What Valuation Models Do Analysts

Published Date: 02 Nov 2017

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Introduction

Valuation models is a way in which the worth of a choice can be calculated or estimated using various quantitative skills which are based on the risk concept and unbiased pricing. A valuation model is an important analytic tool for investors and various companies. This has made it a considerable factor in the field of research.

Theorists of valuation have done studies about the speculative properties ofvaluation outlines and some of them have provided arguments in support of some of the frameworks. Various valuation models have been recommended to fit different sectors. These models include discounted cash flow (DCF) and Residual income Valuation (RIV). The models have been asserted differently by different financial authors. For example, Penman (2001) prefers RIV over DCF.

By applying any of the valuation models the author argues that both produce the same results. The use of numerical methodology for testing the comparativeimportance of the valuation models to investor has a huge significance despite the inconsistency of the anticipated assumptions. Because of this and other probable demerits of using the statistical methodology in analyzing the significance of various models of valuation to investors, an alternative outlook paying attention on the real practices of investors needs to be looked into. In my dissertation such an alternative was used. This perspective has been used before in a different research problem.

Research aims & Objectives

The main aims and objectives of the research were:

Identifying how prices of shares and stock are valued in the United Kingdom

Establishing if there is a steady way of valuing shares in the U.K.

Understanding factors that influence the calculation of the price of stock in the U.K.

Literature Review

The financial sector is a group of stocks that is made up of organizations that offer financial services to retail and commercial customers. This sector includes banks, investment funds, insurance companies and real estate.

Read more: http://www.investopedia.com/terms/f/financial_sector.asp#ixzz2NnM5qznU

During evaluation of shares, there are a myriad of models that various analysts and also investors use to gauge the returns and attractiveness of a certain investments. These models range from the simple and relatively easy to the relatively hard and sophisticated. These models regularly tend have completely dissimilar assumptions that regard the essentials that determine value, but they do share some mutual features and can be classified in terms that are broader. There are several benefits to such a classification it makes it easier to get to have a grip where each model fits in to the whole valuation process, the reason as to why they end up with completely unlike results and when they have vital errors in logic.

Generally, there are mainly four methodologies to valuation of shares. The first approach, that is the discountedcash flow valuation, relates the value of an asset to the present value of expected futurecash flows on that asset. The second approach, accounting and liquidation valuation, is is mainly involved in putting a value to the existing assets of a firm, with accounting estimates of book valueor value often used as a starting point. The third methodology, relative valuation, estimates the value of an assetby scrutinizing the pricing of 'comparable' assets relative to a common variable likeearnings, cash flows, book value or sales. The final approach, contingent claim valuation,uses option pricing models to measure the value of assets that share optioncharacteristics. This is what generally falls under the rubric of real options.

Accounting Information is significant if it has ability to influence a decision-makersprospects of value. One method that can be used to quantify the value relevance of financial statements is to scrutinizethe response of volume or market price to accounting numbers announcements, and the mostunusual measure is the overall return to be made from pre-disclosure understanding of financialstatement data (Hùegh-Krohn et al., 2000). Utilizing stock market statistics to gauge the value relevance is useful in indicating the actual reactions of investors to a particular action. However, there should be a balance between verifiabilityandrelevance as engaging exclusively on relevance can result in financial number games (Litan& Richard Herring, 2001).

Ball and Brown (1968) first studied the correlation between equity valuation andaccounting numbers. They then examined the information content of income numbers and established that income numbers are important in share valuation. They also show that when compared toyearly income statement, provisional reports capture approximately 85-90 percent content. Francis and Schipper(1999) inspected whether financial statements have lost their relevance. Theydocumented an upsurgein the significance of the balance sheet and book value and a decline in the importance of income statement(Collins et al., 1997). Besides this, experimental studiesillustrate that thevalue-relevance of accounting numbers has been diminishing with time andpredominantly reported earning is less effective to explain share prices variations than before (Beaver et al., 1987). In another cross value relevance study, Alford et al. (1993) established that the earnings prepared under the UK GAAP are more value-relevant than earningsprepared under U.S. GAAP.

