What Wall Street could learn from the Business Valuation Profession

One would think that there would be no difference between how Wall Street values a company and how it is done by the BV community, after excluding the valuation adjustments for privately-held status that business valuation consultants make.  Analysts, money managers and traders on Wall Street and privately-held business valuation analysts get the same degrees, whether it is a bachelor's degree in accounting, economics or finance, or an MBA from a leading business school.  Many on Wall Street and in the BV community possess the CFA credential.  So if we are all learning the same techniques, why does it seem we have differing philosophies on value?

To make it clear what I mean, start off with a standard Wall Street analyst's report where Widget Corporation's stock is valued at $20, but is currently trading at $15.  The release of the report is new information, so one would expect the stock to move toward $20 if Wall Street agrees with the analyst's opinion.  Often, however, it seems like Wall Street focuses less on the overall valuation conclusion, and more on beating the EPS estimates for next year and next quarter.  If Widget exceeds its quarterly earnings estimate by 10%, the stock may rise dramatically, sometimes 20% or more in the following month.  More extreme are the consequences of an earnings miss, where a stock often drops 40% in a day on a 10% earnings miss.  The overall result is to generate dramatic swings in market value on relatively small changes in quarterly performance.

So why is this occurring?  Maybe we have to step back from the world of analysts and move into the world of Wall Street traders and mutual fund managers.  Mutual funds are ranked quarterly and annually on their performance versus similar funds.  These rankings are critical to the new money a fund can attract, and since a money manager usually gets paid based on his annual performance and assets under management, it has a direct impact on his bottom line.  So the money manager is incentivized to focus on the short-term:  stocks that are expected to rise in less than one year.  Thus we read of fund managers doing "sector rotation" into stocks in sectors expected to perform well in the next few months.  From this arises the old saying that "Wall Street anticipates earning six months into the future."  This is even more extreme with stock traders, who are buying into a stock for a short-term price increase.  Just read any stock board and you will see discussions that a stock is "dead money" (i.e. that it is not going to move in the near future).  These stocks are dumped by traders.

In contrast, the business valuation professional considers the earnings history of a company for multiple years; many BV books recommend 5 years or more.  He considers both past and future earnings performance.  The BV analyst tries to determine if the past trend is sustainable or not, and relates this to the overall economy and industry at that time.  Each past year's performance is a potential scenario of future earnings, so if we know that 2009 was a recessionary year and 2006 was a boom year, the analyst can see how external economic conditions affected the company's performance.  Thus any forecast the company makes can be evaluated against past results and future economic expectations.

The academic literature on financial bubbles emphasizes that bubbles are often created when stock traders stray from valuation fundamentals and move toward a game of anticipating short-term increases.  Traders may believe that stocks are overvalued, but still believe in the short-term that stock will become even more overvalued.  Of course to make money this way, you have to be a believer in the "greater fool" theory, namely that after the stock rises, there will be a "greater fool" who will buy it from you at that price.  Alan Greenspan referred to this as "irrational exuberance".

Yale Professor Robert Schiller borrowed Greenspan's phrase for the title of his book.  In Irrational Exuberance, Schiller makes the case that in determining value we should take a long-term perspective.  This puts Schiller in accordance with most BV practitioners in most cases.  But Schiller's view of the long-term is long-term indeed.

Schiller's model to determine whether the market is overvalued is fairly simple.  He uses a Price /Earnings ("P/E") ratio model where price is defined as the real (inflation adjusted) value of the S&P 500 index and earnings are defined as the average of the past TEN years of real (inflation adjusted) S&P 500 index earnings.   Using this model, one can go back over the last 150+ years of stock market data and detect that stocks were clearly very overvalued in 1901, 1929, 1966 and 2000, and very undervalued in the early 1980s.  (He uses a similar model to compare house prices to personal income, and one look makes it clear that the current housing crash was perfectly foreseeable).

So it looks like the valuation methodologies employed by BV analysts are more likely to avoid "irrational exuberance" than those used by Wall Street traders.  It also reinforces the argument used by Ibbotson SBBI that the longer the data series, the more likely we are to avoid "irrational exuberance" or "irrational pessimism" in the calculation of equity risk premiums.

This blog

Raymond J. ("RJ") Dragon MBA, MS, ASA, CFFA is a Principal in Citrin Cooperman's Valuation & Forensic Services practice in the New Jersey / New York City area.  His work encompasses valuations for litigation support, marital dissolution, shareholder disputes, estate and gift tax, intangible asset valuation, purchase price allocation and financial reporting.

More from this blog

Bloggers crew

Steve Knowles has spent 25 years in business and practice in the UK, but he also worked in the states and the years haven't dulled his way of seeing an alternative view to everyone else, and every day is a new adventure.

