The Use of Valuation Models by UK Investment Analysts

Abstract

This paper examines the use of valuation models by UK investment analysts. The study is based on, first, semi-structured interviews with 35 sell-side analysts from 10 leading investment banks and with 7 buy-side analysts from 3 asset management firms and, second, content analysis based on 98 equity research reports for FTSE-100 companies covered by the sell-side interviewees. We observe that analysts perceive the discounted cash flow (DCF) (and to some extent 'sophisticated' models in general) to have become significantly more important than prior survey evidence suggests, although we also find the (somewhat paradoxical) continued importance of 'unsophisticated' valuation multiples, notably the price/earnings ratio (PE). We find perceived limitations in the technical applicability of the DCF, which cause analysts to rely in practice upon valuation multiples and subjective judgement of whether the market price 'feels right'. We also find that contextual factors, notably the analysts' need for their research to be credible to buy-side clients, cause the use of subjective, unsophisticated methods of valuation to be played down. Given the inherent flexibility of the DCF model, coupled with its ostensible credibility, it becomes the natural vehicle for conveying the analyst's research, even though it is very rarely relied upon to determine target prices and investment recommendations. We conclude that, while the literature has focused on the technical merits of alternative valuation models, analysts' actual usage of valuation models also requires an understanding of social and economic context and motivations.

Flexibility in cash-flow classification under IFRS: determinants and consequences

“…Cash flow, and particularly OCF, is well established as a basis for business valuation (e.g., Damodaran 2006;Imam et al 2008), 1 contracting (e.g., Dichev and Skinner 2002;Mulford and Comiskey 2005), and financial analysis (e.g., Estridge and Lougee 2007). Although an extensive literature examines classification shifting within the income statement and the balance sheet (Engel et al 1999;Marquardt and Wiedman 2005;McVay 2006;Bartov and Mohanram 2014), less attention has been given to classification variations within the statement of cash flows (Lee 2012) and classification restatements (Hollie et al 2011).…”

Who Uses Financial Reports and for What Purpose? Evidence from Capital Providers

“…However, more recent evidence shows DCF models are used more than earnings models, particularly in growth industries (Demirakos et al, 2004;Glaum and Friedrich, 2006). Based on equity research reports and interviews with sell-side and buy-side analysts, Imam et al (2008) find DCF models to be more important than early research suggests. Valuation models are not used mechanically and are often employed on a relative, rather than an absolute basis.…”

“…Second, across many countries, they are heavily reliant on financial statements. This is the case in France (Chambost, 2007); Germany (Ernst, Gassen and Pellens, 2005;2009;Gassen and Schwedler, 2010;Glaum and Friedrich, 2006;Marton, 1998;Pike, Meerjanssen and Chadwick, 1993); the Netherlands (Vergoossen, 1993); Spain (Rojo Ramírez and García Pérez de Lema, 2006); Sweden (Olbert, 1994) and the UK (Campbell and Slack, 2008;Clatworthy and Jones, 2008;Imam et al, 2008). Third, direct contact with company personnel is very influential and sometimes more important than financial reporting data (Barker, 1998;Barker, Hendry, Roberts and Sanderson, 2012;Glaum and Friedrich, 2006;Holland, 1998).…”

“…First, professional equity investors employ fundamental valuation models -particularly the price/earnings (P/E) ratio and, more recently, discounted cash flow (DCF) models (Barker, 1998;1999b;Imam, Barker and Clubb, 2008). Second, across many countries, they are heavily reliant on financial statements.…”

Valuation of agrifood SMEs. Lessons to be learnt from the stock market

“…When pricing SMEs practitioners tend to rely on accounting methods, namely net asset valuation, or on fundamental methods, namely discounted cash flows, DCF (Rojo & García, 2006). Imam et al (2008) stated that most analysts prefer sophisticated valuation models, such as DCF. Demirakos et al (2010) report that analysts in the UK use DCF models more frequently than Price-Earnings models to value small firms, loss-making firms, and firms with a limited number of industry peers.…”