Dividend Discount Model

According to Penman (2001), dividends are the cash flows that stockholders acquire from the company, theallocations to the owners that are reported in the cash flow statement. However, the value of stock isthe present value of projected dividends on that stock. Thismodel is arguably the simplest model used in valuation of shares. There are differing opinions about the influence of dividends on valuation of shares. Below are some of the examples of the different opinions regarding the influence of dividends in valuation of equities:-

One school of thought, which was put forward by Modigliani- Miller, considers that dividendsare not relevant to value, while others, for example the Gordon’s model and also the Walters’s modelbelieve that dividends are relevant to the value of equities (Khan and Jain, 2004).

The dividend discount model enables us to calculate the value of a stock as the present value of the anticipated future cash dividends (Ross et al., 2008). The formula that is below gives a clear explanation of the dividend discount model:

Where E (t) is the expectation on information available at time t, DIV (t+1) is the dividend at time (t + 1), Re is the cost of equity and S (t) is the value of share at time t.

This is the overall method of solving the dividend discount model

The basis of this ideal is the present value rule, whereby the projected future cash flow is discounted so that the actual worth of a particular asset can be easily obtained.

In spite of their argument that dividend policy is not relevant in the valuation of shares, Modigliani- Miller (1961) come to an agreement that any change in the rate of dividend many a time causes the price at the market to change, but this observation is not compatible with irrelevance and it actually is a reflection of theinformational content of dividends. Despite their irrelevance proposition, many researchershave claimed the contribution of dividend in valuation of equity is highly relevant. This can be seen by the observations of some analysts. For example, Walter (1956) and Black & Scholes (1974) discovered that a change in dividend policy has a great influence on the price of stock and also, the price of stock is a function ofdividend policy. Also, Fisher (1961) describes that profit and dividend have effectsthat can be compared on the prices of shares, and there is a relationship betweendividend growth per share,profit per share and dividend per share with the prevalent share price.

The Discounted Cash Flow (DCF) Model

The worth of firm can be calculated by discounting anticipated freecash flowin the discounted cash flow model. DCF model has three main and key variables i.e. the terminal value,discount rate and Cash flow. The free cash flow (FCF) valuation model is the entity outlook approach of theDCF. Using this approach, below is the formula that brings about the intrinsic value is as shown:

Where FCF (t+1) is the free cash flow at time (t+1),V (t) is the value of entity at time t.

WACC is theweighted average cost of capital whileE (t) is the expectation on information available at time t, free cash flow (FCF) is the cash flow from operations less cash investment in operation. However, it isexpressed as net of tax cash flow arising from the operating activities of the firm (Ross et al., 2008).

From a perspective of equity, the model can also be conveyed as shown in the formula below:

From the above,

V (t) E is the equity value at time t andV (t) D is the value of debt at time t.

The cash flow-based models may give erroneous intrinsic values because they rely on unclear future estimates unlike the residual income valuation model, where a key share of the intrinsic value is entrenched within the evident accounting book value (Vardavaki, 2007).

Additionally, Penman (2001) points out that free cash flow does not take into account accrual accounting and ignores value addition in the short term. Therefore, the gained value cannot be matched with the given up value.

Likewise, because of compulsory capital expenditures, the cash flow of a growing firm may be negativewhich may result into negative intrinsic value of equity.

Theoretically,the discounted cash flow model parallel with other accounting flow based valuationmodels provides the same intrinsic value. The instincts of the user are the ones that drive the option of using a different model. The cash flow based valuation model is common in investors and practitioners. Those who favour cash flow based valuation model have the belief that operating cash flows are better than earnings at explaining equity valuations.

