Equity Research Reports Research Articles

Rating to economic profit: Valuation properties, implementation issues, and the justification of target prices

ABSTRACT This study offers a comprehensive theoretical and empirical analysis of a fundamentals-based investment criterion (HSBC’s Rating to Economic Profit – REP). By employing a large sample of US-listed firms over a 12-year time-period and conducting univariate, multivariate and portfolio analyses, we provide robust empirical results that support the ability of REP to explain contemporaneous stock market valuations, justify financial analysts’ target prices, and predict one-year ahead stock returns. Through content analysis of selected financial analysts’ equity research reports, we also provide some descriptive evidence of the usefulness of accrual accounting numbers over dividends for valuation purposes. To the best of our knowledge, this is the first academic study that offers a comprehensive analysis of REP as a value-based stock screening method that should be of interest to market-based accounting researchers, valuation educators, and capital market participants.

Competing for narrative authority in capital markets: Activist short sellers vs. financial analysts

Activist short sellers (AShSs) and financial analysts are information intermediaries who analyze firm disclosures as well as produce and disseminate influential investment narratives. This study aims to better understand narrative challenges surrounding the legitimate expertise of financial analysts. Specifically, we examine how AShSs challenge sell-side financial analysts' narrative authority (i.e., the perception that they produce expert knowledge) in interpreting firms' performance and future prospects. We investigate how analysts respond (or do not respond) to this challenge. We use 442 AShS reports, 12 interviews with AShSs and analysts, and analysts' stock recommendations and target prices. In their criticisms of analysts (found in one-third of reports), AShSs frequently frame analysts as lacking market expertise and critical thinking – two core dimensions of analysts' narrative authority. Sixty-six percent of analysts, although explicitly criticized in AShS reports, do not engage in written responses in their equity research reports because they reportedly either adopt a renunciation attitude to the challenge or they engage in off-the-record discussions with certain market participants. However, 34% of analysts respond overtly by counter-framing AShSs as lacking market expertise and objectivity. After the dissemination of AShS reports, analysts, on average, do not revise their highly visible stock recommendations but they revise target prices downward. Theoretically, this study extends our understanding of the construction of narrative authority in capital markets as we examine a challenge to the expertise of influential information intermediaries.

Equity Research Report-Driven Investment Strategy in Korea Using Binary Classification on Stock Price Direction

This research examines and proposes an investment strategy by combining the natural language processing on the equity research reports published in the Korean financial market and machine learning algorithms for binary classification. At first, we deduce the part-of-speech from the report using the KoNLPy and Mecab. Then, we define 33 features as the input variables and perform the binary classification on the price direction of the stocks recommended in the report using various machine learning algorithms. Note that we investigate the model performance in detail by dividing the entire period into three sub-periods, including pre-COVID-19 for the sideways market, COVID-19 for the crashing market, and post-COVID-19 for the extreme bullish market. We confirm that the random forest is the best classifier for all periods, so we utilize its results on positively predicted stocks in the test set as the investment universe for the monthly re-balancing and buy-and-hold investment. The proposed strategy shows a significantly higher return on investment than benchmarks during the pre-COVID-19 and COVID-19 periods, whereas the comparable return during the post-COVID-19.

Analysis of Equity Valuation Models and Target Price Accuracy: An Evidence From Analyst Reports in Indonesia

This study examines whether investment analysts (sell-side) in Indonesia tend to prefer cash-flow-based valuation models over the accrual-based valuation model, how the accuracy of valuation models are used, and whether the use of both valuation models simultaneously for generating target prices can improve accuracy. The researchers conducted a comprehensive content analysis of 99 equity research reports for most companies listed in the LQ-45 index. The results show that in the accrual-based valuation model, in particular, the ratio of stock price to income (P/E) was the most popular valuation model that appeared in equity reports in all sectors. However, from the perspective of the valuation model as the producer of the target price (dominant valuation), discounted cash flow (DCF) was the most popular valuation model used. It was also found that the cash-flow-based valuation model gave the highest accuracy. In addition, the researchers also found significant results in the Chi-square test which showed the use of both valuation models simultaneously could improve the valuation results more precisely by the analysts. This was in line with the intuition that the accrual concept adds value to the relevance of the information to cash flow.

