This Just In: Upgrades and Downgrades

At The Motley Fool, we poke plenty of fun at Wall Street analysts and their endless cycle of upgrades, downgrades, and "initiating coverage at neutral." Today, we'll show you whether those bigwigs actually know what they're talking about. To help, we've enlisted Motley Fool CAPS to track the long-term performance of Wall Street's best and worst.

And speaking of the best...
As a general rule, when an analyst comes out and downgrades your stock to sell, you know you're going to be in for a rough day as an investor. So investors in audio tech specialist Dolby Laboratories (NYSE: DLB  ) were probably a bit nervous when trading began today, just minutes after an analyst at JMP Securities announced a downgrade to underperform.

They needn't have worried, though. Instead of heading into a nosedive, the stock turned around and went up 2%. But why?

After all, over the past few weeks we've seen any number of companies tied to the PC industry report disappointing earnings. Last month, Advanced Micro Devices (NYSE: AMD  ) reported a net loss on revenue fully one-third lower than what it collected a year ago. Before that, Intel (Nasdaq: INTC  ) went on record reducing both earnings and revenue guidance for this year, saying the economy is "challenging" and weak PC sales have created an "inventory" problem in the industry. Computer maker Hewlett-Packard (NYSE: HPQ  ) warned that profits this year could come in as much as 19% below what Wall Street had been hoping for.

All this miserable PC news suggests that, even now that we know Microsoft (Nasdaq: MSFT  ) has incorporated Dolby tech into Windows 8, the company may not get as much of a lift from the operating system's release as was previously hoped. And this has JMP thinking the Street's expectations for Dolby's earnings are "high," and Dolby's likely to "miss earnings" when it reports its fiscal Q4 numbers on Wednesday.

Seriously?
And yet, if you ask me, too-high expectations don't really seem to be a problem with Dolby this week. To the contrary, consensus expectations for the stock call for just $0.45 per share in net profit. While a miss is always possible, that number is a good 37% lower than what Dolby earned one year ago. To me, the bar looks low enough that Dolby could just as easily exceed expectations.

Similarly, JMP's assertion that it's downgrading Dolby to the equivalent of a sell rating because its valuation is too high just doesn't ring true. Consider: At 13 times earnings, Dolby looks on-its-face cheap if the company lives up to long-term consensus estimates for 15% earnings growth. And that's before you back out the company's near $1 billion in net cash (which produces an ex-cash P/E ratio of closer to 8.8) or the fact that the company's $365 million in free cash flow gives the stock a enterprise-value-to-free-cash-flow ratio of just 7.3.

Any way you slice it, that looks like a just fabulous valuation on 15% growth. But even if JMP is right, even if Dolby does disappoint us on Wednesday, and even if it grows slower than expected over the next five years, as well... by my calculations the stock remains buyable at a growth rate of even half what's expected.

Foolish takeaway
It takes a lot of courage to come out and recommend that investors short a stock ahead of earnings. If truth be told, I admire JMP for taking this gutsy stand, and putting its reputation on the line with the full knowledge that Dolby's earnings are just three short days away -- giving too little time for investors to forget that JMP was the analyst that led them wrong just days previously.

But this doesn't change the fact that I do think JMP is leading investors astray. This stock isn't overpriced, nor are its expectations too high to achieve. This is why I've bought the stock myself, why I've publicly recommended buying Dolby on Motley Fool CAPS, and why I continue to believe Dolby is a buy today.

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