Earnings appear to be the more illustrative value driver because earnings reflect value changes irrespective of when the cash flows occur. Dechow (1994) documents a strong relationship between earnings and stock return in short term, but in long run the realized cash flow gradually improves. She also considers current cash flow as a base for future earnings and cash flow. Her findings show that earnings are superior to cash flow because of accruals. Therefore, future earnings and cash flow can be forecasted on the basis of current earnings rather than cash flow.

The Residual Income Valuation Model

Residual income can be referred to as economic value added (EVA), or earnings that are abnormal. Residual income valuation model (RIVM) can also be defined as a model that measures added value from estimated residual earnings, where the equity value is equal to the sum of the present value of expected residual earnings and the book value of investment. It can also be defined as earnings that are in excess of the normal return on capital that was used. Analysts have been using discounted cash flow valuation while the residual income valuation model is gaining popularity as of late research shows (Sougiannis and Yaekura., 2001). In addition to evaluating equity, residual income valuation model is also used as a measure of performance (Ohlson, 2002).

The formula that is used to calculate residual income is as shown below:

RI (t+1) = NI (t+1) – (re * BVE (t))

Where

RI (t+1)is the residual income at time t + 1, BE(t) is the book value of equity, re isthe cost of equity, and NI (t +1) is the net income for the time period t+1.

The dividend discount model can be formulated from an equity perspective to express the valueof the equity capital of a firm as the book value of equity plus the present value of expected residual income. Therefore, the dividend discount model can be re-expressed as:

The equation shows that the value of equity is the book value plus the present value of expectedresidual income. From the equity perspective RIVM can be expressed as:

Where

BE(t) indicates the book value at time t, E(t) indicates the expectation based on dataat time t, ROE(t+1) is the after tax return on equity for period t+1, Re denotes the cost of equity,

NI (t+1) denotes net income for the period t+1.

It is earnings in excess of a normal return on the book value of equity capital. If clean surplus relationship holds, earnings is equal to change in the book value of equity plus dividends net of equity issues.

Residual income valuation model is the most favored model in the academic world although it has some execution obstacles. Analysts come up with the conclusion of mainly using the P/E model or the discounted cash flow model (Demirakos et al, 2004). These discoveries give a sign about the feasibility of the residual income valuation model.

Francis et al. (2000) have examined whether the models, that is the discounted free cash flow model,the discounted abnormal earnings model, and the discounted dividend model result in thesame intrinsic value practically? They then made a comparison of the value estimates of the models by referring to; firstly,the ability to explain the observed prices, secondly, accuracy with respect to observed prices and lastly,preferencewith respect to witnessed prices. After they evaluated the three methods, they came up with the conclusion that the value estimate from abnormal earnings model were more accurate. They also discovered that that there was more variation in stock price in the abnormal model than discounted free cash flow model and the discounteddividendmodel. Therefore the discounted abnormal earning model is more superior because largeproportion of the estimated value of equity come from book value, and/or the model has greaterforecasting precision.

Penman and Sougiannis (1998) also compared whether the hypotheticallycorresponding valuation models have the same essential value? Nevertheless, rather than the ex-ante analysts forecasts, they used ex-post payoff. According to their results whichare consistent with Francis et al. (2000), accrual earnings based valuations dominate free cash flow anddividend discount model. However, Lundholm & O’Keefe (2001) contend that the research literature dedicated to paralleling the truthfulnessof these two models is ill-advised and if the models are consistently used it will give similar value estimates. Penman (2001) replied that the Lundholm and O'Keefe’s paper contains some misunderstandings, not only about the concerns in these papers, but also about valuation and accounting. Then, Penman was responded to that residual income valuation model resulted in thesame value as the discounted cash flow model and if the valuation attributes are treated properly,model will give the same result in finite horizon (Fernandez, 2002).

