What Valuation Models Do Analysts Use?

TLDR

The study establishes a foundation for future research that will test more detailed hypotheses about analyst valuation practices. The authors investigate how financial analysts’ valuation methods differ across sectors by analyzing 104 reports on 26 UK‑listed firms in beverages, electronics, and pharmaceuticals. They descriptively assess alternative valuation models, the forecast attributes used, and test hypotheses on sectoral variation in analysts’ practices. They find that comparatives are more common in beverages, analysts predominantly use PE or multiperiod DCF models, none use price‑to‑cash‑flow, and some multiperiod model users still prefer comparatives, underscoring the diversity of analyst practices.

Abstract

This paper adopts a structured positive approach to explaining the valuation practices of financial analysts by studying the valuation methodologies contained in 104 analysts' reports from international investment banks for 26 large U.K.-listed companies drawn from the beverages, electronics, and pharmaceuticals sectors. We provide a descriptive analysis of the use of alternative valuation models focusing on the value-relevant attributes that analysts seek to forecast and the methodologies analysts use to convert the forecasts into estimates of firm value. We postulate and test a number of hypotheses relating to how the valuation practices of analysts vary systematically across industrial sectors. We find that: (1) the use of valuation by comparatives is higher in the beverages sector than in electronics or pharmaceuticals; (2) analysts typically choose either a PE model or an explicit multiperiod DCF valuation model as their dominant valuation model; (3) none of the analysts use the price to cash flow as their dominant valuation model; and (4) contrary to our expectations, some analysts who construct explicit multiperiod valuation models still adopt a comparative valuation model as their preferred model. We believe the study's findings are important for increasing our understanding of the valuation practices of financial analysts. The study also provides a basis for further research that tests a richer and more det ailed set of hypotheses.