ACCOUNTING HORIZONS

Vol. 18, No. 4

December 2004
pp. 221-240
What Valuation Models Do Analysts Use?
Efthimios G Demirakos, Norman C. Strong, and Martin Walker
SYNOPSIS: This paper adopts a structured positive approach to explaining the valua-
tion practices of financial analysts by studying the valuation nfiethodologies contained in
104 analysts' reports from international investment banks for 26 large U.K.-listed com-
panies drawn from the beverages, electronics, and Pharmaceuticals sectors. We pro-
vide a descriptive analysis of the use of altemative valuation models focusing on the
value-relevant attributes that analysts seek to forecast and the methodologies analysts
use to convert the forecasts into estimates of firm value. We postulate and test a number
of hypotheses relating to how the valuation practices of analysts vary systematically
across industrial sectors. We find that: (1) the use of valuation by comparatives is higher
in the beverages sector than in electronics or Pharmaceuticals; (2) analysts typically
choose either a PE model or an explicit multiperiod DCF valuation model as their
dominant valuation model; (3) none of the analysts use the price to cash flow as their
dominant valuation model; and (4) contrary to our expectations, some analysts who
construct explicit multiperiod valuation models still adopt a comparative valuation model
as their preferred model. We believe the study's findings are important for increasing our
understanding of the valuation practices of financial analysts. The study also provides a
basis for further research that tests a richer and more detailed set of hypotheses.
Data Availability: A list identifying the sampled analysts' reports is available from the
authors. The reports themselves are publicly available from the
Investext database.
INTRODUCTION
V
aluation theorists have studied the theoretical properties of several valuation frameworks,
and some authors use these theoretical properties to produce normative arguments in favor
of particular frameworks. Penman (2001) advocates residual income valuation (RIV), in
preference to discounted cash flow (DCF). Copeland et al. (2000) recommend using either the DCF
model or the RIV model.' These authors assert that DCF is most widely used in practice, but that
RIV is gaining in popularity. They also note that both methods, properly applied, result in the same
Efthimios G Demirakos is a Lecturer at Lancaster University; Norman C. Strong and Martin Walker
are Professors at the University of Manchester.
The paper has benefited substantially from the comments of two anonymous referees and from the comments and advice of
the Associate Editor, Stephen Baginski. The authors acknowledge the comments of Miles Gietzman, Ken Peasnell, Peter
Pope, Theodore Sougiannis, and participants at the Spanish Joint Accounting and Finance 2003 Conference. Professor
Demirakos acknowledges a WUN scholarship and a Ph.D. grant from the Propondis Foundation.
Copeland et al. (2000, 131) refer to these as the enterprise DCF model and the economic profit model.
Submitted: May 2003
Accepted: July 2004
Corresponding author: Martin Walker
Email: martin.walker@man.ac.uk
221
222 Demirakos, Strong, and Walker
valuation, and suggest that "the choice is mostly driven by the instincts of the user." Palepu et al.
(2000) adopt a balanced position; they note that properly constructed RIV and DCF models lead to
identical valuations, but acknowledge that the preference for one approach over the other may
depend on the ease of access to acceptable proxies for the model constructs.
Penman (2001), Copeland et al. (2000), and Palepu et al. (2000) all prefer explicit multiperiod
valuation models based on either discounted cash flows or discounted residual income rather than
valuations based on single-period comparatives. The theoretical superiority of multiperiod valuation
models stands in contrast to the evidence on valuation models used in practice. Barker (1999), for
example, reviews and summarizes previous research on the valuation models used by professional
investors or financial analysts. The most consistent findings are, first "that the [price-earnings ratio]
is of primary importance," and second "that [DCF] models, technical analysis, and beta analysis are
of little practical importance to investment decisions" (Barker 1999,197). In his own survey of U.K.
analysts and fund managers. Barker (1999) fmds that both groups rank the PE model and the
dividend yield model as the most important, and both groups rate the DCF and dividend discount
models as unimportant. Barker's findings on the importance of PE multiples support the results of
Arnold and Moizer (1984) and Moizer and Arnold (1984) for the U.K., Pike et al. (1993) for
Germany and the U.K., and Block (1999) for the U.S., all of whom investigate the valuation models
used by analysts using survey-based approaches.
Barker (1999) and the prior research he reviews are based on interviews and questionnaire
surveys of investment analysts and fund managers. To overcome some ofthe subjectivity problems
associated with interview-based research,^ we adopt an altemative research design based on a
content analysis of analysts' equity research reports. This approach complements the results of the
above studies with evidence on the equity valuation models that analysts use in practice. Govindarajan
(1980), Previts et al. (1994), and Rogers and Grant (1997) for the U.S., and Breton and Taffler
(2001) for the U.K. also employ content analysis, but they focus on fmaneial disclosure issues and
the general information needs of analysts. We differ from these studies principally in our explicit
focus on the specific valuation models analysts use, along with any other models or frames of
reference they bring to the specific task of valuation.
Bradshaw (2002) studies the content of 103 U.S. analysts' reports to identify how analysts
justify their stock price recommendations. He finds that valuations based on PE multiples and
expected growth are more likely to be used to support favorable recommendations, while qualitative
analysis of a firm's fundamentals is more likely to be employed to justify less favorable recommen-
dations. He recommends further research to compare analysts' reports both within and across indus-
tries. Our study complements and extends Bradshaw (2002). First, we provide more detail about the
particular valuation models analysts use.^ Second, and crucially, we advance and test specific hy-
potheses about the valuation model choices of analysts. In particular we test hypotheses about how
valuation methodologies vary across industrial sectors.
The next section explains our methodology and theoretical framework, and it explains the
hypotheses that we use to guide our evaluation of analysts' reports. We then describe our data source,
the principles we use in selecting analysts' reports for inclusion in the study, and the criteria we apply
in scoring the reports in our sample. The next section reports our findings on the frequency of use of
altemative valuation models, presents formal tests of our hypotheses, and offers further sensitivity
analyses of our empirical results. Two appendices briefly discuss the properties of two new practical
valuation approaches uncovered in our study of financial analysts' valuation practices.
See Schipper (1991) and Rogers and Grant (1997) for more on this point.
Strictly speaking we identify only the models that analysts refer to in their published reports. We cannot be certain these
are the models ttiat they actually use or rely on.
