How To Learn Stocks | How To In Invest In Stock | How To Pick Stock

Ten days from now, Sioux City, Iowa, will reach a high of 83 degrees Fahrenheit. At least, that’s what I’m estimating. I’m not a trained meteorologist. But then, according to accuracy-tracker ForecastWatch, predictions for more than nine days out tend to be less reliable than simply assuming that date’s weather will match its 30-year average, as I’ve done for Sioux City.

Still, weather forecasters are vastly more reliable than Wall Street analysts when the latter are announcing price targets on stocks. I’m referring to when an analyst says a stock that’s trading at, say, $12 should hit $16 within a year. Mark Bradshaw and Lawrence Brown, professors at Harvard Business School and Georgia State University, respectively, studied the matter and reported in a 2006 paper that analysts “do not exhibit persistent differential abilities to forecast target prices.” That’s a bummer, since most recommendations we see on whether to buy or hold (or rarely, sell) are based on the difference between today’s price and the target price.

Julian Koski and Armen Arus, former analysts, say they can make Wall Street’s predictions more accurate. Financial forecasters should work backward, they believe.

Most of the price targets come from something called discounted cash flow (DCF) analysis. The idea is to predict how much cash a company will generate for investors in coming years, and then calculate how much investors ought to pay today for that string of future profits, based on factors like prevailing interest rates and risk. DCF is a centerpiece of business school curricula, perhaps because it’s math-y enough to seem worthy of the attention of bright minds. It’s not terribly reliable for most companies, though. The snag: The part where analysts predict cash flows years in advance, even though they have difficulty estimating next quarter’s earnings. No matter how much fine math you build atop a foundation of guessing, it’s still only a guess. If only more of the inputs could be known ahead of time.

Koski and Arus think analysts ignore the most important input of all: today’s price. Since we already know it, we can use the reverse of DCF analysis to calculate how much income companies will have to produce in coming years to make today’s price worthwhile. Then all we have to do is determine the probability of companies producing that income, based on their current trajectory. Koski and Arus call that the Required Business Performance (RBP) approach, and six years ago launched a firm called Transparent Value to market it.

Transparent Value assigns high RBP percentages to companies that look likely to do enough business in coming years to justify their prices and low RBP percentages to companies that seem priced for unrealistic expectations. Earlier this year, Dow Jones Indexes (on the corporate family tree, a third cousin twice removed to SmartMoney.com) launched indexes based on RBP. On Monday, Transparent Value filed a request with the Securities and Exchange Commission for permission to launch three mutual funds based on the indexes.

Evidence on RBP returns is theoretical for now, based on back-testing rather than real world performance. The numbers are promising, though. Through the end of 2008, the main RBP index returned an average 8.6% a year, while the S&P 500 index lost an average of 1.4%.

Since this column generally focuses on stocks to buy, and readers sometimes ask for ideas on ones to sell, I recently asked Transparent Value to send over a list of companies with low RBP probabilities — ones that seem priced for disappointment. It included title insurer First American (FAF), property and casualty insurer Progressive (PGR), pharmacy plan manager Express Scripts (ESRX), for-profit school Career Education (CECO) and Darden Restaurants (DRI), owner of Olive Garden and Red Lobster. Find details on each on the table below.

SMARTMONEY ® Layout and look and feel of SmartMoney.com are trademarks of SmartMoney, a joint venture between Dow Jones & Company, Inc. and Hearst SM Partnership. © 1995 – 2009 SmartMoney. All Rights Reserved.

Source: http://feeds.smartmoney.com/smartmoney/investing

Click Here to Learn How To Generate Profitable Winning Trades
On Autopilot In Only An Hour A Day