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The valuation practices of sell-side financial analysts and the usefulness of accounting information for the issuance of stock price recommendations and the derivation of target prices in equity research reports
(04/14/2022) Chlomou, Grigoria; Χλωμού, Γρηγορία; Athens University of Economics and Business, Department of Accounting and Finance; Ballas, Apostolos; Papadaki, Afroditi; Siougle, Georgia; Doukakis, Leonidas; Xevas, Dimosthenis; Tzovas, Christos; Demirakos, Efthymios
The primary research objectives of my Ph.D. thesis are: i) to explore the valuation practices of sell-side equity research analysts; and ii) to examine the usefulness of accounting information for the implementation of valuation models, derivation of target prices, and issuance of stock recommendations. My Ph.D. thesis comprises the following three main parts: i) the first part examines the Sum-of-the-Parts (SOTP) valuation framework and the usefulness of IFRS 8 in identifying the operating segments within a SOTP-based valuation exercise; ii) the second part examines the valuation properties and the implementation issues of HSBC’s Rating-to Economic-Profit (REP) as well as its ability to justify financial analysts’ target prices; and iii) the last part examines the valuation methods that financial analysts use to value firms with a going-concern audit opinion and the impact of Covid-19 on the ongoing operations of the firms. Chapter I investigates how financial analysts implement the Sum-of-the-Parts (SOTP) valuation framework. Although SOTP constitutes a popular valuation approach among sophisticated practitioners and investors, it is mostly ignored by researchers and academics. We adopt a structured content analysis of 265 equity research reports written by 33 investment brokerage houses for 140 UK-based firms. We find that analysts typically use EBITDA multiples to implement SOTP. Furthermore, financial analysts are more likely to consider SOTP the dominant or preferred valuation model in their report. We show that managers disclose a greater quantity of segmental information if their firms are considered difficult to analyze and value by investors and creditors, decreasing in this way the information asymmetry with their capital providers. In specific circumstances, we document that financial analysts identify more segments in their SOTP analysis compared to the reportable segments in the firms’ annual reports based on IFRS 8. We argue that the financial analysts’ choice to employ a greater number of segments in their SOTP models might be primarily driven by their effort to support their reports’ optimistic target prices. Finally, although SOTP seems theoretically ideal to estimate the value of a multi-segment firm, we do not find empirical evidence to support the hypothesis that SOTP significantly outperforms a full-blown Discounted Cash Flow (DCF) model, when the latter is used separately to value the company as a whole. The primary objectives of Chapter II are to critically analyze and extend a fundamentals-based investment criterion (HSBC’s Rating to Economic Profit, REP) and to examine its ability to justify analysts’ target prices. This study justifies the use of REP as an investment appraisal technique, provides significant extensions of the basic formula, and discusses implementation issues. It also conducts a content analysis of selected analysts’ reports, which may serve as insightful cases facilitating the work of valuation educators and practitioners. We provide some descriptive evidence of the usefulness of accrual accounting numbers over dividends for valuation purposes. We also demonstrate that analysts may use REP to justify their target prices and explain concurrent stock market valuations. Finally, we offer estimates of the implied growth rates and the implied cost of equity by reverse-engineering the alternative formulas of REP. To the best of our knowledge, this is the first academic study that offers a comprehensive analysis of REP. Chapter III focus on UK-listed firms with a going-concern audit opinion to identify the valuation methods that financial analysts use to value distressed companies. The argument that financially distressed firms are difficult to value motivates our work and highlights the importance of our findings and the implications of our study. In this context, we also examine the effects of contemporary macroeconomic environment, Covid-19 pandemic, and accounting issues on firms’ liquidity and solvency as depicted in their expanded audit reports. The Covid-19 pandemic has put a significant number of firms, especially in the Travel & Leisure sector, under pressure potentially affecting the auditors’ decision to raise a going-concern flag. To accomplish our research objectives, we analyze the content of equity research reports for this sample of financially distressed firms to find the most popular valuation methodologies that financial analysts adopt to base their target prices and stock recommendations. Moreover, we investigate the extent of financial analysts’ optimism in firms that are considered distressed. Hence, our research sheds light on both auditors’ and financial analysts’ frameworks of analysis.Finally, Chapter IV offers a synopsis of the main findings of the Ph.D. thesis and highlights the contribution of this study to the field of market-based accounting research and its implications for valuation practitioners.

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