the Earnings Quality variable works when you split top half vs. bottom half in each sector/style universe.

Source: AFGView client databases from 9/1998 - 5/2009   Universe size: 4,000 to 5,500 firms

Here is a look at an example of a poor Earnings Quality company that has a negative earning surprise and thus underperforms.

Eastman Kodak

• Other Liabilities declined in Q308, leading to high accruals – change in licensing agreement required immediate recognition of deferred revenue.
• Eastman Kodak (EK) subsequently missed earnings in Q408.
• EK’s stock dropped 29% on January 28th, when Q408 earnings were announced.
• EK has underperformed the S&P500 by almost 70% since January 28th.
 

source: www.economicmargin.com

Traditional Discounted Cash Flow (DCF) models have been been underutilized in equity analysis over the years primarily because of the assumptions one has to sign off on. We will concentrate on just two of the major issues we have with traditional DCF models, the lack of ability to deal with competition and the perpetuity assumption embedded in a DCF model. These assumptions lead to irrational calculations of intrinsic value and force analysts to make compromising decisions in their model building efforts.

AFG uses a modified DCF model that accurately addresses the competitive nature of the business while also dealing with the perpetuity issue through our Economic Margin decay or competitive advantage period.

The four factors that affect AFG’s Competitive Advantage Period (CAP) are;

Profitability – High Profit leads to increased competition and a higher decay rate
Variability – Higher volatility leads to less predictability and a higher decay rate
Trend – AFG gives the benefit of the doubt to an upward trend which leads to a lower decay rate
Invested Capital – Large Invested Capital creates barriers to entry and leads to lower decay rate

The Decay Rate is the rate at which the Economic Margins™ will diminish over time due to competition, market conditions and limited investment opportunities. Higher decay rates translate into shorter competitive advantage periods, while lower decay rates translate into longer competitive advantage periods.

The Decay Rate profile is downward sloping to the right, which means that Economic Margins™ over time diminish to zero. This does not mean that the company will not have earnings, but instead the company will have an Economic Margin™ of zero, which indicates there are no excess profits after the investors are paid and the depreciating assets are replaced.When selecting securities, companies that are maintaining a high level of economic profitability or growing their profits rapidly are attractive from an investment standpoint. However, the more profitable a firm is the more likely other companies will attempt compete away excess returns.

To illustrate this, one has to look no further than Dell Computer. Dell Computer had Economic Margins™ hovering around 40% (top 5% of all companies) in 1997 and 1998, but soon every major firm was announcing that they were going to build computers to order. Why? Because they saw the huge profits that Dell was making. The result is that Dell's Economic Margin™ for 1999 was around 25%, a decline of 37.5% in just one year. The remaining factors are relatively straight-forward, in that volatile returns are worth less than consistent returns, companies with an increasing Economic Margins™ are worth more than a company in decline, and large companies have a natural barrier to entry, thus a lower decay rate.

Theory: Excess return gets competed away

Fact: In 1997, the median top decile Economic Margin (EM) firm = 17.4%. 10 years later, that same group of companies had a median EM of 6.5%. On the other hand, the bottom decile had an EM of -12.2%, 10 years later that same group had a median EM of -1.0%.

Current Top Decile Economic Margin Companies (S&P 500 ex. financials)

Join Value Expectations... it's FAST and FREE!

Bloomberg provides a score for companies within the S&P 500 based on an average of all analyst ratings from the street. Below is a table highlighting companies with the best analyst ratings, largest increase in rating, highest price targets, and worst analyst ratings and the valuation attractiveness of each of these companies based on The Applied Finance Group’s (AFG) valuation model.

Companies within each of these groups are ranked from most attractive from a valuation perspective to the least attractive. VE.com will actively track the performance of these recommendations and see how they stack up to the analyst recommendations in each group. AFGview.com, AFG’s professional investor website allows you to compare any company using their rating versus the consensus ratings of the sell side. If you are interested in an analysis on a specific company, contact afgsales@afgltd.com.

