Tuesday, April 28, 2015

Paper: "Identifying Overvalued Equity" and the "O-Score"

Reading a paper called Identifying Overvalued Equity by Beneish and Nichols:

"Our model is a scoring system that combines firm characteristics into an overvaluation score (O-Score) ranging from zero to five. Firms receive one point for having a high likelihood of earnings overstatement (based on the Beneish (1999)’s PROBM measure), high sales growth, low operating cash flows to total assets, an acquisition in the last five years, and unusual amounts of equity issuance in the past two years. Thus, firms with glamour characteristics, poor current operating cash flow performance, a high likelihood of earnings overstatement, a history of merger activity, and recent but excessive issuances of stock fit our profile of overvalued equity. And, we show the overvaluation is substantial; firms with O-Scores equal to five lose about a quarter of their value."
Indexing idea: use Falkenstein's low volatility approach, and also prune any firms with high O-scores or high yield debt.

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