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 valuation practices of financial analysts by studying the valuation nfiethodologies contained in 104 analysts' reports from international investment banks for 26 large U.K.-listed companies drawn from the beverages, electronics, and Pharmaceuticals sectors. We provide 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 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 ofManchester.
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

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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 recommendations. He recommends further research to compare analysts' reports both within and across industries. 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 hypotheses 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.

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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 singleperiod 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 implementing 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 arguments 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 requires 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.

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TABLE 1 Profiles of the Sampled Industry Sectors Sector Bvr Elec Phar 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 singleperiod 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 argument 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 constructs 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.

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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 characterize 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 marketbased 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).

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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 pharmaceuticals 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 sellside 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 research 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 valuation 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.

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TABLE 3 Definitions for the Valuation Scoring Convention Major Valuation Models Single-Period Eamings Comparative multiples (E)

Definition 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.

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 the standard cash recovery rate (CRR) and the cash flow retum on investment (CFROI). rates (CRR) Economic value the retum spread times the book value of a firm's assets. added (EVA) Continuing value (Cont.V.) Technology value (Tech.V.) Options-Pr Multiperiod 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.

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)

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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 pharmaceuticals 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.

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TABLE 5 Formal Tests of HI and H2' Panel A: Use of Alternative Valuation Models Single-Period Comparative Industry Valuation Techniques Beverages Electronics Pharmaceuticals Multiperiod Valuation Models

Panel B: Industry

73 14 63 15 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 Choice of Dominant Valuation Models Single-Period Comparative Multiperiod Valuation Techniques Valuation Models

Beverages Electronics Pharmaceuticals

25.5 3 18 10 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 Electronics Pharmaceuticals 3 10 10 4 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, comparative valuation techniques are used 114 times in 72 reports with multiperiod valuation models employed 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.

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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 (beverages) 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 models 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 beverages (,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 pharmaceuticals 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.

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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. Instead, 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).

TABLE 6 Analysis of Profitability

Profitability Analysis Accruals Based Cash-Flow Based Spread 17 53.1% 13 38.2% 1 2.6% 31 29.8% CRR 1
3.1%

Sector Bvr Elec Phar Totals

Number of Reports 32 34 38 104

ARR 23 71.9% 20 58.8% 1 2.6% 44 42.3%

PM 32 100% 31 91.2% 22 57.9% 85 81.7%

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.

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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 methodology. 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.
TABLE 7 Dominant Valuation Models Valuation Models SinglePeriod and Multiperiod 1 3.1% 1 2.6% 2 1.9% Single- Hybrid Period and MultiHybrid period 1 3.1% 1 2.6% 1 1% 1 2.6% 2 1.9%

Sector Bvr Elec Phar Totals

Number Single of Reports Comparitive Hybrid 32 34 38 104 25 78.1% 18 52.9% 22 57.9% 65 62.5% 1 3.1% 1 2.9% 4 10.5% 6 5.8%

Multiperiod 2 6.3% 10 29.4% 8 21.1% 20 19.2%

E versus DCF E 22 68.8% 13.5 39.7% 20 52.6% 55.5 53.4% 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.

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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 possibilities, 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 singleperiod 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.

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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 frequency 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 profitability 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 ABNAmro Deutsche Bank UBS Warburg Profitability Models (EPM)

%
69.2 68.4 45.5 42.9 30.0 22.2 16.7 16.7

9.1

Panel B: No. 1 2 3 4 5 6 7 8 9

Rankings of Sell-Side Analysts Based on the Use of Accounting-Based Economic %

72.7 42.9 36.8 36.4 25.0 11.1 10.0

Sell-Side Analysts HSBC Merrill Lynch Credit Suisse First Boston UBS Warburg ABNAmro Societe Generale Westib Panmure Deutsche Bank Dresdner Kleinwort Wasserstein

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) accounts 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 crosssectional differences in the use of multiperiod versus single-period valuation models between stable and growth sectors remain significant.

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lype of Recommendation In choosing the sample, we ignored the investment recommendation given in the report. However, 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 positive recommendations. The categories Market Perform, Neutral, and Hold are neutral recommendations. 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' recommendations 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 hypotheses. 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 consistent 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 forecasting system and valuation model shows that profitability analysis is more prominent in reports for the beverages sector than for electronics or phannaceuticals.

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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.

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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 negative, 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 amortization) 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 performance 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 overvalued. 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.

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