Multiples-Based Valuation Models

Use of multiples is a very common method of evaluation of shares (carter and vanAuken., 1990). This method can be defined as the ratio of stock price to a special accountingnumber from the financial statements e.g.the price to cash flow ratio, theprice to sales ratio (P/S),the price-to-book ratio (P/B), and price –earnings ratio (P/E). Analysts regularly use P/E and P/B aspricing multiples to estimate value of the firm. However, every valuation multiple must have anassociated financial performance variable, for example, the price/ book value multiple is associated with the firmreturn on equity. The target firm value is solved by the identification of comparable firms that havethe same tasks as the target firm, and application of average of the multiples to themeasures of target firm,under the method of comparables.

If the chosen comparable firms have similar risk and expected future cash flow proportional to the target firm, then multiple-based valuation models will perform. However, inpractice it is very difficult to have perfect comparables.

Despite displaying that it has many deployment problems, this method of multiple-based valuation of shares is the most widely used and popular of all the other methods of evaluating equity. Recently, research was carried out by Kim and Ritter (1999) and they tested the implementation of multiple-based evaluation of shares forInitial Public Offering (IPO) valuations and they established that P/E multiples with projected earnings give precise estimatedvalue than multiples that use trailing earnings in evaluation of equity. It has been documented that valuation by comparatives isexceedingly used in the beverages sector than in Pharmaceuticals orelectronics; the dominant valuationmodel typically used by analysts is either a PE model or an explicit multiperiod DCF valuation models and none of the analysts use the price to cash flow as their dominant valuation mode, in the recent research on the valuation methodologiesused (Demirakos et al, 2004).

Similarly, Boatsman and Baskin (1981) applied P/E multiple by selecting comparable firms:

(a) Randomly and (b) firms with almost similar 10 year average earnings growth rate. Theyfound thataccuracy of approach (b) is higher. Consistent with Boatsman and Baskin (1981), Foster (1986)documented that selecting comparables from the same industry can improve comparability becausethey use the same accounting standards and methods, but Penman (2001) argued that differentaccounting methods for comparables and target firm creates implementations problems with method ofcomparables.

Previous academic research insists on industry based comparables having no definition forindustry. However Alford (1992) provides clear guidelines for selecting appropriate comparable firms.

METHODOLOGY

Methodology issues

Standard discussions of the valuation models and theories were used to create a plannedoutline for storing the data from analysts' reports and for creating hypothesis abouthow the data from reports change as by the state of the examined company. The theoreticalframework of this research paper is basedmainly on Penman (2001) and other with information extracted from Copeland et al. (2000) and Palepu et al. (2000).

The methodology was established according to Penman (2001, 11) five-step model of fundamental analysis and these are:

Strategic analysis- Knowing and understanding the business

Examining information -accounting and non-accounting analysis of information

Identifying, computing and forecasting value-relevant attributes.

Translatingthe forecast data to a valuation.

Operating on the valuation.

The keyaim of the paper was on the value-relevant features that market analysts seek to predict andthe methodology the analysts employ to translate their forecasts into a solid value. Provided that my study raised methodological matters which had not been broadly tackled in the common literature, a great consideration should be paid to the matters and related to mymajor research problems before proceeding to the analysis and discussion for my results.

My data was influenced by the general academic interest in the difference between the DCF and other complicated models as compared with straightforward models. The other comparison was between cash flow advances and accrual approaches to valuation of equity. To be specific I used both the interview and data collected from content analysis to illustrate the degree of the other models of valuation which are employed. I also incorporated the general practical importance of single-period comparative valuation approaches even though the techniques are usually viewed as cheap techniques that produce inaccurate valuations

Methods of Research

In the paper I used two methods of research which are:

Semi-structured interviews- these were used mainly with the sell-side analysts in London and a few with the buy-side analysts.

Content analysis-It was based on theresearch findings of the interviewees.

The information obtained from the semi-structured interviews were used to give a wide understanding and in depth analysis of the methodological matters while the content analysis was used to authenticate and extend the data obtained from the interview.