Accounting Horizons, December 2004
What Valuation Models Do Analysts Use? lii
METHODOLOGY AND THEORETICAL FRAMEWORK
A Structured Content Analysis
We draw on standard discussions of valuation concepts and models to establish a structured
framework for recording the content of analysts' reports and for generating testable hypotheses about
how the content of reports varies according to the nature of the company analyzed. The conceptual
framework of this paper is influenced primarily by Penman (2001), with additional insights drawn
from Palepu et al. (2000) and Copeland et al. (2000).
Penman (2001, 11) introduces a five-step process of fundamental analysis.
1) Knowing the business (strategic analysis).
2) Analyzing information (accounting and nonaccounting information analysis).
3) Specifying, measuring, and forecasting value-relevant payoffs.
4) Converting forecasts to a valuation.
5) Trading on the valuation.
The main focus of this paper is on the value-relevant attributes that analysts seek to forecast and
the methodology analysts use to convert their forecasts into firm value, i.e., steps 3 and 4 of
Penman's process.
Initially we anticipated finding three main types of valuation analysis: some form of single-
period comparative or benchmark valuation (such as PE multiples), valuation via a finite horizon
multiperiod DCF model, and valuation via a finite horizon multiperiod RJV model. The latter two
models figure prominently in Palepu et al. (2000). Penman (2001) focuses most attention on imple-
menting the RIV model, while Copeland et al. (2000) focus on the DCF model. All three sources
mention the widespread practical use of single-period comparative valuation techniques, although
they all view such techniques as low-cost simplifications that are likely to lead to less accurate
valuations than a full implementation of either the DCF or the RIV models. Penman (2001) is
particularly scathing of valuation by PE ratios. In our empirical work, we find evidence of all three
forms of valuation model. Another form of valuation practice we expected to encounter was an
attempt to use option pricing models to value future growth opportunities independently of the
valuation of assets in place. However, we encounter only limited use of these approaches.
During the course of our empirical work, several valuation methods and themes emerge to a
more significant extent than anticipated. As detailed below, various analysts provide valuation argu-
ments based on hybrid value creation indicators. These are not complete valuation models but are
deployed as partial analytical support for a valuation "case."
Industry Sectors
Our study focuses on three industries: beverages, electronics, and Pharmaceuticalschosen
intentionally to give potential variation in analysts' valuation practices. To confirm the differences in
industry fundamentals and as background to our empirical hypotheses. Table 1 reports growth and
volatility characteristics for our three sectors. For each sector, we report the median and interquartile
range for annualized sales growth, the volatility of earnings changes, the ratio of R&D to Sales, and
the ratio of market to book value of equity over the period 1997-2001. Comparing beverages with
Pharmaceuticals shows that the former has lower and more stable growth, lower volatility of earnings
changes, much lower R&D to Sales, and lower and more uniform market to book ratios. On most of
the indicators, electronics lies between beverages and Pharmaceuticals.
Empirical Hypotheses
Our paper adopts a structured positive approach to the study of valuation practices. This re-
quires us to postulate hypotheses that we can test through this methodology. For this paper, we
develop four specific hypotheses related to the value-relevant attributes that analysts forecast and the
methodologies they use to convert their forecasts into firm value.
Accounting Horizons, December 2004
224 Demirakos, Strong, and Walker
Sector
Bvr
Elec
Phar
TABLE 1
Profiles of the Sampled Industry Sectors
Annualized Sales Growth
(%)
4.73
(13.07)
9.31
(12,30)
36.01
(47,62)
Volatility of Earnings Changes
(%)
1.89
(4.24)
4.53
(1.98)
13.37
(172.30)
R&D/Sales
(%)
0.01
(0.20)
4.60
(4.37)
39,00
(227.24)
MTBV
2.27
(3.53)
3.46
(3,59)
4.07
(6,20)
Sectors examined are beverages (Bvr), electronics and electrical equipment (Elec), and Pharmaceuticals (Phar),
Data is for the period 1997 to 2001,
Annualized sales growth is the geometric average sales growth of each firm. We report the cross-firm median and
interquartile range (in parentheses).
Volatility of earnings changes is the firm-specific standard deviation of the annual change in earnings deflated by average
sales. We report the cross-firm median and interquartile range.
We report the median and interquartile range of R&D to Sales and of MTBV (market to book value of equity) for all
company years.
Our first hypothesis concerns the choice between valuation based on industry or sector single-
period comparatives and valuation using explicit multiperiod valuation models. The prior research
discussed above finds that valuation by PE comparatives is the most pervasive form of valuation
model. This approach could yield a good first approximation for industries that have:
fairly uniform and stable growth;
costs of capital, accounting methods and capital structures that are comparable across companies;
and
transitory earnings items that can be identified and excluded from the analysis.
In such instances, the simplicity of the PE approach may be attractive to analysts.* A similar argu-
ment applies to other methods of valuation by single-period comparatives that we identify in our
study (for example, those based on single-period amounts of sales, cash flow, or book values).
Given our results in Table 1, beverages is a sector characterized by fairly uniform and stable
growth where valuation by single-period comparatives might yield a reasonable first approximation,
while electronics and pharmaceutical are sectors for which the ideal conditions for valuation by
comparatives are much less likely to hold. This gives rise to the following hypothesis.
HI: Use of valuation by single-period comparatives is higher in the beverages sector
than in electronics or Pharmaceuticals.
Second, we are interested in why analysts choose accruals-based accounting valuation con-
structs over cash-fiow-based constructs. Note that this choice operates within both the single-period
comparative valuation and the multiperiod valuation sets of models. We first consider the choice
between cash-flow-based and residual-income-based multiperiod models.
Multiperiod valuation models can be expressed in terms of projected cash flows, in the case of
DCF models, or in terms of initial book value and projected abnormal earnings in the case of the RIV
model. Theoretically the two techniques are equivalent. Since both techniques require forecasts of
future amountseither residual earnings for RIV or cash fiows for DCFease of use does not seem
to favor one method over the other.
* However, see Penman (2001, 40-44) for a clear statement of the circularity and conceptual problems of employing the
method of comparatives and of PE comparatives in particular.
