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." So you might think we'd be the last people to give virtual ink to such "news." And we would be -- if that were all we were doing.

But in "This Just In," we don't simply tell you what the analysts said. We'll also show you whether they know what they're talking about. To help, we've enlisted Motley Fool CAPS, our tool for rating stocks and analysts alike. With CAPS, we'll be tracking the long-term performance of Wall Street's best and brightest -- and its worst and sorriest, too.

And speaking of the best ...
As markets closed for the extended weekend, investors in Motley Fool Rule Breakers recommendation NetEase.com (NASDAQ:NTES) received a holiday gift from the generous analysts at Pali Research: an upgrade from "neutral" to "buy."

According to Pali, first-quarter earnings at the Chinese gaming house were "very strong" (though not everyone agreed). Sales rose 18%, and although earnings per share declined, higher taxes caused this, not operational weakness. In fact, Pali pointed out that the opposite was true: "revenue beat consensus, gross margins and operating margins improved."

Pali expects the good times to keep on rolling as NetEase rolls out new games, along with expansion packs for Westward Journey II and III, over the next few months. As if all that weren't enough, Pali closed with a bang, predicting that NetEase will earn $2.20 per ADR -- nearly 50% higher than most analysts expect.

Gutsy call! You rarely see an analyst wander this far from the herd. But does Pali have the reputation to back up its prognostication? Let's find out.

Let's go to the tape
Although its 70th-percentile CAPS rating may not exactly knock your socks off, you have to give Pali credit -- it gets nearly 61% of its predictions right, whereas the average on Wall Street is far lower. Focusing on its Chinese picks in particular, we find:

Unfortunately, after getting off to such a great start, Pali promptly stumbles, and we find it getting just as many Chinese picks wrong:

So we're left back where we started when first introduced to Pali -- the analyst has a respectable, but hardly stellar, CAPS rating. Similarly, it has a strong record of picking stocks correctly -- but that record is limited (only 21 active and 34 total picks, as tracked by CAPS), and weaker on China in particular.

So why, despite the conflicting evidence, do I think Pali's right on this one? Not because Rule Breakers recommended the stock. Regular readers know that I often contradict my more adventurous Foolish brethren (last week, for example). Nor do I necessarily agree with Pali's gutsy prediction that NetEase will earn 50% more than anyone else on Planet Earth (practically) thinks possible next year. To be honest, it doesn't matter.

Foolish takeaway
For me, it's a simple question of valuation, and the likelihood that an investment at today's price will "work out" based on accepted growth predictions. Over the last 12 months, NetEase generated $211 million in free cash flow. That's more than it reported in net income under GAAP accounting standards, meaning that investors are valuing this stock at just 14 times free cash flow.

Which means that you can forget about Pali's exuberant predictions for next year. If you accept only the consensus predictions of 18% annual growth over the next five years, NetEase still looks cheap at today's price.