Interview Research

Research surveys can be executed by using two ways namely questionnaire and interview. Both produced same results but for my research I selected interviews over questionnaires because of the flexibility of the data obtained from interviews. The interviews give a more affluent and a more multifaceted close-up look intofund managers’ and analysts’ views and a have high degree of reliability and trustworthiness than questionnaires.I carried out semi-structuredinterviews with various sell-side analysts. I selected two companies randomly but from different sectors of the economy and dida short interview within their departments of equity research. Ofall the companies only sixty six percentdecided to take part inthe interview. In the interview the staffs from the various equity departments were interviewed.

The quantitative data from the semi-structured interviews was obtained by asking the analysts to rate and rank methods of valuation on a given scale. In choosing the valuation models three major sources were considered and these are:

a sample of the reports by the sell-side analysts obtained from a database by Investext Plus

Textbooks about valuation equity for example Lundholm and Sloan (2004)

Previous literature about the topic for instance Penman and Sougiannis (1998) and Liu et al (2002).

The qualitative data analysis was done by first recording the interviews and then by going through a lot ofcomprehensions and readings bringing up regularlyhappening patterns.

Content Analysis

It is a method of research where the data and information collected from the interviews are evaluated and analyzed. This process is usually suitable to a research plan which permits inferences to be done and one which it can be complemented using other process of collection of data like interviews. In performing the content analysis, I chose research reports and equity from the Investext Plus database for each participant in the interview. Of all the reports, fifty fitted well in the areas that the interviewees corresponded to out of which forty nine firms were looked at by the interviewees.

So as to tackle the three research inquiries raised in the document, I developed a system of coding to give an arrangement model to the evaluation of the contents. Just as Demirakos et al. (2004) examine, I evaluated the prevailing models in the research problems. In the model I evaluated if there was any lucid presumption in the report. I recognized a model as a dominant model by the use ofthe occurrence frequency of the model in the research reports. If there were no clear preferences in the reports, I evaluated ifit was used to validatesuggestion. If the model was employed, Imeasured that as the dominant model and if it did not giveany declarationabout the main models but described the suggestion.Where the scheme used above did not identify a dominant model I evaluated the occurrence frequency in the research problem and the one with high frequency was termed dominant

The Prior literature categorized valuation models by degree of sophistication and cash flow vs. accrual based category.I categorized all absolute valuation models as complicated and all relative models of valuation as straightforward.

Findings

3.1. What Models are used?

Table 2. Panel A: Valuation model usage (sell-side analysts’ interviews)

How importantare thefollowing Types Sell-sidevaluation of analystsmodels?

1 2 3 4 5 Mean Rank Mean Rank Mean Rank K-W (sig.)

Price/earnings

(PE) A-US 0 2 12 13 8 4 2 3.78 2 3.77 1 2.811 (0.729)

DCF (or FCF) C-S 1 6 8 7 13 3.25 4 3 5 3.71 2 8.094 (0.151)

EV/EBITDA A-US 1 7 9 14 4 1.75 9 3.89 1 3.37 3 6.498 (0.261)

Price to cash

Flow C-US 1 7 16 9 2 2.75 6 3 5 3.11 4 1.642 (0.896)

CFROI C-S 6 5 11 9 4 1.75 9 3.44 3 3 5 7.692 (0.173)

EV/sales A-US 4 10 13 6 2 1.75 9 2.89 8 2.77 6 6.897 (0.228)

Price to book

Value A-US 7 9 10 4 5 4.75 1 3.22 4 2.74 7 15.89 (0.007)_

Dividend yield

(DY) C-US 7 4 18 5 1 3.25 4 3 5 2.69 8 6.003 (0.306)

EVA A-S 8 11 6 8 2 2.75 6 2.89 8 2.57 9 2.647 (0.754)

PEG A-US 9 11 10 5 0 2.25 6 1.78 11 2.31 10 8.139 (0.149)

Price to sales A-US 8 15 7 5 0 1.5 13 2.22 10 2.26 11 3.946 (0.557)