How do financial analysts implement the Sum-of-the-Parts (SOTP) valuation framework?

In this study, we investigate 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, thereby decreasing 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.

Do financial analysts care about FCPA violations

In this paper, we examine 12,954 equity research reports for 24 firms that are subject to enforcement actions by the US Securities and Exchange Commission (SEC) for violations of the Foreign Corrupt Practices Act (FCPA). We search the text of the equity research reports for a number of FCPA-related keywords and identify 1079 reports, where an analyst considers the SEC investigation an important issue. Our multivariate empirical analysis shows that financial analysts are more likely to be interested in incidents of FCPA violations, if the fines imposed to the firms by the SEC, DOJ (Department of Justice), and other US agencies represent substantial components of their revenues, operating income, and market capitalisation. We also find that the interest of financial analysts in these cases increases when the subject firms are relatively small with poor profitability. We offer illustrative examples of how financial analysts actually refer to the FCPA violations in their equity research reports. We believe that this study contributes to the relevant literature by highlighting the importance and implications of the FCPA statute for capital market participants.

Do financial analysts care about FCPA violations

In this paper, we examine 12,954 equity research reports for 24 firms that are subject to enforcement actions by the U.S. Securities and Exchange Commission (SEC) for violations of the Foreign Corrupt Practices Act (FCPA). We search the text of the equity research reports for a number of FCPA-related keywords and identify 1,079 reports, where an analyst considers the SEC investigation an important issue. Our multivariate empirical analysis shows that financial analysts are more likely to be interested in incidents of FCPA violations, if the fines imposed to the firms by the SEC, DOJ (Department of Justice), and other U.S. agencies represent substantial components of their revenues, operating income, and market capitalization. We also find that the interest of financial analysts in these cases increases when the subject firms are relatively small with poor profitability. We offer illustrative examples of how financial analysts actually refer to the FCPA violations in their equity research reports. We believe that this study contributes to the relevant literature by highlighting the importance and implications of the FCPA statute for capital market participants.

The Equity Research Program’s Effect on Technology Investors: The Tel-Aviv Stock Exchange Case Study

The Tel-Aviv Stock Exchange (TASE) initiated an equity research program in 2016 dedicated to the technology sector. The main goal of the program was to draw more investor attention to Israeli tech firms. Today, nearly all equity research is performed by stock brokers, investment banks, and other entities which have a financial interest in the market. On the other hand, independent equity research is a boutique service offered by only a few firms worldwide. The aim of such research is to provide an unbiased opinion on the state of a company, including its share price and potential forthcoming changes. We conducted a study to explore events, such as initiation analysis report publications, as the release of new information to market participants. We hope to contribute to the growing literature on the effect of analyst reports on investor activities. Our findings indicate a broad market reaction to equity research reports published in TASE during 2017-2018.

An Analysis of the Level of Qualitative Efficiency for the Equity Research Reports in the Italian Financial Market

Corporate reports issued by various financial intermediaries play a major role in investment decisions. For this reason, it is particularly interesting to understand the accuracy of the forecasts, by carrying out an empirical analysis of the "equity research" system in Italy, identifying structural features, degree of reliability and incidence in the market. The choice of the analysis of the efficiency level information on the Italian market proposes to assess the interest of equity research of a niche market (339 listed companies in 2017) but with characteristics of potential growth such as having been acquired by LSEGroup in 2007, the 6th stock-exchange group at international level for the number of listed companies and the 4th for capitalization.The analysis was carried out on the reports issued on companies belonging to the Ftse Mib stock index during a period of 5 years.It aims to analyse the composition of the equity research system in Italy as well as the analysts' ability to properly evaluate the stocks' fair price, so as to test their degree of reliability and detect possible anomalies in recommendations to the investors.

