Does valuation model choice affect target price accuracy?

Efthimios G. Demirakos
Athens University of Economics and Business

Norman C. Strong
Manchester Business School

Martin Walker
Manchester Business School

Keywords: Equity valuation, investment analysts, target price accuracy, valuation model
choice.

Acknowledgement: The authors acknowledge the helpful comments and advice of Martyn
Andrews, Richard Barker, Nicholas Collett, Susan Ettner, Theodore Sougiannis, Richard
Taffler, seminar participants at Edinburgh University and Reading University, and
participants at the European Accounting Association 2007 Conference. Efthimios Demirakos
acknowledges a PhD scholarship from the Propondis Foundation.
 Does valuation model choice affect target price accuracy?

Abstract

We investigate the factors that influence the forecast accuracy of target prices that investment

analysts issue in their equity research reports, in particular whether the choice of valuation

model influences target price accuracy. We examine 490 equity research reports from

international investment brokerage houses for 94 UK-listed firms published over the period

07/2002–06/2004. 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_error);

and (iv) the forecast error of target prices that are not met at the end of the 12-month forecast

horizon (miss_error). Based on met_in and abs_error price–earnings multiples outperform

DCF, while based on met_end and miss_error the difference in valuation model performance

is insignificant. However, these results change after controlling for variables that affect both

the valuation model choice and performance. Controlling for the factors that influence

valuation model choice, the performance of DCF improves in all specifications and, based on

miss_error, it outperforms price–earnings multiples. These findings are robust to standard

controls for selection bias.

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 Does valuation model choice affect target price accuracy?

1. Introduction
The three major verifiable predictions of sell-side analysts’ equity research reports are

their earnings forecasts, stock recommendations, and target prices. While many studies

investigate analyst earnings forecasts and stock recommendations, academic interest has only

recently turned to target prices.1 Since the target audience of sell-side analysts’ equity

research is investment fund managers, analysts must be careful when choosing a valuation

methodology to justify their target prices. Fund managers are powerful players in the

investment community, and analysts need to cultivate a positive reputation with professional

fund managers to advance their careers.

In this paper we use equity research reports as evidence of how analysts carry out the

valuation task. We provide evidence on the empirical performance of an observable outcome

of the equity research report: the target price. Sell-side analysts produce target prices for the

stocks they cover by developing forecasts and converting these forecasts into valuations using

alternative valuation models. We focus on a comparison of the predictive performance of

target prices derived from two popular valuation frameworks: price–earnings multiples (PE)

and discounted cash flow (DCF) models.

The ideal approach to evaluating the performance of these models is to compare the

target prices of DCF and PE applied to random samples of companies. Unfortunately, we

cannot observe these target prices as analysts do not apply DCF and PE to companies on a

random basis. Instead, firm characteristics are likely to determine the choice of valuation

model. For example, if analysts use DCF (PE) to analyze more (less) risky firms, and if

riskier firms are more difficult to forecast, then DCF will appear to have higher forecast errors

if we fail to control for risk. Thus we also explore whether analysts’ valuation model choice

varies across firms with different characteristics.

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 We contribute significant new empirical evidence relevant to the areas of valuation

model choice, the empirical assessment of alterative valuation models, and the properties of

target prices. Regarding valuation model choice, financial statement analysis textbooks

explain the advantages of multi-period valuation over single-period valuation techniques

(Koller et al. 2005, Lundholm and Sloan 2003, and Penman 2003). The main argument is that

multi-period valuation models better capture long-term value. In contrast, the main message

to emerge from the literature on valuation model choice in practice is that single-period

earnings multiples are the preferred valuation approach of sell-side analysts (Barker 1999,

Block 1999, Bradshaw 2002, Demirakos, Strong, and Walker 2004, and Asquith, Mikhail,

and Au 2005). To explain the popularity of PE over DCF, some researchers stress the

difficulty of making multi-period forecasts in an uncertain corporate environment and

estimating the appropriate discount rate for the DCF model (Block 1999). Other research

shows that analysts tailor their valuation methodologies to firms with different profiles,

preferring multi-period models to value companies with volatile earnings streams and

unstable growth (Demirakos et al. 2004). More recently, Glaum and Friedrich (2006)

examine the valuation preferences of European telecommunication analysts and find that the

popularity of the DCF model has increased significantly since the end of the 1990s, when

valuations were primarily driven by earnings multiples.