Accounting Horizons, December 2004
What Valuation Models Do Analysts Use? 225
In making the choice between RIV and DCF, analysts will consider which technique they are
most familiar with, which technique their clients are most comfortable with, and the extent to which
the published accounting information of the firm can be used as a credible starting point for the
analysis. DCF models have a long history of use relative to RIV and have been taught extensively in
Finance courses. Thus, DCF is in essence a default. For analysts to pick RIV over DCF, they have to
be confident that the published accounting information captures the essence of the business.^ The
question to consider is why and how the confidence of analysts in the ability of accounting to
faithfully represent the value generation processes ofthe business might vary across sectors.
A number of authors, notably Lev (2001), have pointed out that accounting is relatively strong in
valuing tangible assets and relatively weak in valuing intangible assets. We therefore expect the
choice between DCF and RIV to reflect the nature of the firm's assets. In particular we expect
accounting measures of performance to be less relevant for intangibles-rich firms or for firms with
large portfolios of growth opportunities. Consistent with the results reported in Table 1 we character-
ize pharmaceuticals as falling most clearly into this category, with beverages being at the other
extreme and electronics falling between these two cases.
These arguments lead to our second hypothesis:
H2: Use of multiperiod DCF models relative to multiperiod RIV models is higher in the
pharmaceuticals sector than in the beverages sector, with the electronics sector
falling between the two extremes.*
Copeland et al. (2000) note that an important conceptual advantage ofthe RIV model is that it
focuses on whether the company is generating a return in excess of its cost of capital.^ This in turn
suggests that the use of RIV and other hybrid accrual models is likely to be greatest in sectors where
accounting-based measures of profitability are a relatively more reliable indicator of economic
profitability. As before, we expect reliability to be lower for companies with higher amounts of
intangibles. This argument suggests a more general version of H2:
H2': Use of multiperiod and hybrid cash fiow models relative to the use of multiperiod
and hybrid accrual models is higher in sectors with relatively high proportions of
intangible assets.
We now consider accrual versus cash fiow in the single-period setting. Penman (2001, 117)
notes that "Free cash fiow does not measure value added in the short mn; value gained is not matched
with value given up." In other words, firm valuation based on a multiple of a single year's free cash
fiow is not sensible because free cash fiow is not a defensible proxy for value. This gives our third
hypothesis:
H3: Given the limitations of single-period cash fiow as a measure of value generation,
no analyst will use it as their dominant approach.
Finally we hypothesize that analysts view valuation by comparatives as a form of simplified
valuation analysis. If they incur the cost to produce a full-blown multiperiod model, they present it as
their dominant model. This results in our fmal hypothesis:
This is consistent with the suggestion of Copeland et al. (2000) that instinct ofthe user drives the choice.
Lev and Sougiannis (1996) identiiy pharmaceuticals and electronics as high R&D sectors. They also produce empirical
estimates that the payoff per $1 invested in R&D is higher and longer lived in the pharmaceuticals sector than in the
electronics sector.
This claimed advantage ignores conceptual problems in comparing accounting-based measures of return with market-
based costs of capital. For a discussion of this issue in the context of retum on equity and the cost of equity capital see
Soffer (2003).
Accounting Horizons, December 2004
226 Demirakos, Strong, and Walker
H4: Analysts who construct a multiperiod valuation analysis of either type do not adopt
valuation by comparatives as their dominant model.
DATA, SAMPLE SELECTION, AND SCORING CONVENTION
This section reports our data source, our sample selection criteria, and the scoring convention
we adopt when analyzing the contents of analysts' reports.
Data
We download the analysts' reports from Investext Plus. Investext Plus is a database of reports
and forecasts by top Wall Street and intemational investment firms and analysts. The service covers
over 11,000 U.S. and intemational companies from 53 industries. The current study examines
reports by intemational investment firms regarding U.K. companies.
Sample Selection
The reports selected for the study are from the period January 1997 to October 2001 and consist
of reports exceeding 15 pages in length. They cover listed companies in the London Stock Exchange's
beverages, electronics and electrical equipment (which we abbreviate to electronics), and pharma-
ceuticals sectors. All companies are constituents of the FTSE All-Share Index. Where an analyst
publishes more than one report for a particular company in the same year, we select the largest
report.
From all the reports satisfying these conditions, we select a manageable final sample of 104 sell-
side analysts' equity research reports covering 26 companies.* We have between 32 and 38 reports
per sector. Table 2 reports summary statistics for the sample of companies and reports. Of the 26
companies in the sample, 9 are among the 100 largest U.K.-quoted companies. The 4 (12,
10) beverage (electronics, pharmaceutical) companies we study represent 57.1 (57.1,43.5) percent
of the beverage (electronics, pharmaceutical) companies appearing in the FTSE All-Share index.
The selection of reports for analysis reflects our focus on the most detailed research reports. The
Investext Plus database contains a wide range of report lengths, from just a few pages to over 100
pages. The very short reports contain little by way of analysis and often focus on the implications of
a particular event or update a previous eamings forecast. We focus on comprehensive equity re-
search reports of over 15 pages. Table 2 shows that the length of our sampled reports ranges from 15
to 176 pages with the median length being around 28 pages for all three sectors. This characteristic
of our data selection permits us to extend and complement the analysis of previous studies that
mainly analyze the content of reports containing only a few pages.'
We choose reports from multiple investment houses so that a particular house does not dominate
the results. But we also require each investment house to be included in more than one sector because
differences in valuation methodologies across sectors should reflect genuine diflFerences between the
sectors, not differences in which investment houses cover each sector.
Scoring Convention
Table 3 describes the valuation perspectives and modelsand their definitionsfound in our
analysis of the valuation content of sell-side analysts' equity research reports. It shows that analysts
employ single-period comparative valuation models, hybrid valuation models, and multiperiod valu-
ation models. We classify the various price or value multiples as single-period comparative valuation
models, various value creation indicators along with real option valuation techniques as hybrid
In moving from the reports satisfying our main selection criteria to our fmal sample, we ensure that we maintain both the
relative numbers of companies and the distribution of investment houses in each sector.
We include an analysis of the effect of excluding shorter reports in a sensitivity analysis section below.
Accounting Horizons, December 2004
What Valuation Models Do Analysts Use? 227
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Accounting Horizons, December 2004
228 Demirakos, Strong, and Walker
Major
Valuation
Models
TABLE 3
Definitions for the Valuation Scoring Convention
Definition
Single-Period Eamings
Comparative multiples (E)
Sales
multiples (S)
Price-to-book
(BV)
Price-to-assets
(Assets)
Price to cash
flow (CF)
Dividend yield
(DY)
Enterprise
value to R&D
(R&D)
Rating to
economic
profit (REP)
Hybrid Accounting
rates of return
(ARR)
Cash recovery
rates (CRR)
Economic value
added (EVA)
Continuing
value (Cont.V.)