Best/Worst Analyst Rated Companies (Bloomberg)

AFG's Valuation Model – Using AFG’s modified discounted cash flow model to measure the intrinsic value of a firm compared to its peers. AFG's Value Score - A score which represents the ranked percent to target (deviation between stock’s current trading price and AFG’s current default target price) or attractiveness (upside) relative to the universe. A Value Score of 100 is the most undervalued and 0 is the most overvalued company in the universe.

For the past 26 years Steven Halpern, editor of thestockadvisors.com has gone to well known and respected advisors once a year to find out which stocks they like for the coming year. Take a look at the list of stocks advisors liked in 2008 and their performance. Also listed are the picks of 75 prominent advisors for 2009 along with sales growth expectations for the companies to justify their current price (VE Sales Growth) which can be compared to what they have delivered in revenue growth over the past 5 years(5 Year Median Sales Growth). These companies are worth a look because they are in favor of well-respected advisors, but the companies that also have low expectations for sales growth priced-in to their stock are especially worthy of a close review.

2008 Blogger Picks Conservative and 2008 Performance

2008 Blogger Picks Speculative and 2008 Performance

Blogger Picks for 2009 and Sales Expectations

* denotes # of years historical sales numbers available

VE Sales Growth calculated for these firms on 1-6-09

Economic Margin (EM) Defined - A measure of corporate performance that captures off balance sheet items, by looking at how much a company is earning above or below their cost of capital. EM is expressed in a % or margin. The Economic Margin Framework™ is more than just a performance metric as it encompasses a valuation system that explicitly addresses the four main drivers of enterprise value: profitability, competition, growth and cost of capital.

Here is a list of companies, two from each sector within the S&P 500 that are expected to improve their Economic Margins (EM) the most over the next two years along with the bottom two in each sector expected to have their EM’s deteriorate the most. Companies expected to improve their EM’s more than their sector peers have proven to be more likely to out-perform. Improving EM’s coupled with low expectations priced-in for sales growth are the companies on this list that may be worth a look as a potential investment.

Also included in this table is the implied sales growth priced-in over the next five years in order to justify the stock’s current trading price compared with their achieved 5 Year Median Sales Growth. Ask the question are the expectations for sales growth realistic compared with what revenue growth the firm has delivered in the last five years.

If you would like to learn more about the Economic Margin methodology or Value Expectations feel free to contact an AFG representative to schedule a web-demo at support@afgltd.com.

S&P 500 Companies with the Biggest Forecasted Change in Economic Margins

These 20 companies produced the greatest returns in 2008 within the S&P 500. Let’s take a look at what is priced-in for sales growth going forward to justify their current price. Compare what expectations are priced-in (VE Sales growth) to what the company has been able to deliver the past five years (5 Year Median Sales Growth) to see if each company has realistic expectations. The more realistic the expectations are, the more likely the company will be on this list next year.

Top 20 Return S&P 500 Companies and Their VE Sales Growth

VE Sales Growth was calculated for these companies on 12/16/08

According to Bespoke Investment Group, these ten companies have the highest percentage of Buy ratings from the analysts that follow them. This table shows the number of analysts covering each stock and the number of buy and sell ratings as well as the percentage of buy ratings on the top 10 companies from Bespoke. Also in the table is the achieved 5 year median sales growth and the VE Sales growth (Sales Growth expectations priced in to the stock at today’s price). Only the top 4 companies on the list LO, PM, TMO, and AYE have 100% buy ratings from all analysts. Of those four, only AYE has high expectations relative to what they have delivered in sales growth in the past. Six out of the twelve companies on the list LO, PM, TMO, GOOG, COV, and BLL have very realistic expectations for sales growth priced-in compared to what they have been able to achieve. With the high percentage of buy ratings on these stocks they all deserve a more in-depth look, but the six with low expectations look especially worthy of consideration as potential investments.

S&P 500 Stocks with the Highest Percentage of Analyst Buy Ratings.

*denotes company only has 2 years of historical sales growth
**denotes company only has 3 years of historical sales growth
VE Sales Growth was calculated for these companies on 12/12/08.