Our study complements the above literature by providing further evidence that

analysts make intelligent valuation model choices. Consistent with the predictions of

valuation theory, analysts prefer DCF over PE when they face more challenging valuation

cases. Our empirical results show that analysts use DCF more frequently than PE to value

small firms, high-risk firms, loss-making firms, and firms with a limited number of industry

peers.

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 With respect to the empirical assessment of alternative valuation models, previous

studies that explore the prediction errors of equity valuation models use either ex-ante analyst

earnings forecasts (Francis, Olsson, and Oswald 2000) or ex-post financial statement data

(Penman and Sougiannis 1998) for the practical implementation of the models. More

recently, Asquith et al. (2005) use 818 analyst reports from 1997–1999 to investigate whether

there is a significant relationship between the valuation methodology used to generate the

target price and target price accuracy. They find no significant relationship. However,

analysts select which valuation methodology to use for each firm they follow. Comparing the

target price accuracy of alternative valuation models unconditionally may produce misleading

results if analysts tailor their valuation methodology to the circumstances of the firm, or if

analysts who use a particular valuation model self-select companies for which they feel they

have a comparative advantage.

Gleason, Johnson, and Li (2006) use a large database of analyst earnings and target

price forecasts over the period 1997–2003. As part of their study, they follow Bradshaw

(2004), inputting analyst earnings forecasts to price-to-earnings-growth (PEG) and residual

income valuation (RIV) models to generate pseudo-target prices. They find little evidence

that the pseudo-target prices generated by the RIV model using accurate earnings forecasts are

associated with more accurate target prices.

Our study extends and complements Asquith et al. (2005) and differs from Penman

and Sougiannis (1998), Francis et al. (2000), and Gleason et al. (2006). We compare the

accuracy of PE and DCF using four definitions of performance. Instead of producing our own

pseudo-valuation estimates based on the models and associating these with actual target

prices, we use a large sample of comprehensive equity research reports that explicitly show

the valuation model used to derive the target price. We condition our results on a set of firm-,

report-, and industry-specific factors that determine the level of difficulty of the valuation

5
task. Our empirical results show that the target price accuracy of the DCF model improves

after including control variables in the various model specifications, suggesting that analysts

choose DCF in more demanding valuation settings.

Finally our work relates to the empirical literature that investigates the properties of

target prices. Brav and Lehavy (2003) use a large database of target prices from 1997–1999

and document significant abnormal returns around target price revisions both unconditionally

and conditional on contemporaneous stock recommendations and earnings forecasts.

Employing a cointegration analysis to capture the long-term relation between these two

measures, they estimate that the long-term mean target-price-to-current-price ratio is 1.28, i.e.

target prices are 28% higher than current stock prices. They claim that their study serves as a

starting point for further research on various related questions, including the valuation models

used to determine target prices.

Asquith et al. (2005) provide evidence that changes in target prices incorporate

important information, especially in cases of downgrade or reiteration recommendations.

Target price revisions impound new information beyond earnings forecast revisions and stock

recommendations, and the market reaction to a target price change is stronger than to an equal

percentage change in earnings forecast. Bradshaw and Brown (2006) use a large-scale sample

of analyst target price forecasts from 1997–2002 drawn from the First Call database. They

show that analysts do not exhibit differential ability in setting target prices and the market

does not react differently to analysts with bad or good track records. They stress the

importance of the difference between target price and current stock price as a determinant of

target price accuracy. They argue that since there are no formal rankings of analysts based on

target prices, analysts can show their optimism by issuing higher target prices.2

Our study complements the above studies by reporting updated evidence on the

relation between target prices and current stock prices. Previous empirical studies have based

6
their analysis on data from periods when stock market indices reached unprecedented levels.3

The practices of sell-side analysts and the quality of their research during these periods have

been heavily criticized, and the industry has been undergoing a structural change since 2001.4

Compared to the studies of Asquith et al. (2005) and Bradshaw and Brown (2006) our sample

contains more reports with neutral or negative recommendations and reports with more

conservative target price forecasts. These differences might be due to institutional differences

between the City of London and Wall Street (Breton and Taffler 2001) or reflect overall

changes in the practices of sell-side analysts. Our study partially captures any effects of these

underlying changes on the quality of analysts’ research output. We also provide additional

empirical evidence on the determinants of target price accuracy.

