The Valuation of Security Analysis

39 Pages Posted: 26 Jul 2001 Last revised: 7 Apr 2010

See all articles by Alex Kane

Alex Kane

University of California, San Diego (UCSD) - Graduate School of International Relations and Pacific Studies (IRPS)

Alan J. Marcus

Boston College - Department of Finance

Date Written: June 1986

Abstract

Active portfolio management is commonly partitioned into two types ofactivities: market timing, which requires forecasts of broad-based marketmovements, and security analysis, which requires the selection of individualstocks that are perceived to be underpriced by the market. Merton (1981) hasprovided an inciteful and easily-implemented means to place a value on markettiming skills. In contrast, while a normative theory of stock selection wasoutlined long ago in Treynor and Black's (1973) work, no convenient means ofvaluing potential selection ability has yet been devised.We present a framework in which the value of a security analyst can becomputed. We also treat market timing ability in this framework, andtherefore can compare the relative values of each type of investmentanalysts. We find that stock selection is potentially extremely valuable, butthat its value depends critically on the forecast interval, on the correlationstructure of residual stock returns, and on the ability to engage in shortsales. Finally, we show how to modify the value of selection for theimportant case in which analysts' forecasts of stocks' alphas are subject toerror.

Suggested Citation

Kane, Alex and Marcus, Alan J., The Valuation of Security Analysis (June 1986). NBER Working Paper No. w1958. Available at SSRN: https://ssrn.com/abstract=278028

Alex Kane (Contact Author)

University of California, San Diego (UCSD) - Graduate School of International Relations and Pacific Studies (IRPS) ( email )

9500 Gilman Drive
La Jolla, CA 92093-0519
United States

Alan J. Marcus

Boston College - Department of Finance ( email )

Fulton Hall
Chestnut Hill, MA 02467
United States
617-552-2767 (Phone)
617-552-0431 (Fax)

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