Accounting comparability and the accuracy of peer-based valuation models

We examine the link between enhanced accounting comparability and the valuation performance of pricing multiples. Using the warranted multiple method proposed by Bhojraj and Lee (2002, Journal of Accounting Research) and controlling for economic comparability, we demonstrate how enhanced accounting comparability leads to better peer-based valuation performance. Empirical tests using firms from 15 EU countries over the period 1997-2011 (with comparable peers selected from the entire cross-section of foreign firms) document significant improvement in valuation performance measured as pricing accuracy, the ability of value estimates to explain cross-sectional variation in observed price, and the ability of the pricing multiple to predict future market-to-book multiples. Findings for a series of identification tests suggest that enhanced valuation performance is the consequence of improvements in the degree of crossborder accounting comparability that occurred during the sample window, and that a significant fraction of comparability gain operates through improved peer selection

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 frame-work. 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

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.

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

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