We use a sample of 490 equity research reports published over the period July 2002–

June 2004 to examine the accuracy of target prices based on PE and DCF models. We use

descriptive and univariate evidence to quantify the relative frequency of use, the target price

accuracy, and the forecast error of PE and DCF across firms and reports with different

characteristics. We subsequently examine the determinants of analyst valuation model choice

between PE and DCF and test whether there is any significant difference in the empirical

performance of the two valuation frameworks after controlling for the factors that determine

this choice.

A particular issue we focus on is the relation between forecast accuracy and the

“boldness” of the target price. We define boldness as the absolute value of the target price

minus the current stock price on the target price date, deflated by the current price. We find

that boldness is a highly significant determinant of performance in all target price accuracy

and forecast error models. We also find in our basic choice model, but not in our full choice

model, that increased boldness increases the probability of an analyst selecting a DCF

valuation.

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 The remainder of the paper continues as follows. The next section discusses data

collection and research methodology issues. Section 3 presents descriptive statistics and

univariate tests of differences in the frequency of use and empirical performance of PE and

DCF across a series of control variables. Section 4 reports and discusses the results of our

multivariate probit and linear regression models. Section 5 offers concluding remarks.

2. Empirical research design

This section discusses data collection and research methodology issues. Our sample

consists of comprehensive equity research reports by financial analysts from international

investment brokerage houses. Reading the content of these reports serves to identify whether

the analyst employs PE or DCF as the dominant model to justify a target price. We exclude

reports without a target price, reports that do not use PE or DCF as a dominant model, and

reports where the analyst’s preferred valuation methodology is unclear. To investigate the

predictive performance of the reports, we compare the target price forecasts in the reports

with actual outcomes. We employ a mixture of univariate tests and multivariate models to

assess each model’s predictive performance unconditionally and conditional on several

controls for the relative difficulty of the valuation task.

The following subsection describes the stages of the sample selection procedure, the

determinants of the dominant valuation methodology, and the characteristics of the sampled

industries, firms, and reports. The second subsection presents the design of our empirical

analysis, our multivariate probit and linear regression models, and the definitions of the model

variables.

2.1. Equity research reports

We download equity research reports from the Investext database. The reports are

published in the period July 2002 to June 2004. The sampled reports cover firms listed on the

8
London Stock Exchange drawn from a balanced portfolio of old and new economy sectors,

including Beverages, Construction and Building Materials, Engineering and Machinery, Food

and Drug Retailers, Food Producers and Processors, Electronic and Electrical Equipment,

Information Technology Hardware, Pharmaceuticals and Biotechnology, and Software and

Computer Services.

We first identify firms that are constituents of one of the nine FTSE industry sector-

indexes and of the FTSE All-Share index. We subsequently search Investext to find the

number of reports that are available for each of these firms. We find a total of 8,031 reports.

Investext contains not only equity research reports but also industry reports, morning notes,

conference calls, and other non-valuation reports. We focus on firm-specific equity research

reports with valuation content and length greater than 10 pages. As the majority of equity

research reports include an executive summary, the firm’s condensed financial statements,

and detailed disclosure notes, our 10-page cut-off means that we focus on reports that are

more likely to contain original equity research. The number of reports that satisfy these

criteria is 1,250, representing 15.56 percent of the total number of reports.

In some cases we find reports from the same investment brokerage house for the same

firm with the same recommendation and target price. These reports have similar information

content, i.e. similar narratives and valuation discussions. In most cases, these reports are

updates for important corporate events that do not change the analyst’s view of the firm, the

recommendation rating, or the target price. To avoid violating sample independence, where

we find multiple reports with the same target price for the same firm by an analyst from the

same investment house, we include only the first published report in our final sample. This

procedure leads to the exclusion of 292 reports.

We also find several reports that disclose foreign currency target prices for cross-listed

firms. In the majority of these cases, the target prices are also expressed in GBP. However

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some reports do not disclose information about the exchange rate used to translate the foreign

currency. In these cases we exclude the reports (120 reports).5 As we explain below, for the

current study it is essential to know the firm’s (current) stock price when an analyst writes a

report.6 The current price normally appears on the front page of the report along with the

target price. For 19 reports the current price is unclear from the text. We exclude these 19

reports from the analysis. We also exclude reports that do not disclose a target price (116

reports).