DDM C-S 11 16 3 1 4 3.5 3 1.67 12 2.18 12 7.626 (0.178)

EV/BV A-US 16 12 5 2 0 1.75 9 1.67 12 1.8 13 2.554 (0.768)

Kendall’s

(significance) 0.62 0.36 0.26

Table 2. Panel B: Valuation model usage (content analysis)

Number of times model appears as dominant model

Dominant model

Financial

Industrial

Total

Ramk

DCF (or FCF)

1

10

11

2

Price/earnings (PE

15

4

19

1

EV/EBITDA

0

4

4

5

Price to book value

9

2

11

2

DDM

10

0

10

4

CFROI

0

0

0

EV/sales

0

2

2

6

PEG

0

0

0

9

EVA

0

0

0

9

Dividend yield (DY

1

1

1

7

Price to cash flow

1

0

1

7

Price to sales

0

0

0

9

EV/BV

0

0

0

9

Total dominant models

37

23

Total reports analysed

17

15

Table 3. Model classification and usage across sectors (content analysis)

Total Financial Industrial

Panel A: Model usage across sectors (cash flow vs. accrual)

Pure cash flow 1 1 0

Cash-flow-based model(s) dominance 60 9 9

Accrual-based model(s) dominance 6 2 0

Pure accrual 28 5 6

Unable to determine 3 0 0

Panel B: Model usage across sectors (sophisticated vs. unsophisticated)

Only sophisticated model(s) 3 1 0

Sophisticated model(s) dominance 59 8 9

Unsophisticated model(s) dominance 4 2 0

Only unsophisticated model(s) 29 6 6

Unable to determine 3 0 0

Note: Panel A shows frequency of reports according to the classification of cash flow vs. accrual-based

model across five sectors. Panel B shows frequency of reports according to the classification of sophisticated

Table 4. Ranking of accounting variables (sell-side and buy-side analysts’ interviews)

Please rank thefollowing accountingvariables in order ofimportance in valuation

Financial (5) Industrial (9) Overall (35) Buy-side (7)

Mean Rank Mean Rank Mean Rank Mean Rank

Free cash flow 3 1 2.44 1 2.27 1 2 1

Operating cash flow 3.32 3 3 3 2.97 2 3.29 2

Operating earnings 3 1 2.7 2 3 3 3.87 5

Revenue 4.25 6 3.4 4 3.49 4 3.57 4

Net income 3.4 4 4 5 3.51 5 3.29 2

Book value 3.75 5 5 6 5.3 6 4.57 6

Note: ‘1’ is the most important one and ‘6’ is the least important one. Except for the last two columns, all columns represent sell-side analysts’ interview findings.

Table 5. Valuation model usage (buy-side analysts’ interviews)

How important are thefollowing valuationmodels?

Buy-side analysts’

Responses Buy-side

analysts

5 4 3 2 1 Total (mean) Rank

DCF (or FCF) 3 3 0 0 1 28(4.00) 1

Price/earnings (PE) 1 4 1 1 0 26(3.71) 2

CFROI 2 2 1 1 1 24(3.43) 3

Price to cash flow 0 3 3 1 0 23(3.29) 4

Dividend yield (DY) 0 4 0 2 1 21(3.00) 5

Price to book value 0 2 1 3 1 18(2.57) 6

DDM 1 1 1 0 4 16(2.29) 7

PEG 0 2 1 1 3 16(2.29) 7

EVA 0 1 1 4 1 16(2.29) 7

EV/sales 1 0 1 3 2 16(2.29) 7

EV/EBITDA 0 1 1 3 2 15(2.14) 11

Price to sales 0 1 0 4 2 14(2.00) 12

EV/BV 0 0 1 3 3 12(1.71) 13

Note: 5 ¼ extremely important, 4 ¼ very important, 3 ¼ important, 2 ¼ not very important, 1 ¼ not

at all important. Spearman’s rho correlation between sell-side analysts’ interview ranking (Panel A,

Table 2) and buy-side analysts’ interview ranking is 0.716 which is significant at 10% level.

