2. Discuss whether James Stewart’s assessment of eBay reflects any biases (3 marks).
3. In what ways are the events described at Intel and eBay similar and in what ways are they different (4 marks)?
Question # 1
Brandt Cornell’s paper “Is the response of analyst to information consistent with fundamental valuation?” reveals that analyst recommendations are pro cyclical. As bad news arrives and the underlying price of the firm’s stock goes down , analyst downgrade company , the opposite effect arises when good news arrives. As Cornell says , this leads to a positive feedback loop. Thus, if analyst recommendations influence investor actions , then such a feedback could strengthen price movements in both direction. recommendation on DCF valuation but instead relied on representativeness. Debondt and Tahler (1990 found a tendency towards overreaction in forecast changes and under reaction in forecast revisions. As in the case of Intel , managers responded that market had overreacted. Debondt and Tahler also found overreaction for positive forecast modifications and under reaction for negative forecast modifications. Finally, they also found that overreaction, under reaction and excess optimism increase with forecast horizon suggesting that the longer the prediction horizon, the larger the prediction bias. Furthermore, Cornell ,Conrad and Landsman (2000) prove that as the level of the market rises , individual stock becomes more sensitive to bad news.
Analyst who followed Intel appear not to have based their recommendation on DCF. According to Bloomberg ,virtually none of the28 analysts reports on Intel, examined DCF valuation analysis .Additionally, the few analysts who actually referred to DCF in their report , did not include enough information to understand the basis for the calculations. As Brandford Cornell points out , the lack of developed DCF model leads analyst to overlook the significance of expected returns in investors decision . What is more , by not focusing on fundamental value, and by not presenting DCF valuation models , analyst short change investors . Nearly in every case, the financial projection are estimated in short time frame - 2 years or less which is not satisfactory enough to arrive at valid valuation. Thus it is tricky to understand and distinguish the reasons behind changes in response to events such as Intel’s press release. In valuation approach, securities whose price is less than the present value of expected future cash flows discounted at the risk adjusted rate, are those which are appealing to the buyer . In comparison, bond ratings, aims to measure the credit quality of a firm thus it can be evaluated without taking valuation into consideration. In the “ Is the response of analyst to information consistent with fundamental valuation?” paper, author claims that analyst recommendations are not based on comparison of market price with fundamental value . They are rating the company, rather than investment . Credit ratings reflect the ” goodness” of a firm rather than a stock. Therefore analyst recommendations, in behaving like a credit ratings, tend to be linked with the quality of the firm than the attractiveness of its stock . It finally appears that analyst did not based their recommendation on DCF valuation but instead relied on representativeness. Analysts adhere to representativeness in shaping opinions about risk and return. Thus, it leads analysts off track in their estimates of the market risk premium and to succumb to gambler’s fallacy when evaluating return forecast for specific stocks. Gambler’s fallacy also leads them to sell shares in their companies after a year of stock price appreciation, and to keep or buy shares after a year of low…