The heart of investment research is still appraisal—that is, valuing the worth of a security. But, increasingly, traditional comparative analysis, which compares two closely similar undertakings and establishes relative values for each, is being supplemented by valuation rules that apply to entire classes of securities. The rules now in general use discount future cash flows to the investor, hence depend critically on the forecast of cash flows and on the discount rate applied.
For shares, there is an emerging discipline of long-term earnings forecasting, which generates dividend predictions that serve as inputs to the Dividend Discount Model. The disclosure of new types of information in the public reports of American companies—such as business segment data, replacement costs of plant and equipment, and information on pension funding—has enabled researchers to develop new fundamental approaches to present and potential operating earnings.
For fixed-income securities, the problem is one of appraising the options available to issuer and investor. In this regard, the subtle option valuation rules that have emerged with the rapid growth of options markets are proving to be important tools for the valuation of corporate liabilities.
Discount rates for both shares and fixed income are studied from the perspective of capital market theory. Extensions of the simple Capital Asset Pricing Model (which argued that only one aspect of risk deserves compensation in the form of higher expected return) now suggest that several factors of risk (including both the risk of the equity market and interest rate risk) command expected reward. Substantial progress has also been made in articulating the structure of discount rates over time.
It is obviously important that the researcher use good judgment in allocating a limited budget across the many opportunities for study. In this context, it is necessary to recognize the difference between appropriate research in an inefficient market and appropriate research in a “fairly efficient” market. To be profitable, research must give the investor an advantage relative to the consensus, hence it must emphasize skills or insights not possessed by others.