3.2. Why are Particular Model(s) Used?

Table 6. Model classification, model basis and recommendations (content analysis)

Recommendations

Total Positive Neutral Negative

buy (hold (sell)

Panel A: Model classification (cash flow vs. accrual)

Pure cash flow 1 1 0 0

Cash-flow-based model(s) dominance 60 37 15 8

Accrual-based model(s) dominance 6 5 1 0

Pure accrual 28 12 8 8

Unable to determine 3 1 1 1

Panel B: Model classification (sophisticated vs. unsophisticated)

Only sophisticated model(s) 3 1 2 0

Sophisticated model(s) dominance 59 36 14 9

Unsophisticated model(s) dominance 4 4 0 0

Only unsophisticated model(s) 29 14 8 7

Unable to determine 3 1 1 1

Total 98 56 25 17

Panel C: Dominant model basis

Clearly mentioned 24 19 3 2

On the basis of recommendation and/or target price 59 29 19 11

On the basis of frequency 15 8 3 4

Note: Panel A shows frequency of reports according to the classification of cash flow vs. accrual-basedmodel and its association with recommendations (buy, hold and sell). Panel B shows frequency ofreports according to the classification of sophisticated vs. unsophisticated model and its associationwith recommendations (buy, hold and sell). Panel C shows dominant model basis and its associationwith recommendations (buy, hold and sell).

3.3. How the Models are Used?

Table 7. Model usage and recommendations, change in recommendations and change in price targets (content analysis)

Recommendations/price target basis

Recommendations Recommendations (price target) change

Total Positive Neutral Negative Upgrade Reiterate Downgrade Initiation

One model only 9 6 2 1 0 (3) 7 (1) 1 (2) 1 (1)

One model and

qualitative

factors 42 21 13 8 8 (14) 28 (14) 3 (10) 3 (3)

Average of

combination of

models 9 7 1 1 2 (3) 6 (4) 0 (0) 1 (1)

Average of

combination of

models and

qualitative

factors 23 14 6 3 4 (4) 14 (9) 2 (5) 3 (3)

Unable to

Determine 15 8 3 4 2 (0) 12 (8) 1 (2) 0 (0)

Total 98 56 25 17 16 (24) 67 (36) 7 (19) 8 (8)

Note: The figures in the table represent the number of reports. The figures in Table 7 are different from Tables 3 and 6 because figures in Table 7 were drawnonly from any statement related to recommendations, change in recommendations and change in target price irrespective of whether the model(s) was thedominant one or not.

Analysis

Findings

3.1. What Models are Used?

Table one shows the findings got after analyst were asked to rate the importance of valuation model on a scale of 5 meaning very important to a scale of 1 meaning less important. The table suggests that PE ratio and DFC are dominant. It also shows that three unsophisticated and two sophisticated models achieved a rating higher than the mid point meaning that neither of the two is dominant. It is also noted that DCF is rated highly while EVA and DDM are perceived to be of less importance despite all of them having a similar discounted cash flow. It is also seen that unsophisticated methods are perceived to be important when they are based on cash flow or earnings and unimportant when based on other variables. This is to say that the three most highly rated models are PE and EV/EBITDA method which are unsophisticated and DCF which is sophisticated. This finding is in line with the empirical findings in capital market that state that earnings are more associated with share prices than cash-flow in the analysis of linear regression and points out that sophisticated multi-period models are important in coming up valuation based on cash-flow.

