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 track the long-term performance of Wall Street's best and brightest -- and its worst and sorriest, too.

And speaking of the best ...
Banking giant Goldman Sachs (NYSE:GS) started off the trading week with a bang, upgrading Merck (NYSE:MRK) to "conviction buy" (from, I suppose, "an uncertain buy"?) this morning.

According to Goldman, the potential for cost savings plus revenue upside will help Merck substantially outperform the market over the next 12 months. Combine this with Merck's valuation being set at a discount to the market, and Goldman is convinced this stock's a buy.

But is this prediction as good as Goldman?

Let's go to the tape ... no, wait, let's not
It's hard to say. You see, while Goldman has the reputation of a fine analyst, it lacks the record to back it up. This banker is one of the few that declines to submit its ratings to Briefing.com for independent record-keeping, which makes it difficult to say precisely how good Goldman is at what it does.

While not every Goldman pick is on record, some of its higher profile picks do occasionally get picked up in the media. And of these, every once in a while we find something worth writing about.. As a result, we've caught a few glimpses of Goldman's thoughts over the years:

• For example, when Goldman upgraded Procter & Gamble (NYSE:PG) to buy on Jan. 17, 2007.
• Or when, on Nov. 3, 2008, Goldman downgraded Boeing (NYSE:BA) to "conviction sell."
• Or the banner day of Oct. 7, 2008, when Goldman gave us a two-fer -- advising investors to sell both SunPower (NASDAQ:SPWRA) and First Solar (NASDAQ:FSLR).

How did these recommendations work out, you ask? Over the 12-month timespan Goldman traditionally set for its picks (or as far as we've gotten toward it), the results are as follows:

So, hey! Not bad! Four high-profile predictions, and so far Goldman is batting .750 on the bunch. (For the sell ratings on Boeing and SunPower, underperforming the S&P 500 has been a good thing for Goldman; in contrast, it appears to have been overly pessimistic about First Solar.) Although this is only a very small sample of recommendations, it still bodes well for Goldman's strong recommendation of Merck.

That's good news, too, for investors, who could probably use the help right now -- because in the middle of its merger with Schering-Plough (NYSE:SGP), Merck is a tricky beast to value. You see, you can't just look at Merck and say: "11 P/E, 2% projected 5-year growth -- this stock is a dog." Because whatever the numbers look like right now, they're bound to change dramatically once Merck absorbs Schering and its $18 billion revenue stream. Once that transaction consummates, we'll be looking at a new company that looks something like this:

• Market cap: $65 billion (or thereabouts).
• Annual revenues: $41 billion, give or take.
• Profits: Hard to say. But seeing as Merck nets about 24.5% on its $23 billion revenue stream, while Schering nets only 14.5% on its $18 billion, we can estimate that the combined company could churn out $8.2 billion a year in net profit -- perhaps more, if Goldman's predicted cost-cutting takes place.

It will take many, many quarters to see how the new Merck-Schering-Plough merger works out, of course. There will be goodwill to amortize. Probably layoffs and severance costs to absorb, and a whole host of related merger expenses in the early quarters. But once everything has shaken out, we could very easily be looking at a combined firm selling for as little as eight times earnings, depending of course on the market's reaction to the "new" Merck. Nevertheless, considering analysts expect Schering to grow 11% over the next five years, it is feasible we could see the combined firm grow significantly faster than Merck was expected to grow pre-merger.

Foolish takeaway
Posit say an 8.0 P/E, and perhaps a 7% five-year growth rate, and I must admit that an initial review of Goldman's advice illustrates it's likely to add to this banker's win column.

Goldman's right: Merck's a buy.