Does sophisticated DCF outperform heuristics driven PE? Evidence from India

Purpose PE and DCF are two popular valuation methodologies used by analysts to derive target price forecasts while performing equity research. Recent studies in developed markets show that analysts using sophisticated models like DCF produce more accurate target price forecasts as compared to heuristics driven models like PE. This study investigates if analysts using DCF outperform analysts using PE in an emerging market institutional set up. Design/methodology/approach An in-depth analysis of 392 equity research reports is conducted to understand the dominant valuation model used by analysts to derive target price forecasts. Research reports with clear mention of valuation methodology (PE or DCF) to derive target price forecast are used for the purpose of performing this analysis. Multivariate OLS and logit regression analysis has been conducted to investigate if analysts using DCF outperform analysts using PE to derive target price forecasts. Findings The study finds that analysts using PE produce significantly better short-term results than analysts using DCF i.e. when target price accuracy is measured anytime during forecast horizon of 12 months. However, there is no significant difference in target price performance or target price forecast error of PE and DCF model when analyst performance is measured at the end of the forecast horizon. Practical implications In contrast to results from developed markets, this study does not find evidence of superior target price performance of DCF. On the contrary, results suggest that PE outperforms DCF on the short-term measure of target price accuracy. This study shows that PE model which captures market moods and sentiments effectively is more suitable in dynamic, emerging markets like India. Originality/value Past studies have explored the performance of PE and DCF in developed markets and this study provides fresh empirical evidence on target price accuracy of valuation model from an emerging market like India. The superior short-term target price performance of PE as compared to DCF may be relevant exclusively in emerging markets like India.

FINRA regulation: new fixed-income research rule, modifications to equity research rule, and FAQ on conflicts of interest in offering process

Purpose To address practical issues broker-dealers may face in reviewing and revising their policies and procedures in response to FINRA’s new fixed-income research rule, modifications to its equity research rule, and its FAQs regarding conflicts of interest in the offering process. Design/methodology/approach Reviews FINRA’s new fixed-income research rule, modifications to its equity research rule, and its FAQs regarding the its equity research rule, and provides detailed comparisons between current rules and new rules to help firms consider how to review and revise their policies and procedures. Findings Although significant exemptions may apply depending on firm structure, under FINRA’s new fixed-income research rule, firms producing fixed-income research reports will now be subject to regulation similar to that FINRA has imposed on firms producing equity research reports, including with respect to information barriers, other policies and procedures, and certain disclosures. The modified FINRA equity research rule retains the core provisions of the existing NASD and NYSE equity research rules and adds a “principles-based procedures” approach to potential conflicts of interest, shortens or eliminates quiet periods, and imposes some of the Global Settlement prohibitions on all firms. Firms will need to review and revise their policies and procedures for research in response to these rule changes. Firms should also take note of FINRA’s guidance in its FAQs regarding conflicts of interest in the offering process. Originality/value Overview of recent FINRA enforcement activity, rule modifications, and practical guidance from experienced securities and financial services lawyers.

Changes in underwriters' selection of comparable firms pre- and post-IPO: Same bank, same company, different peers

We compare the selection of peer firms made by investment banks as underwriters at the IPO with that done shortly thereafter as analysts. We find that 3 out of 7 comparable firms, on average, are changed. The peers published in the IPO prospectuses have higher valuations than those published in the post-IPO equity research reports of the same firm, especially if the underwriter is US-based. We argue that underwriters select comparable firms that make the issuer's shares look conservatively priced at the IPO, while this conflict of interest tends to fade afterwards. The upward bias in peer selection is larger for underwriters with greater market power, and lower for repeat players in the IPO market. A biased selection of peers results in higher underpricing and lower long run performance of IPOs.

Infringement Risk in Copyright-Intensive Industries

We have reviewed equity research reports issued in 2013 for eight leading companies in copyright-intensive industries: two software firms (Microsoft and Adobe); two publishers (Pearson and Reed Elsevier); the owners of two major motion picture studios (Disney and Viacom, owner of Paramount); and the owners of two major record labels (Sony, owner of Sony Music Entertainment, and Vivendi, owner of Universal Music Group). We found that the overwhelming majority of the equity research reports did not mention copyright infringement as a possible risk factor. None of the 14 reports for Reed Elsevier and 18 reports for Pearson identified copyright infringement as a risk factor. Only 13% of the 15 reports for Sony and 22% of the 23 reports for Vivendi mentioned copyright infringement as a potential risk. Just 8% of the 26 reports for Viacom and 27% of the 26 reports for Disney referred to copyright infringement as a risk factor. 26% of the 19 reports concerning Adobe and 41% of the 27 reports concerning Microsoft identified copyright infringement as a risk factor. Cumulatively, only 19% (32) of the 168 reports referred to copyright infringement as a possible risk; 81% did not. The vast majority of the reports written by sophisticated analysts simply do not consider copyright infringement a significant enough threat to the subject companies’ financial health to merit mention to potential investors. If the analysts with expertise in these industries are not concerned about the possible impact of copyright infringement, perhaps policymakers should not be either.

