Partha S. Mohanram

Inferring the Cost of Capital Using the Ohlson-Juettner Model

We compare risk premia (RP) inferred using the Ohlson-Juettner (RPOJ) and residual income valuation (RPRIV) models in three ways: (1) correlation with risk factors; (2) correlation with RP estimated by multiplying current realizations of risk factors by coefficients obtained from regressing prior-year RP on prior-year risk factors; and (3) correlation with ex post returns. RPOJ has expected correlations with risk factors, a modest correlation with RP estimated from prior-year regressions, and an economically significant association with ex post returns. RPRIV has generally higher correlations, but regression coefficients are sensitive to whether the industry median ROE is computed with or without loss firms.

Private Information, Earnings Manipulations, and Executive Stock Option Exercises

This paper investigates the decision by top-level executives of more than 1,200public corporations to exercise large stock option awards in the period 1992-2001. Wehypothesize and find that abnormally large option exercises predict stock return futureperformance. We then hypothesize that this predictive ability represents private information about disappointing earnings in the post-exercise period. Consistent with this hypothesis we find that abnormally positive earnings performance in the pre-exercise period turns to disappointingearnings performance in the post-exercise period, and that this pattern comes as a surprise to even sophisticated market participants (financial analysts). We also hypothesize and find that the disappointing earnings in the post-exercise period represent a reversal of inflated earnings in the pre-exercise period. Collectively, these findings suggest that the private information used by top-level executives to time abnormally large exercises follows from earnings management so as to increase the cash payout of exercises.

How Has Regulation FD Affected the Operations of Financial Analysts

In this paper, we analyze how financial analysts generate information, make decisions about firm coverage, and try to maintain their forecasting accuracy after the passage of Regulation Fair Disclosure (“Reg FD”). Using the model developed by Barron, Kim, Lim, and Stevens 1998, we find that analysts are investing more effort in idiosyncratic information discovery. In order to do this, individual analysts appear to be reducing coverage for well-followed firms while increasing coverage of firms that were less followed prior to Reg FD. Analysts who had preferential links with firms that they covered, such as analysts from large brokerage houses, tend to have greater forecast accuracy in the pre-FD period. However, these analysts are unable to sustain their forecasting superiority in the post-FD period, which suggests that there has been a leveling of the information playing field among analysts. Overall, our results reflect a trend toward greater reliance on idiosyncratic information discovery on part of the financial analysts.

Evaluating Cross-Sectional Forecasting Models for Implied Cost of Capital

The computation of implied cost of capital (ICC) is constrained by the lack of analyst forecasts for half of all firms. Hou et al. (J Account Econ 53:504–526, 2012, HVZ) present a cross-sectional model to generate forecasts in order to compute ICC. However, the forecasts from the HVZ model perform worse than those from a naive random walk model and the ICCs show anomalous correlations with risk factors. We present two parsimonious alternatives to the HVZ model: the EP model based on persistence in earnings and the RI model based on the residual income model from Feltham and Ohlson (Contemp Account Res 11:689–732, 1996). Both models outperform the HVZ model in terms of forecast bias, accuracy, earnings response coefficients, and correlations of the ICCs with future returns and risk factors. We recommend that future research use the RI model or the EP model to generate earnings forecasts.

Analysts’ Cash Flow Forecasts and the Decline of the Accruals Anomaly

The accruals anomaly, demonstrated by Sloan (1996), generated significant excess returns consistently for over four decades until 2002, but has apparently weakened in the subsequent period. In this paper, I argue that one factor responsible for this decline is the increasing incidence of analysts’ cash flow forecasts that provides markets with forecasts of future accruals. The negative relationship between accruals and future returns is significantly weaker in the presence of cash flow forecasts. This anomalous relationship becomes weaker with the initiation cash flow forecasts but continues after cash flow forecasts are terminated. Further, the mitigating effect of cash flow forecasts is greater for forecasts that are more accurate. The results are incremental to explanations based on the improved accrual quality, reduced manipulation of special items and restructuring charges and greater investment in accruals strategies by hedge funds and highlight the increasing importance of analysts’ cash flow forecasts in the appropriate valuation of stocks.

Mutual Forbearance and Competition Among Security Analysts

Research in industrial organization and strategic management has shown that rivals competing with each other in multiple markets are more willing to show each other mutual forbearance, i.e., compete less aggressively, within their spheres of influence, i.e., the markets in which each firm dominates. Sell-side equity analysts typically cover multiple stocks in common with their rivals. We examine the impact of this “multipoint contact” for mutual forbearance on two key dimensions of competition among security analysts: forecast accuracy and information leadership (issuing earnings forecasts or stock recommendations that influence rival analysts). We find that multipoint contact is associated with analysts exerting greater information leadership on stocks within their own spheres of influence. We also find greater forbearance related to information leadership under Regulation Fair Disclosure (Reg FD). In contrast, multipoint contact was not associated with greater forecast accuracy on stocks within analysts’ spheres of influence, either before or under Reg FD. Our analysis is among the first to consider mechanisms of competition among securities analysts and also adds to the literature on Reg FD by demonstrating that the increased workload imposed on analysts after Reg FD fostered mutual forbearance as a response. This paper was accepted by Mary Barth, accounting .

Fundamental Analysis: Combining the Search for Quality with the Search for Value

Using cross-sectional forecasts, we combine fundamental analysis strategies based on quality, such as the FSCORE from Piotroski (2000) and the GSCORE from Mohanram (2005), with strategies based on value, such as the V/P ratio from Frankel and Lee (1998) and the PEG ratio. While all four strategies generate significant hedge returns, combining quality-driven and value-driven approaches substantially improves the efficacy of fundamental analysis. Our parsimonious two-dimensional approach can be applied to a wide cross-section of stocks and outperforms common practitioner approaches that require a lengthy time-series of data. The improvements in hedge returns hold for a variety of partitions and are robust to controls for risk factors and other determinants of stock returns. While the efficacy of fundamental analysis has declined in recent years, this can partially be attributed to investors arbitraging away excess returns by investing in fundamental strategies.

Fundamental Analysis: Combining the Search for Quality with the Search for Value: Fundamental Analysis: Combining the Search for Quality with the Search for Value

Using cross-sectional forecasts, we combine fundamental analysis strategies based on quality, such as the FSCORE from Piotroski (2000) and the GSCORE from Mohanram (2005), with strategies based on value, such as the V/P ratio from Frankel and Lee (1998) and the PEG ratio. While all four strategies generate significant hedge returns, combining quality-driven and value-driven approaches substantially improves the efficacy of fundamental analysis. Our parsimonious two-dimensional approach can be applied to a wide cross-section of stocks and outperforms common practitioner approaches that require a lengthy time-series of data. The improvements in hedge returns hold for a variety of partitions and are robust to controls for risk factors and other determinants of stock returns. While the efficacy of fundamental analysis has declined in recent years, this can partially be attributed to investors arbitraging away excess returns by investing in fundamental strategies.