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Room for Manipulation by Stock Analysts?

Posted in Investing Expertise

How do professional analysts value stocks? In their March 2014 paper entitled “Peering Inside the Analyst ‘Black Box’: How Do Equity Analysts Model Companies?”, Andreas Markou and Simon Taylor examine the private stock valuation models of a group of analysts working in research departments of large investment banks. They examine both modeling methods and inputs. Using 53 Excel-based valuation models from professional analysts covering the European healthcare and chemicals sectors acquired during the third quarter of 2009, they conclude that:

  • Analysts routinely use discounted cash flow (DCF) valuations and employ some version of the capital asset pricing model to generate discount rates.
  • All models have separate worksheets for profit and loss, balance sheet and cash flow statements, with line item forecasts typically extending three to five years ahead. Profit and loss and cash flow statements link to valuation templates.
  • Analysts also generally estimate firm values separately via ratios such as price-to-earnings and enterprise value-to-EBITDA.
  • Analysts then calculate stock target prices either by averaging the estimates from different valuation methods or by arbitrarily choosing a value within the range of target prices generated by different methods. When relying exclusively on DCF valuation, analysts generally exercise judgment, such that DCF-indicated values and target prices differ.
  • Analysts within and across investment banks use different risk-free rates, equity risk premiums and betas for specific stocks. Such discretion suggests lack of internal controls/room for manipulation.

In summary, evidence from detailed stock analyst models indicates inconsistency/latitude in methodologies and assumptions.

Cautions regarding conclusions include:

  • The sample is limited to three large investment banks and analysts focused on European healthcare and chemicals sectors.
  • Differences in assumptions may reflect differences in true beliefs and changing beliefs rather than manipulation.
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