Every day, Wall Street analysts upgrade some stocks, downgrade others, and "initiate coverage" on a few more. But do these analysts even know what they're talking about? Today, we're taking one high-profile Wall Street pick and putting it under the microscope...

Bouncing back from weaker than expected earnings last quarter, shares of entry-level homebuilder MDC Holdings (NYSE:MDC) are hopping this morning. They're being buoyed by a big earnings beat -- and an upgrade on Wall Street.

This morning, analysts at Merrill Lynch, who had previously been pretty down on MDC stock, reversed course and double upgraded the stock all the way from underperform to buy, reports StreetInsider.com (subscription required). When last sighted trading just above $30 a share, MDC was below even Merrill's pessimistic $36 price target. Now, however, the analyst sees every possibility that MDC shares will soar to $42 within a year.

Here's what you need to know.

Workers reading a construction blueprint

M.D.C. Holdings has a plan for growth -- and it involves buying a whole lot of land to build on. Image source: Getty Images.

Beating earnings with stick-built houses

MDC builds mostly entry-level homes under its Richmond American Homes brand name, targeting first-time and move-up homebuyers -- a popular segment of the market given the dearth of existing homes available for sale and the current environment of rising interest rates that magnifies the cost of buying any home.

In MDC's report, released last night, the company had been expected to report profits of $0.85 per share for its fiscal Q2, reports TheFly.com. Instead, "healthy demand" for new homes "at affordable price points ... allowed us to raise prices in a majority of our communities during the quarter," said CEO Larry Mizel.

This helped MDC to grow its gross margin 230 basis points (to 19.1%), even as selling, general, and administrative expenses held steady at 10.9% of revenue. The combination of better gross margins and steady costs transformed an already respectable 16% rise in revenue in Q2 into a boffo 48% increase in pre-tax income -- and an 89% increase in net income.

Earnings per share soared to $1.12, easily eclipsing estimates. What's more, although MDC didn't give specific guidance for earnings for the rest of this year, it did note that "[b]acklog dollar value" is up 16% year over year. If you assume that will roughly translate into sales growth also in the 16% range, then revenue should continue rising nicely as we go forward -- and assuming no change in profitability, so should earnings.

What Wall Street said about that

Merrill Lynch liked this news a lot, praising MDC's "solid" performance and in particular the expanding gross margins that made its earnings beat possible.

Perhaps noting the same backlog number I saw, Merrill further expressed confidence that MDC's "execution" will continue, and also cited an expanding millennial demographic in need of affordable starter homes as a good market niche for MDC to be targeting. Regarding the housing market at large, Merrill thinks it looks "solid."

Not everyone is so optimistic. Reviewing these same numbers, Deutsche Bank elected to keep its rating at hold and only ratcheted its price target up $1 to $34 per share. Order growth at MDC was not quite as strong as what Deutsche wanted to see. But Deutsche was even more hesitant to endorse MDC's strategy of buying additional land in anticipation of being able to build and sell houses on it.

"MDC's lot supply has grown 38% over the past year," observed Deutsche, "and the company is targeting 10% community count growth for FY18 and beyond." And while that does appear to lay the groundwork for continuing to grow sales, Deutsche is taking the conservative position that "we don't think ramping up investment at this later stage of the housing cycle is the optimal strategy." 

Or in other words, Deutsche thinks we're getting a bit late in the housing cycle, and MDC may be bulking up on inventory at exactly the wrong time.

Valuing MDC stock

Is Deutsche right about that, or is Merrill Lynch right to be optimistic about the company's ability to keep on growing in an environment of higher interest rates (but constrained supply of new houses for people to buy)?

I honestly don't know. At $1.7 billion in market cap and $188 million in GAAP earnings (i.e., a P/E ratio of only 9.1), MDC stock certainly looks cheap enough that there shouldn't be a lot of risk in betting on Merrill Lynch getting the better of this argument. That being said, the strategy of buying up lots has had the suboptimal effect of pushing MDC into the red on free cash flow -- now negative $127 million on a trailing-12-month basis, after having been comfortably in the black over the past two years.

Long-term debt levels are still inching up -- now over $1 billion -- against cash reserves that have dwindled to less than $400 million. At Just $2.3 billion in enterprise value, and with strong GAAP earnings, I still wouldn't call MDC stock expensive, exactly.

But I'll be a whole lot more comfortable investing in this company once I see its free cash flow move back above sub-zero levels.

Rich Smith has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.