The primary purpose of this study is to compare the target price accuracy of PE and

DCF models. We therefore exclude from our final sample any reports that do not use PE or

DCF to justify their target prices and any reports where the analyst’s preferred valuation

model is unclear. To identify the analyst’s preferred valuation model, we first check the

disclosure pages at the end of the report. Among the information on these pages, some

brokerage houses have recently started to disclose which particular valuation methodology

they use to reach the target price (e.g. CSFB). We next read the valuation section of the

report. If the analyst uses only one valuation model, we consider this to be dominant. If the

analyst uses more than one model we search for a clear statement of the analyst’s preferred

model in justifying the report’s target price. We also read the first page and the executive

summary of the report to see if the analyst highlights a preferred valuation model. If none of

these approaches reveal the dominant model, we consider the association between the

fundamental value estimate of each model and the report’s target price. We identify the

dominant model as the model whose estimate is most closely associated with the report’s

target price.

In cases where an analyst reaches a target price by averaging the value estimates of

two different valuation models, we exclude the report from our analysis. We also exclude

reports that use DCF jointly with the RIV (or Economic Value Added) model and base their

10
target price on the average of the different value estimates of these models. If the models

generate the same valuation, we include this report in our sample.7 Finally, where a report

implements a sum-of-the-parts valuation approach, we include the report in our final sample if

the analyst uses only PE (or only DCF) to value all the business divisions.

This process leads to the exclusion of 213 reports. The final number of reports in our

sample is 490, accounting for 39.2 percent of the total number of comprehensive reports with

valuation content and more than 10 pages in length. Hence, our final sample comprises

reports that use either PE or DCF as dominant valuation methodologies to justify their target

price. PE includes trailing and leading price–earnings multiples, EV/EBITDA (Enterprise

Value to Earnings before Interest, Taxes, Depreciation and Amortization), EV/EBIT

(Enterprise Value to Earnings before Interest and Taxes), PEG ratio, and any other earnings-

based comparative valuation techniques. DCF models include equity and enterprise versions

of DCF, CRR (Cash Recovery Rates), NPV (Net Present Value) and any option-style

valuation techniques.

Table 1 provides descriptive statistics on the number of sample industries, firms,

equity research reports, and investment brokerage houses. The total number of firms in our

sample is 94, representing 60.26 percent of the firms included in the FTSE All-Share index

for our sample industries. The number of pages per report is 20.45, which is substantially

higher than the average page length of reports used in studies that impose no length

restriction.8 The total number of investment brokerage houses is 22 with an average number

of 22.27 reports per brokerage house. Finally, the average number of reports per firm is 5.21.

[Table 1 here]

2.2. Statistical analysis and models

We analyze the valuation content and predictive performance of the reports using a

combination of univariate and multivariate analyses. We use univariate tests to quantify the

11
frequency of use, target price accuracy, and forecast error of PE and DCF models across

reports and firms with different characteristics. Results of the univariate analysis inform the

design of our multivariate models. This subsection defines the variables and describes the

specifications of the probit and linear regression models whose results we report and discuss

in the multivariate analysis section. Table 2 defines the dependent and independent variables.

Table 3 presents 14 specifications of valuation method choice and probit and linear

performance regression models that we use in the study.

[Tables 2 and 3 here.]

We use four alternative methods to measure the empirical performance of target prices

derived by PE and DCF. The first measure of target price accuracy (met_in) measures

whether a particular target price is met at any time within a 12-month forecast horizon. This

variable takes the value one if the report’s target price is within the 12-month-ahead

Highest/Lowest stock price range, and zero otherwise.9 Met_in is the dependent variable in

Models 2a–2c.

The second measure of target price accuracy (met_end) measures whether a target

price is met on the last day of the 12-month forecast horizon. This variable takes the value

one if: (a) the target price is above the current price and the stock price on the last day of the

forecast horizon is greater than or equal to the target price; or (b) the target price is below the

current stock price and the stock price on the last day of the forecast horizon is less than or

equal to the target price. Met_end is the dependent variable in Models 3a–3c.