Technology
value (Tech.V.)
Options-Pr
price to eamings (PE), enterprise value to eamings before interest, taxes,
depreciation and amortization (EV/EBITDA), enterprise value to eamings
before interest and taxes (EV/EBIT), PEG ratio (PE multiple scaled by
eamings' grovrth rate), and discounted future eamings multiple (DFE
multiple). Appendix A discusses the DFE valuation approach in more detail.
price to sales (P/S) and enterprise value to sales (EV/S) multiples.
stock price to book value per share (only scored for reports containing a
distinct analysis of this ratio).
stock price to asset value multiple.
price to cash flov*' multiple.
the dividend yield method.
Enterprise Value divided by R&D expenditure.
ratio of the market-to-book value of the enterprise to the retum on invested
capital scaled by the weighted average cost of'capital. Appendix B provides
more detail. REP includes all forms of analysis that combine economic
spread and book value multiples (including graphical representations of their
relation, REP multiples etc.). In practice, analysts perform this analysis in a
single-period comparative framework.
the retum on equity (ROE) and retum on invested capital (ROIC) ratios
when analysts use these as valuation models and not simply as indicators of
economic profitability.
the standard cash recovery rate (CRR) and the cash flow retum on
investment (CFROI).
the retum spread times the book value of a firm's assets.
the capitalized value of a firm's net operating profit (using the weighted
average cost of capital as a discount factor) minus its current debt.
market value minus cash plus debt, compared to similar firms (used in
valuing biotechnology stocks).
real option style models and simple probability weighted net present value
models.
Multiperiod Discounted cash the present value of a firm's cash flows over multiple future periods,
flow (DCF)
Residual current book value of equity plus the present value of residual eamings over
income valuation multiple future periods.
(RIV)
Accounting Horizons, December 2004
What Valuation Models Do Analysts Use? 229
valuation models, and the explicit discounted cash flow and residual income valuation models as
multiperiod valuation models. Table 3 provides a short definition of each valuation model. We give
the report a score of 1 for each valuation model in Table 3 only if the analyst uses and discusses that
particular valuation model in the main text of the report. Any tables contained in analysts' reports are
only analyzed when analysts refer to the content in their narrative. This scoring convention assumes
that only the arguments presented in the narrative are value relevant and useful.'"
We classify a valuation model as dominant if it is most closely associated with the analyst's own
stock price recommendation. Where a report uses only one model, we score this valuation model as
dominant. Where a report uses more than one model, we first check the valuation section of the
report to see if it reveals the analyst's preference. We also examine the first page of the report or the
executive summary to see which valuation model is highlighted. If these initial assessments yield no
clear view, we calculate the differences between the analyst's alternative value estimates and the
analyst's final target price. We select the dominant model as the one closest to the target price.
However, some reports do not have a target price and some valuation techniques do not produce a
specific value estimate. In the rare cases where we are unable to determine the dominant valuation
model using the above criteria, we use the amount of space in the report devoted to the analysis of
each model to select the dominant model. In our formal tests, we assign a score of 1 when a model is
used as the sole dominant valuation model, and we assign a score of 0.5 to a valuation model when it
is used jointly with another model as the dominant valuation model.
MAIN FINDINGS
This section reports the main findings of our empirical analysis. We begin by describing the
frequency of use of the various types of valuation methodologies we encounter. We then test our
hypotheses. Finally, we report a number of sensitivity analyses.
Descriptive Analysis
Table 4 presents descriptive evidence on the range of valuation models analysts employ. This
table serves as a comparison with prior work. The table shows that almost all the sampled reports
contain some form of valuation by reference to a multiple of earnings. In the electronics sector, only
four reports (out of thirty-four) contain no valuation by reference to earnings. Two of these reports
focus on DCF models, one on a hybrid model, and one on a multiple of sales. In the pharmaceuticals
sector, eight reports (out of thirty-eight) contain no valuation by reference to earnings. Of these eight
cases, five rely on some form of cash flow valuation analysis, one combines price to sales with DCF,
another combines price to sales with some form of option-pricing analysis, and one focuses on
option-pricing analysis. These results suggest that using earnings as a basis of valuation is the
prevalent form of analysis for the beverages sector, but that it is less prevalent for the pharmaceuti-
cals sector, with electronics falling between.
As in previous studies such as Barker (1999) and Bradshaw (2002), we find widespread use of
PE models, but we also fmd that the attention given to PE models varies systematically across sectors
in understandable ways. In contrast to prior studies, we find considerable use of explicit multiperiod
DCF models.
Tests of Empirical Hypotheses
Hypothesis 1
Hypothesis 1 states that valuation by single-period comparatives is greater in the beverages
sector than in electronics and pharmaceuticals due to differences in the growth characteristics of the
three sectors. Table 5 presents the results of a formal test of this hypothesis. Panel A shows that
Breton and Taffler (2001) adopt a similar scoring convention in their content analysis.
Accounting Horizons, December 2004
230
Demirakos, Strong, and Walker
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Accounting Horizons, December 2004
fVhat Valuation Models Do Analysts Use? 231
TABLE 5
Formal Tests of HI and H2'
Panel A: Use of Alternative Valuation Models
Single-Period Comparative Multiperiod
Industry Valuation Techniques Valuation Models
Beverages 73 14
Electronics 63 15
Pharmaceuticals 51 13
y^^ test of beverages versus pharmaceuticals = 0.45, p-value = 0.504
^^ test of beverages versus electronics + pharmaceuticals = 0.47, p-value = 0.491
Panel B: Choice of Dominant Valuation Models
Single-Period Comparative Multiperiod
Industry Valuation Techniques Valuation Models
Beverages 25.5 3
Electronics 18 10
Pharmaceuticals 23 9
j(^ test of beverages versus pharmaceuticals = 2.94, p-value = 0.087"
^ test of beverages versus electronics + pharmaceuticals = 4.62, p-value = 0.032
Panel C: Frequency of Use of Multiperiod Valuation Models as Dominant Model
Use of Multiperiod
Dominance of Multiperiod Valuation Model as a
Industry Valuation Model Nondominant Model
Beverages 3 10
Electronics 10 4
Pharmaceuticals 9 4
^ test of beverages versus pharmaceuticals = 5.57, p-value = 0.018
^ test of beverages versus electronics + pharmaceuticals = 7.9, p-value = 0.005
Panel D: Use of Multiperiod and Hybrid Accrual Models versus Multiperiod and Hybrid Cash Flow
Models
Multiperiod and Hybrid Multiperiod and Hybrid
Industry Accrual Models Cash Flow Models
Beverages 15 14
Electronics 13 17
Pharmaceuticals 1 14
^ test of beverages versus pharmaceuticals = 8.68, p-value = 0.003
y^ test of beverages versus electronics + pharmaceuticals = 3.14, p-value = 0.076"
"After Yates' conection for continuity this statistic is no longer significant at 10 percent.
