NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

The Valuation of Security Analysis

Alex Kane, Alan J. Marcus

NBER Working Paper No. 1958
Issued in June 1986
NBER Program(s):   ME

Active portfolio management is commonly partitioned into two types of

activities: market timing, which requires forecasts of broad-based market

movements, and security analysis, which requires the selection of individual

stocks that are perceived to be underpriced by the market. Merton (1981) has

provided an inciteful and easily-implemented means to place a value on market

timing skills. In contrast, while a normative theory of stock selection was

outlined long ago in Treynor and Black's (1973) work, no convenient means of

valuing potential selection ability has yet been devised.

We present a framework in which the value of a security analyst can be

computed. We also treat market timing ability in this framework, and

therefore can compare the relative values of each type of investment

analysts. We find that stock selection is potentially extremely valuable, but

that its value depends critically on the forecast interval, on the correlation

structure of residual stock returns, and on the ability to engage in short

sales. Finally, we show how to modify the value of selection for the

important case in which analysts' forecasts of stocks' alphas are subject to

error.

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Document Object Identifier (DOI): 10.3386/w1958

Published: Kane, Alex, Alan J. Marcus, and Robert R. Trippi. "The Valuation of Security Analysis." Journal of Portfolio Management 25, 3 (Spring 1999): 25-36.

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