43140

Joel M. Ungar, CPA is a lifelong resident of the Detroit area and a graduate of The University of Michigan. He is a principal with Silberstein Ungar, PLLC, a Top 15 auditor of SEC public reporting companies.

75583

Allan Boress, CPA, with over 25 years as a practitioner and consultant to the accounting profession. Mr. Boress is the author of 12 published books in 6 different languages, including a best-seller, The "I-Hate-Selling" Book.

48087

Larry Perry, CPA, CPA Firm Support Services, LLC, is the author of accounting and auditing manuals, author and presenter of live staff training seminars, and author of webcast and self-study CPE programs. He blogs about small audits, reviews, and compilations.

88555
Sandra Wiley, COO and Shareholder, is ranked by Accounting Today as one of the 100 Most Influential People in Accounting as a result of her prominent role as an industry expert on HR and training as well as influence as a management and planning consultant. She is also a founding member of The CPA Consultant's Alliance. Sandra is a certified Kolbe™ trainer who advises firms on building balanced teams, managing employee conflict and hiring staff.
20283

Maria Calabrese, CIR, Human Resources manager for Fazio, Mannuzza, Roche, Tankel, LaPilusa, LLC in Cranford, New Jersey, Maria's topics revolve around the world of: Mentoring, Performance management, and The "Y Generation," a.k.a. "The whY generation".

55277

William Brighenti is a CPA, Certified QuickBooks ProAdvisor, and Certified [Business] Valuation Analyst, operating an accounting, tax, and QuickBooks consulting firm in Hartford, Connecticut, Accountants CPA Hartford.

80235

Ken Garen, CPA, is the co-founder and President of Universal Business Computing Company (www.ubcc.com), a software development firm of high-volume, high-productivity accounting and payroll technology.

24784

Eva Rosenberg, MBA, EA, is the publisher of TaxMama.com, and author of the weekly syndicated Ask TaxMama column. She provides answers to tax questions from taxpayers and tax professionals worldwide.

63757

Amy Vetter, CPA, CITP is the CPA Programs Leader for Intacct Corporation responsible for leading the CPA/BPO Partners nationally.

34221
Brian Strahle is the owner of LEVERAGE SALT, LLC where he provides state and local tax technical services to accounting firms, law firms and tax research organizations across the United States. He also writes a weekly column in Tax Analysts State tax Notes entitled, "The SALT Effect." For more info, visit his website: www.leveragestateandlocaltax.com
102272
Scott H. Cytron, ABC, is president of Cytron and Company, known for helping companies and organizations improve their bottom line through a hybrid of strategic public relations, communications, marketing programs and top-notch client service. An accredited consultant, Scott works with companies, organizations and individuals in professional services (accounting, finance, medical, legal, engineering), high-tech and B2B/B2C product/service sales.
25606

Rita Keller is a nationally known CPA firm management consultant, speaker, author, mentor and blogger. She has over 30 years hands-on experience in CPA firm management, marketing, technology and administrative operations.

52208
Stacy Kildal is the mom of two fantastic kids, an Advanced Certified QuickBooks ProAdvisor, Certified Enterprise Solutions ProAdvisor, Sleeter Group Certified Consultant, a nationally recognized member of the Intuit Trainer and Writer Network, and co-host of RadioFree QuickBooks.
27496
Michael Alter's blog specializes in providing practical advice to those who seek greater profitability and practice management tactics that enhance deeper client relationships.
31792

Sally Glick, CMO, Principal, Marketer of the Year in 2003 and AAM Hall of Famer in 2007, leads a lively discussion of the constantly expanding roles of marketing and the professional marketers that drive this initiative in accounting firms of all sizes.

100005

The IMA Young Professionals Blog features the insights of IMA’s Young Professionals Committee. Committee members share advice and experiences on careers, continuing education, work/life balance, and other issues affecting young accounting and finance professionals.

32965

FEI Financial Reporting Blog provides highlights from SEC, PCAOB, FASB, IASB, and other regulatory news, including reporting under Sarbanes-Oxley Sect 404. It is written by Edith Orenstein, Director of Technical Policy Analysis at FEI.

110938

Sue Anderson has 30 years of experience in continuing education for accountants. Currently she is the program director for online CPE provider CPE Link.

60659

Jim Fahey is COO of Apple Growth Partners, a regional CPA firm in Ohio. His focus is on the effective and efficient use of technology within the firm by all team members.

38929
Caleb Newquist is the Editor-in-Chief of Sift Media US, overseeing content for both AccountingWEB and Going Concern.
66126

Leita Hart-Fanta, CPA, CGFM, and CGAP is the author of "The Yellow Book Interpreted" and owner of Yellowbook-CPE.com a website devoted to training for governmental auditors.

92128

AccountingWEB is more than just a U.S. team of journalists and financial and technology experts - we have an international side, too! Members of our British team who publish AccountingWEB.co.uk share their ideas, insights, and perspectives from across the pond.

53169