comparative valuation techniques are used 73 times in the 32 reports covering beverages, while
multiperiod valuation models are used only 14 times." In electronics and pharmaceuticals, compara-
tive valuation techniques are used 114 times in 72 reports with multiperiod valuation models em-
ployed 28 times. Panel A of Table 5 shows that a Chi-square test for this difference between
beverages and the other two high-growth sectors is not significant.'^ Although this result is inconsistent
" The figure of 73 can be found in Table 4 by adding the entries under E, S, BV, CF, DY, REP, and Assets. Similarly, the
figure of 14 can be found by adding (he entries under DCF and RIV.
'2 All results reported in the paper are based on the standard X^ '^st. In each case we also calculate Yates' correction for
continuity (see Siegel and Castellan 1988). Except in one case that we refer to below, the correction makes no difference
to any of our conclusions.
Accounting Horizons, December 2004
232 Demirakos, Strong, and Walker
with HI, it is not surprising given the heavy use of comparative valuation techniques. Financial
analysts probably feel a need to use comparative valuation techniques as a starting point even if they
are not their preferred valuation choice.
A more powerful test of the difference between the stable and high-growth sectors in the
prevalence of valuation by single-period comparatives compared with multiperiod valuation models
is based on dominant valuation models. Panel B of Table 5 reports the results of this test. In
beverages, valuation by comparatives is dominant in 25.5 reports, while multiperiod models are
dominant in only 3 reports. In electronics and pharmaceuticals, the corresponding numbers are 41
and 19 reports. A Chi-square test of the relative proportions of reports in which single-period and
multiperiod valuation models are dominant reveals a significant difference between stable (bever-
ages) and high-growth sectors (electronics and pharmaceuticals) at the 5 percent level (x^ = 4.62;
p-value = 0.032). This result is consistent with Hl.'^
An altemative approach to testing this hypothesis is to see how many of the reports that use a
multiperiod valuation model choose this as their dominant valuation model. Table 5, Panel C shows
that, in beverages, 13 reports use multiperiod valuation models, but they are dominant in only 3 (23.1
percent) of these reports. Corresponding figures for pharmaceuticals are multiperiod valuation mod-
els dominant in 9 out of 13 reports (69.2 percent), and for electronics multiperiod valuation models
dominant in 10 out of 14 reports (71.4 percent). Consistent with HI, we find a significantly greater
use of multiperiod models as the dominant model in pharmaceuticals and electronics than in bever-
ages (,x^ = 7 9; p-value = 0.005).'"
Hypothesis 2
Hypothesis 2 suggests that use of the DCF model relative to the RIV model should be higher in
the pharmaceuticals sector than the beverages sector due to the difference in the extent to which
financial statements properly capture the value of a firm's tangible and intangible assets. Table 4
shows that only one report in beverages, one report in electronics, and no reports in pharmaceuticals
use RIV. Interestingly, both instances of RIV are implemented jointly with DCF and produce the
same valuation estimates as the DCF models. Perhaps analysts who use RIV perceive a need to back
up this "new" approach with the more widely accepted DCF. RIV is never employed as the sole
dominant valuation model, and it is used jointly with DCF as the dominant valuation methodology in
only one report (in electronics). This empirical evidence clearly shows that financial analysts prefer
DCF to RIV. While finding one instance of RIV for both beverages and electronics and no instances
of RIV for pharmaceuticals is directionally consistent with H2, a formal Chi-square test lacks power
to reject the null hypothesis.
Hypothesis H2' broadens the issue of choice between RIV and DCF, to the more general issue of
the use of multiperiod and hybrid cash flow versus multiperiod and hybrid accrual models. Table 5,
Panel D reports our test of this more general hypothesis. We find that the use of RIV and other hybrid
accrual models for valuation purposes varies markedly across sectors. We define hybrid accrual
models as comprising accounting rate of retum (ARR) and Economic Value Added (EVA^"^) while
hybrid cash flow models include cash recovery rate (CRR). Consistent with H2', the beverage sector
analysts use hybrid and multiperiod accrual models more often than analysts covering the pharma-
ceuticals sector (statistically significant at the 1 percent level), while the use of cash flow models is
constant across sectors.
Insight into the combined choice of forecasting system and valuation model can be achieved by
considering the extent to which the use of accounting profitability analysis varies across sectors.
Financial statement analysis textbooks teach students to focus on firm profitability ratios, typically
" A test for the difiference between beverages and pharmaceuticals alone is significant at 9 percent before Yates' correction
for continuity, but is insignificant at 10 percent after correction.
''' The difference between beverages and pharmaceuticals alone is also significant at 2 percent.
Accounting Horizons, December 2004
What Valuation Models Do Analysts Use? 233
represented by return on net operating assets, and then introduce the disaggregation of this ratio into
a multiple of the operating profit margin and the ratio of sales to net operating assets (see, e.g..
Penman 2001,354). Fairfield and Yohn (2001) show that disaggregating the change in return on net
operating assets can improve forecasts of future profitability. On the other hand, we know that
accounting profitability ratios are problematic in high-growth, intangibles-rich industries due to the
accounting treatment of R&D expenditures and intangible assets. Hence we expect profitability
analysis to be more prominent in an industry such as beverages where value comes mainly from
assets in place than in an industry such as pharmaceuticals where a large component of value comes
from growth opportunities.