Table 2 panel B shows findings of how methods of valuation play a role in equity reports. It shows that DCF, out of 49 played a primary role in 49 reports while PE in 45 and EV/EBITDA in 25. It also shows that there were the only reports that played primary role in significant number. This finding is consistent with reports from panel A of table 3. DY was only mentioned 2 reports as being important in playing a primary role meaning that its use as primary valuation model is limited whereas DDM was not mentioned in any report other than the10 reports where it was used as a primary model. DFC was mentioned in 3 reports but not used as primary model. From this, we can say that DFC and DDM are used as primary valuation models but not secondary models while DY can be used as a secondary model. Thus conclusions can be made that sophisticated models DFC and DDM are used as primary valuation models while unsophisticated models PE and EV/EBITDA can be used as both primary and secondary and multiples such as DY have secondary use only.

In table 3 panel B, 68 out of 98 cases show that sophisticated models are dominant. This is consistent with findings in table 3 panel A that reports that cash flow (DFC) dominates. This shows that decision making is heavily relied on sophisticated DCF model. Hence we can say that valuation models are used in complementary to each other but not in isolation. It also shows primary usage for sophisticated models such as DFC and secondary usage of unsophisticated valuation models.

Table four shows six accounting variables and their order of importance. 20 out of 35 analyst rank cash flow as most important while 15 rank earnings as most important. FCF is ranked as most preferred followed by operating cash flow and operating margin. The importance of DCF and PE holds in all sectors. Kruskal-Wallis statistics in table 2 shows that there isn’t any significant difference in sectors.

Why are Particular Model(s) Used?

Analyst while asked in an interview to explain why certain valuation models are used their main focus was on technical motivation. Contrast between profit and cash flow is an example of a technical factor.

Table 6 shows valuation model preferences according to investment recommendations. 61 out of 98 show cash flow as being dominant while 34 reports show accrual-based models as being dominant. We see that 8 out of 64 reports having negative recommendations when cash flow is dominant while accrual based has 8 out of 34 reports as having negative feedback. In addition to that, 38 out of 61 reports have a positive recommendation. This shows that analysts prefer using cash flow based models such as DCF due to the ease of building up model as one desires. Models build with DFC are easier to explain and justify due to its flexibility. PE on the other hand is less flexible. This due to the denominator being forward one or two-year earning and it is also easily verifiable because it is widely used in the market. Panel B of the same table shows results that are consistent to this. In panel C it is seen that 24 out of 98 reports have clear statements of primary valuation process. Out of this reports, 19 had were recommended positively. And out of 59 reports where model testing was decided by price tags, 30reports had either neutral or negative recommendations while 29 had positive recommendations.

From this, we can conclude that analysts tend to declare their preferences when they provide positive recommendation about valuation models. When there are more negative opinions, analyst prefer to use multiple valuation and are often not clear about their preferences. It is also seen that analyst tend to use an additional qualitative information when they have negative opinions(Bradshaw, 2002).

How the Models are Used?

This involves evaluations of how valuation models are used to come up with price targets and recommendations.

Content analysis findings are presented in Table7. The table shows recommendations and price targets in 98 reports. In 9 reports, price target is based on one model and on another 9 reports it is based on a combination of models. This might be overstated as seen earlier that a DCF model can incorporate a subjective data to give it a more objective appearance. 42 reports used one model and several qualitative factors while 23 reports used models and qualitative factors to justify the price target. In the other 15 reports, there was no need for justification but negative recommendations need to be handled carefully as it was not possible to understand the basis of price targets.

The changes in recommendation and price targets in accordance to the basis used for price target/recommendation are also shown in Table 7. We see that there are more repeated recommendations and price targets as compared to upgrades or downgrades. Upgrades and downgrades provide an addition insight as it helps in explaining the decision making process used to change the position of the stock. 20 out of 23 changes in recommendations were used in in qualitative factors while three were based on valuation models only. On the other hand, 8 out of 43 changes to target price were based on valuation models alone while 35 were based on qualitative factors. This shows that it is more preferred to use models in combination with qualitative factors as opposed to using models alone.

CONCLUSION

This dissertation has attained its objectives of determining the valuation models used in the UK, why they are used and how they are used. It provides a more informed approach into how analyst use valuation models.