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 …
On Tuesday, Pali Securities advised that investors sell Disney (NYSE:DIS): "Why go to a sell now, with Disney down about 38% in the past three months?" Good question. And in fact, Pali asked itself just this yesterday -- and then answered:

[E]ssentially everything is going wrong at the same time. ... The theme park business continues to deteriorate. ... We are ... concerned that the dramatic change in foreign currency rates will lead to a notable drop in foreign travel to Orlando over the coming year.

Pointing out that an influx of "high revenue, higher margin" foreign tourists to Disney parks in the U.S. has been "fueling margin expansion at the parks," Pali worries that this influx "appears set to drop significantly over the coming 12-24 months." Yet Wall Street still expects a 13% increase in Disney earnings per share next year.

Simply put: Pali thinks Disney will miss that goal. And rather than get caught inside when the Mouse house catches fire, Pali's heading for the exit today. But is it right to do so?

Let's go to the tape
The disclaimers in every prospectus ever penned notwithstanding, I firmly believe that past performance is -- if not a guarantee -- then at least a good indicator of future success. It's from that perspective that I review Pali's record, and tell you that this analyst is one of "Wall Street's Best."

Over the two years that we've been tracking Pali's overall performance, this analyst has racked up a superb record of 60% accuracy on its picks and has beaten the S&P 500's returns by an average of four percentage points per pick. What's more, Pali has an extensive track record in the media and entertainment spheres in particular. Here, we find Pali making the occasional bad call:

But more often than not, Pali's right on target:

M-I-C ... I see you have a point, Pali ...
And in fact, I believe Pali's right again when it tells us to foreclose on the House of Mouse. Why? Well, consider the numbers.

Right now, Disney shares can be had for a price-to-earnings ratio of about 8 -- which sounds cheap in light of analysts' consensus expectations of 9% five-year growth. And cheaper still if you believe the 13% number that Pali dissed yesterday.

Problem is, that P/E is based on GAAP earnings -- not actual free cash. Over the past year, Disney has reported $4 billion of "accounting profit." But as far as free cash flow goes, the company generated just $3.4 billion.

I look at Disney not as a stock trading for 8 times earnings, but as an enterprise trading for 13x its free cash flow. And if free cash flow grows at a rate anything like the pace analysts posit for accounting profits, a multiple of 13 times free cash flow looks a mite pricey for a 9% grower. Thus, the stock's valuation looks a little aggressive to me.

... K-E-Y ... why, valuation is the key
Don't get me wrong. I believe Disney is a superb franchise. My kids love the movies, my wife loves the ABC network, and I like the business itself quite a lot. But as far as the stock goes, today's price seems to offer little or no margin of safety.

This fact, plus the risk Pali's highlighting -- lower-than-expected earnings in the near term, which could spook the Street into a sell-off if Disney misses next year's earnings -- tells me discretion is the better part of investing in Disney. Avoid this one until it gets just too darn cheap not to.