Table 6 reports our examination of the profitability analyses contained in analysts' reports. Table
6 shows, as expected, that there are differences in the importance of profitability analysis across the
three sectors. An analysis of accounting profitability is more prominent in beverages and electronics
than in pharmaceuticals. Analysts employ a ratio-based profitability decomposition more frequently
in beverages and electronics. But, even in these sectors, the decomposition is rudimentary, with the
depth of analysis restricted to a consideration of ARR and of profit margins for some individual
products. In pharmaceuticals, analysts devote little space to accounting and financial analysis. In-
stead, an analysis of strategic issues and of R&D projects is the critical part of the valuation process.
Except for phannaceuticals, analyzing accounting profitability is clearly more popular than
analyzing cash fiows. For example, in beverages, the ARR is used in 23 out of 32 reports compared
with 1 report that uses the CRR. Corresponding figures in electronics are ARR in 20 out of 34 reports
and CRR in 3 reports. In most cases, the analysts compare the ARR with the cost of capital. In
contrast to beverages and electronics, both the ARR and the CRR are each referred to in only one
pharmaceutical report.
From Table 6, the proportion of analyst reports containing a profitability analysis based on profit
margins is significantly lower (at the 1 percent level) in pharmaceuticals (57.9 percent) than in either
beverages (100.0 percent) or electronics (91.2 percent). Similarly, the proportion of analyst reports
containing a profitability analysis based on ARRs is significantly lower (at the 1 percent level) in
pharmaceuticals (2.6 percent) than in either beverages (71.9 percent) or electronics (58.8 percent).
Sector
Bvr
Elec
Phar
Totals
Number of Reports
32
34
38
104
TABLE 6
Analysis of Profitability
ARR
23
71.9%
20
58.8%
1
2.6%
44
42.3%
Profitability Analysis
Accruals Based
PM
32
100%
31
91.2%
22
57.9%
85
81.7%
Spread
17
53.1%
13
38.2%
1
2.6%
31
29.8%
Cash-Flow Based
CRR
1
3. 1 %
3
8.8%
1
2. 6%
5
4. 8%
Sectors examined are beverages (Bvr), electronics and electrical equipment (Elec), and pharmaceuticals (Phar).
ARR = accounting rate of return.
PM refers to any reference to gross margins, operating margins, product margins, etc.
Spread relates to a comparison of the ARR with the firm's cost of capital.
CRR = the cash recovery rate.
Accounting Horizons, December 2004
234
Demirakos, Strong, and Walker
Hypothesis 3
Table 7 lists the types of models that we classify as being dominant in each report. Table 7 shows
that PE multiples are the dominant valuation model in 68.8 percent of reports in the beverages sector,
in 39.7 percent of reports in the electronics sector, and in 52.6 percent of reports in pharmaceuticals.
Across all sectors, a PE model is the dominant model in 55.5 (53.4 percent) ofthe reports, and a
multiperiod DCF models is the dominant approach in 21.5 (20.7 percent) of cases. Consistent with
H3, we fmd no report that uses a single-period cash flow multiple as its dominant valuation method-
ology. This result is important in relation to public debates and pronouncements on valuation issues.
One often comes across the slogan "cash is king," but we fmd no evidence to support this view in our
data. Nevertheless, we do fmd several instances of price to cash flow being used as a sensitivity
analysis. Moreover we fmd greater use of price to cash flow as a sensitivity check in beverages than
in the other two sectors. The evidence reported in Table 4 shows that a cash flow multiple is used in
11 out of 32 reports in the beverages sector and only twice out of 72 reports in the other two sectors.
This difference is statistically significant at the 1 percent level. These fmdings appear to conflict with
H3. However, in sectors of relatively low growth and reasonably stable and predictable levels of
capital investment, operating cash flows provide a viable altemative estimate of sustainable earnings
that is not prone to manipulation via discretionary accounting accruals. Our data are thus consistent
with analysts valuing the firm based primarily on an estimate of core earnings, but they support this
valuation with a sensitivity check based on a multiple of operating cash flows.
Hypothesis 4
We expect analysts who produce a complete multiperiod valuation model to identify it as their
dominant model. A total of 40 reports produce a valuation using a multiperiod model. Of the 40
reports that implement a multiperiod valuation model. Table 7 shows that 20 reports identify a
multiperiod model as their sole dominant model, while 4 other reports use DCF along with other
models. In 4 cases out of 40, the dominant model is not clear from the text. This leaves 12 cases out
of 40 (30 percent) where the analysts prefer some other form of valuation. Of these 12 cases, 10
reports favor valuation based on PE multiples, and 2 cases are based on the technology value'^ ofthe
company (both pharmaceuticals firms). These 12 cases are inconsistent with H4. Perhaps these
analysts believe users of their reports prefer to focus on valuation by comparatives.
Sector
Bvr
Elec
Phar
Totals
Number
of
Reports
32
34
38
104
Single
Comparitive
25
78.1%
18
52.9%
22
57.9%
65
62.5%
TABLE 7
Dominant Valuation Models
Hybrid
1
3.1%
1
2.9%
4
10.5%
6
5.8%
Valuation Models
Multi-
period
2
6.3%
10
29.4%
8
21.1%
20
19.2%
Single-
Period
and
Multi-
period
1
3.1%

1
2.6%
2
1.9%
Single-
Period
Hybrid

1
2.6%
1
1%
Hybrid
and
Multi-
period
1
3.1%

1
2.6%
2
1.9%
E versus
E
22
68.8%
13.5
39.7%
20
52.6%
55.5
53.4%
DCF
DCF
3
9.4%
9.5
27.9%
9
23.7%
21.5
20.7%
As explained in Table 3, technology value is a technique used to value biotechnology companies. Technology value ofthe
finn equals market value less cash plus debt.
Accounting Horizons, December 2004
What Valuation Models Do Analysts Use? 235
SENSITIVITY ANALYSES
Length of Sampled Equity Research Reports
Our interest in comprehensive equity research reports that offer a detailed analysis of the firm
differs from previous studies that mainly base their results on the content analysis of short reports of
only a few pages in length.'* While prior work and our results report a preference for valuation by
single-period comparatives, the longer reports in our sample contain more examples of sophisticated
valuations than in the prior evidence. To examine the effect of excluding reports of less than 15
pages, we analyze a smaller sample of 22 short reports (with average length 8.1 pages per report) for
15 of the firms in our initial sample. The reports are written by analysts from the same investment
houses as in our initial sample. Seven (nearly one third) of these reports do not highlight any
valuation model in their main text. Two reports base their recommendation on the DCF model, while
the remaining thirteen use some form of single-period comparative valuation to generate a stock
recommendation. This limited analysis of shorter reports suggests a greater use of valuation by
comparatives than in longer reports, although multiperiod DCF models are still used. Prior results
based on short reports may understate the sophistication of the analysts.