Complementing a positivist approach to investment analysis with critical realism

PurposeThe purpose of this paper is to identify the challenges in adding a critical realist epistemological perspective to a positivist approach in research on listed companies by equity researchers and other financial services professionals.Design/methodology/approachA purposive sample of publicly available equity research reports was examined to assess the dominant epistemological approach to investment analysis.FindingsIt was found that there is an absence of a critical realist epistemological approach to investment analysis, confirming the dominance of a positivist approach to obtaining and analysing investment information.Research limitations/implicationsThis research drew on a small, purposive sample, and could be followed by more wide‐scale research. Taking a critical realist approach may create a clash of “institutional logics” which will need to be considered by a range of stakeholders.Originality/valueEquity research reports are examined through the lens of critical realism. This exploration allows for an additional epistemological perspective on analysis of firm value.

Equity valuation models and target price accuracy in Europe: Evidence from equity reports

This study examines whether European investment analysts prefer cash flow based valuation models over accrual based models, how accurate valuation models are and whether the use of cash flow based models (with or without accrual based models) improve forecast accuracy. We conduct a comprehensive content analysis of equity research reports for most of the firms on the components list of the Dow Jones Euro Stoxx 50 Index. We find that earnings multiples and the discounted cash flow (DCF) valuation models are the two most popular valuation models and the use of accrual based multiple alongside a cash flow based model improves the forecast error and this is in line with the intuition that accruals add value relevant information to cash flows. However, we also find that neither cash flow nor earnings multiples are superior to book value and return on equity (ROE) based models in terms of forecast error. Our results provide support for the use of book value and ROE based models which provide more precise forecasts and this, in turn, supports the use of accounting based models, i.e., a residual income model.

Does Valuation Model Choice Affect Target Price Accuracy?

We investigate whether the choice of valuation model affects the forecast accuracy of the target prices that investment analysts issue in their equity research reports, controlling for factors that influence this choice. We examine 490 equity research reports from international investment houses for 94 UK-listed firms published over the period July 2002–June 2004. We use four measures of accuracy: (i) whether the target price is met during the 12-month forecast horizon (met_in); (ii) whether the target price is met on the last day of the 12-month forecast horizon (met_end); (iii) the absolute forecast error (abs_err); and (iv) the forecast error of target prices that are not met at the end of the 12-month forecast horizon (miss_err). Based on met_in and abs_err, price-to-earnings (PE) outperform discounted cash flow (DCF) models, while based on met_end and miss_err the difference in valuation model performance is insignificant. However, after controlling for variables that capture the difficulty of the valuation task, the performance of DCF models improves in all specifications and, based on miss_err, they outperform PE models. These findings are robust to standard controls for selection bias.

The Use of Valuation Models by UK Investment Analysts

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.

Portfolio Returns and Target Prices

In this paper we examine the profitability of trading strategies based on target prices embedded in equity research reports. We adopt target prices as information signals to build our portfolio strategy. At the first stage, we exploit implicit returns (difference between the current price and the target price) as a buying or short selling signal to open every transaction in the portfolio. Next, we use raw and adjusted target prices as a closing transaction signal. We build three different strategies to verify if the overshooting of target prices revealed by several studies could affect the profitability of a trading strategy based on these target prices. We have formed four portfolios within every strategy to verify whether analysts' target prices have any investment value. We find that all strategies deliver positive abnormal returns against the market. In particular, the highest and lowest implicit return classes exhibit the highest stock returns and abnormal returns. In the last part control these returns for systematic risk, factors through the CAPM and the Fama & French three factor model. The positive performances of our strategies persist and, in particular, our strategies beat the market with consistent abnormal returns in all the four implicit return classes analyzed. From the three factors equation, it seems that analysts tend to advise buying stocks with risk above the average market risk, with growth profile and with large market value. Conversely analysts advise selling value stocks and those with a negative beta.

The Advantage of Same-Sex Programs

Recent sex equity research reports that females often unintentionally receive unequal treatment in the classroom.