Firms Reporting Losses
Differences in the use of DCF multiperiod models across sectors could be due to variation in the
incidence of reported losses. The presence of losses may force analysts to base their valuations on
something other than PE multiples. We find that half of the sampled pharmaceutical reports refer to
firms reporting losses, raising the possibility that our results could be due to the incidence of losses
rather than the high-tech nature of the industry. In order to discriminate between these two possibili-
ties, we examine another high-tech sector that does not have a high incidence of losses during our
sample period. Specifically, we examine 28 reports for 10 firms in the information technology
hardware sector.'^ Of the 28 reports, 24 refer to profitable firms. We find:
1) Sixteen (57.1 percent) of the IT hardware reports use DCF, and a multiperiod DCF model is
the dominant model in 11.5 (41.1 percent) reports.
2) There are 40 instances of single-period comparative valuation techniques and 18 instances
of multiperiod models. The greater use of multiperiod valuation models relative to single-
period models in information technology hardware compared to beverages is significant
(X^ = 4.52; p-value = 0.034).
3) Single-period comparative valuation models are the dominant choice in 14 IT hardware
reports, with multiperiod valuation models dominant in 11.5 reports. The greater use of
single-period comparatives as the dominant model in beverages compared to IT hardware is
statistically significant (x^ = 819; p-value = 0.004).
In the light of these additional findings, we conclude that the use of multiperiod valuation
models and DCF models in particular is greater in high-growth sectors irrespective of the incidence
of reported losses.
Brokerage Firms' House Styles
Bradshaw (2002, 40) suggests that "It would be interesting to examine the extent to which
analysts' reports systematically differ across brokerage houses ..." As mentioned earlier in the
descriptive analysis section, ahnost all the equity research reports include some form of single-
'* Breton and Taffler (2001), for example, analyze reports with an average length of 4.3 pages. Previts et al. (1994) examine
reports with an average length of 7.3 pages. This compares with the average length of reports in this study of 32.6 pages.
'^ In selecting and studying these reports, we follow the same criteria used to select and analyze our initial sample. The
reports are written by analysts from the same investment houses as our initial sample.
Accounting Horizons, December 2004
236 Demirakos, Strong, and Walker
period comparative valuation analysis. However, investment houses might differ in their preferences
for DCF and accounting-based economic profitability models. Panel A of Table 8 reports the fre-
quency of employing DCF analysis at each house; Dresdner Kleinwort Wasserstein (69.2 percent),
Credit Suisse First Boston (68.4 percent), and HSBC (45.5 percent) use DCF the most.'* Table 8,
Panel B offers a sell-side analysts' ranking based on the use of accounting-based economic profit-
ability models (rating to economic profit, accounting rates of return, economic value added, and
residual income valuation model). HSBC uses some form of economic profitability analysis for
valuation purposes in 72.7 percent of its reports, followed by Merrill Lynch (42.9 percent). Credit
Suisse First Boston (36.8 percent), and UBS Warburg (36.4 percent).
TABLE 8
Differences in the Choice of Valuation Model across Brokerage Houses
Panel A: Rankings of Sell-Side Analysts Based on the Use of the Discounted Cash Flow
(DCF) Model
No.
1
2
3
4
5
6
7
8
9
Sell-Side Analysts
Dresdner Kleinwort Wasserstein
Credit Suisse First Boston
HSBC
Merrill Lynch
Westib Panmure
Societe Generale
ABNAmr o
Deutsche Bank
UBS Warburg
%
69.2
68.4
45.5
42.9
30.0
22.2
16.7
16.7
9.1
Panel B: Rankings of Sell-Side Analysts Based on the Use of Accounting-Based Economic
No.
1
2
3
4
5
6
7
8
9
Profitability Models (EPM)
Sell-Side Analysts
HSBC
Merrill Lynch
Credit Suisse First Boston
UBS Warburg
ABNAmro
Societe Generale
Westib Panmure
Deutsche Bank
Dresdner Kleinwort Wasserstein
%
72.7
42.9
36.8
36.4
25.0
11.1
10.0
8.3
7.7
Accounting-based economic profitability models refer to REP, ARR, EVA""^, and RIV.
This variation in the valuation preferences of sell-side analysts does not appear to influence our results on cross-sectional
differences in the use of multiperiod and comparative valuation models, since the sum of the reports of the three
brokerage houses that employ DCF valuation more frequently (Credit Suisse First Boston, Dresdner, and HSBC) ac-
counts for 43.8 percent, 41.2 percent and 39.4 percent ofthe total beverages, electronics and pharmaceuticals reports,
respectively. However in order to test this more rigorously, we remove the top two (Dresdner Kleinwort Wassertstein,
Credit Suisse First Boston) and bottom two (UBS Warburg; Deutsche Bank or ABN Amro) users of DCF. The cross-
sectional differences in the use of multiperiod versus single-period valuation models between stable and growth sectors
remain significant.
Accounting Horizons, December 2004
What Valuation Models Do Analysts Use? 237
lype of Recommendation
In choosing the sample, we ignored the investment recommendation given in the report. How-
ever, when carrying out the analysis, we record the recommendations made by the analysts. Twelve
types of recommendation appear in the reports. Six types of recommendation (Strong Buy, Buy,
Accumulate, Market Outperform, Add, Undervalued) are positive. The 104 reports contain 64 posi-
tive recommendations. The categories Market Perform, Neutral, and Hold are neutral recommenda-
tions. The sample contains 25 of these. Only 15 reports contain one of the remaining three negative
categories (Market Underperform, Reduce, Sell). Counting the neutral recommendations as weak
negatives, the sample contains 64 positives and 40 negatives. A standard binomial test rejects the
hypothesis of an equal number of positive and negative recommendations at the 1 percent level.
These findings are consistent with previous work indicating a tendency for analysts' recommenda-
tions to be biased toward a buy.
Looking at the individual sectors, we find that the proportion of positive recommendations is
46.9 percent in beverages, 67.6 percent in electronics, and 68.4 percent in pharmaceuticals. These
differences could drive the choice of valuation model. We therefore examine whether the choice of
DCF as a valuation model varies significantly across types of recommendation. Of the 64 (40)
reports that have a positive (neutral/negative) recommendation, 27 (13) use DCF analysis i.e., 42.2
percent (32.5 percent) of the reports. A Chi-square test reveals that this difference is not significant
i;^^ = 0.98; p-value = 0.323). For reports containing a DCF valuation, the DCF valuation is
dominant in 15 out of 27 (55.6 percent) for the positive recommendation cases, and 6.5 out of 13 (50
percent) for the negative recommendation cases. This difference in the proportion of reports for
which DCF is the dominant valuation model across different types of recommendations is not
significant (^ ^ = 0.11; p-value = 0.74). These results suggest that the type of recommendation does
not drive the choice of valuation model.
SUMMARY
The main message to emerge from this content analysis of financial analysts' reports is that
analysts appear to tailor their valuation methodologies to the circumstances of the industry. PE
models remain the mainstay of valuation practice, but other forms of analysis complement these as
circumstances demand. In some cases DCF models are used, and in others, more detailed analyses of
price-to-sales multiples, growth options, or profitability analysis are used. Another finding is that use
of the RIV model is extremely limited, but analysts frequently use accounting data in single-period
comparative and hybrid models. Analysts appear to vary the choice of valuation methodology in
understandable ways with the context in which the valuation is made, but analyst familiarity with a
valuation model and its acceptability to clients is a strong driving force.
In terms of our positive approach to explaining valuation practices, we examine four hypoth-
eses. The pervasiveness of comparative valuation techniques results in no significant difference in
their use across sectors (HI). However, a more discriminating test shows that a multiperiod valuation
model rather than a single-period method of comparatives is more likely to be the analysts' dominant
model in the electronics and phannaceuticals sectors compared with beverages. This result is consis-
tent with the hypothesis that comparative valuation models are more popular in more stable sectors
where conventional accounting does a better job of capturing the value of the firm. Insufficient
instances of RIV mean that we cannot reject the null hypothesis on the relative use of DCF and RIV
across sectors (H2). However, if we broaden this hypothesis to compare the use of multiperiod and
hybrid valuation models based on cash and accruals, respectively, we find a significantly greater use
of accruals models in beverages than in pharmaceuticals. Analysis of the combined choice of fore-
casting system and valuation model shows that profitability analysis is more prominent in reports for
the beverages sector than for electronics or phannaceuticals.
Accounting Horizons, December 2004
238 Demirakos, Strong, and Walker
We find no report that uses a single-period cash fiow multiple as its dominant valuation model
(H3), consistent with analysts understanding the limitations of using a single-period cash fiow
number. Some analysts use price to single-period cash fiow as a sensitivity check in sectors where the
rate of growth is relatively stable. Finally, we find that over half of the analysts who construct a
multiperiod valuation analysis choose it is as their dominant model. However, we also find that over
one-quarter of these analysts subsequently adopt valuation by single-period comparatives as their
dominant model, inconsistent with H4. We conjecture that this latter finding is due to valuation by
comparatives, with the implicit support of a more sophisticated model, being preferred by the
analysts' clients.
This research suggests that careful study of comprehensive analysts' reports can improve our
understanding of the variations in valuation practice. Specifically, the types of valuations used to
justify analysts' recommendations depend on characteristics of the company being analyzed. In this
paper, we focus on differences across industrial sectors, but we anticipate that valuation behavior
may vary in other contexts. Further insights may emerge from studying analysts' reports for firms
involved in IPOs, mergers, and major capital issues. Also, analysts may employ different models for
dividend payers versus nonpayers. The special problems of valuing firms that report losses is also
worthy of further work. Finally, sensitivity analyses suggest that prior results based on short, less
comprehensive reports may understate the sophistication of the valuation models used by analysts.
Accounting Horizons, December 2004
What Valuation Models Do Analysts Use? 239
APPENDIX A
DISCOUNTED FUTURE EARNINGS (DFE)
When analysts value a firm based on a PE multiple, they control for the effects on earnings of
nonrecurring events, transitory components, and accounting conservatism. Where a firm has nega-
tive, very low, or very high earnings that are unlikely to continue, financial analysts try to normalize
earnings. The DFE approach to valuation, given by the following equation, is one such technique:
V, = ^{EBITDA,^^ )/(l + waccj ]x (EVIEBITDA), (1)
where F, is the fundamental value ofthe firm at date /, EBITDA^^^ is earnings before interest, taxes,
depreciation, and amortization in period / + x, wacc is the firm's weighted average cost of capital,
and (JEVIEBITDA)J is (enterprise value)/(eamings before interest, taxes, depreciation and amortiza-
tion) for comparable firms at date /. Financial analysts project forward to the period when the firm is
expected to reach a sustainable level of performance and discount the relevant future earnings to the
present using the firm's weighted average cost of capital. Multiplying by a current benchmark value
of EVIEBITDA for a set of comparable firms yields the fundamental value ofthe firm.
APPENDIX B
RATING TO ECONOMIC PROFIT
The rating to economic profit (REP) is based on the relation between the market-to-book ratio at
the enterprise level and the ratio of the retum on invested capital to the weighted average cost of
capital:
REP = (EV,/IC,)/{ROIC,^J wacc) (2)
where EV^ is the market value ofthe firm's equity plus the book value ofthe firm's debt at date t, IC,
is the book value ofthe capital invested in the firm at t, ROIC,^^ is the expected retum on invested
capital in period / + 1, and wacc is the firm's weighted average cost of capital. Valuation theory
suggests that the book-to-market ratio is an increasing function ofthe finn's cost of capital, and that
a relatively high spread between the expected retum on invested capital and the weighted average
cost of capital should lead to a high market-to-book multiple. If the latter relation does not hold, then
the market does not impound properly all the available information about a firm's future perfor-
mance in its current market value, and, hence, the firm is undervalued. Similarly, a low expected
economic performance leads to a relatively low market-to-book ratio, otherwise the firm is overval-
ued. Although analysts consider REP to be a sophisticated form of price-to-book ratio, it can be
shown that REP equals EVINOPLAT (where the denominator is one-year ahead net operating
profit less adjusted tax) multiplied by the weighted average cost of capital. Assuming costs of capital
and leverage are constant within sectors, the profitability of an investment strategy based on REP
should be similar to one based on one-year-ahead PE ratios.
Accounting Horizons, December 2004
240 Demirakos, Strong, and Walker
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