The third measure of valuation model performance is the absolute forecast error

(abs_error). This is the absolute difference between the target price and the stock price on

the last day of the 12-month forecast horizon, scaled by the current stock price.10 This is the

dependent variable in Models 4a–4c. Using the absolute forecast error instead of the signed

forecast error focuses on the accuracy rather than the bias of the target price. The signed

12
forecast error is problematic due to its different interpretation for target prices above and

below the current price. For example, a negative sign means the target is met if the target

price is below the current price, but it means the target is missed if the target price is above

the current price. Hence, it is difficult to evaluate whether the forecast is optimistic or

pessimistic.

Finally, we use a fourth measure of performance for the forecast error of missed target

prices (miss_error). This measure takes the value zero if the target price is met on the last

day of the 12-month forecast horizon. If the target price is not met on the last day of the 12-

month forecast horizon, it equals the absolute difference between the target price and the

stock price on the last day of the 12-month forecast horizon, scaled by the current stock price.

Miss_error is the dependent variable in Models 5a–5c.

The variable valmodel plays a central role in our analysis. It equals one if the

analyst’s preferred valuation methodology is DCF; it equals zero if the dominant valuation

model is PE. We expect analysts to prefer PE to DCF for easier valuation cases. Models 1a

and 1b examine the factors that determine the valuation model choice by expressing valmodel

as a function of the variables that affect the difficulty level of the valuation task. We expect

DCF to dominate in reports that value stocks whose characteristics make the valuation task

more challenging. This prediction is consistent with discussions in financial statement

analysis textbooks, which recommend using PE for firms whose current earnings figure is a

reliable indicator of fundamental value.

In Models 2–5, we use valmodel as an independent variable. We predict that the

relation between valuation model choice and measures of target price accuracy (forecast

error) are negative (positive) in specifications that do not control for the level of difficulty of

the valuation task (Models 2a, 3a, 4a, and 5a). When the specifications include control

variables, we predict that the performance of DCF improves and this improvement results in a

13
change of sign of the coefficient or a decrease in the significance level of the predicted

relation (Models 2b, 2c, 3b, 3c, 4b, 4c, 5b, 5c).

An important control variable is target price boldness (boldness). This is the absolute

value of the difference between the target price and the current price scaled by current price.

We expect the larger the absolute difference between the target price and the current price, the

more difficult it is to meet the target price.11 Therefore, we predict a negative (positive)

association between target price accuracy (forecast error) and boldness. Glaum and Friedrich

(2006) argue that analysts preferred PE to DCF in the late 1990s because it was easier to

justify bold target prices in relation to the high earnings multiples of that period. As our study

covers a period after the market “correction” of the late 1990s, we expect analysts to use DCF

to capture the long-term value of the firm and for it to be positively associated with robust

statements about future stock price performance.

One of the control variables we use is risk, measured as the standard deviation of daily

stock returns over a two-year period before the report’s publication.12 Based on option

pricing theory, Bradshaw and Brown (2006) predict that target price accuracy is higher for

stocks with higher price volatility.13 While this prediction is reasonable, we also expect to

find a positive association between a firm’s risk and forecast error. This is because although

it is easier for the target price of a highly volatile stock to be met at some point during a 12-

month forecast horizon, it is more challenging for the analyst to predict the price of a volatile

stock at the end of the forecast horizon. We also expect analysts to use DCF more frequently

for high risk firms. High-risk firms have volatile future earnings and cash flow streams and

valuation by PE most probably leads to biased outcomes, since the current earnings figure in

the denominator of the multiple is not a good indicator of future value.

Size is another control variable that we use in the various specifications. Size is the

natural logarithm of the firm’s market capitalization on 1/7/2002 if the report is published in

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the period 1/7/2002 to 31/6/2003, or on 1/7/2003 if the report is published in the period

1/7/2003 to 31/6/2004.14 We expect a positive association between target price accuracy and

firm size and a negative association between forecast error measures and size, based on the

argument that it is easier for an analyst to value a large, mature, well-established firm, where

information about its future prospects is readily available. On the other hand, small firms are

less complicated in structure but they usually operate in niche markets and their future

performance is more uncertain. We expect to find that PE is more popular in valuing large

established firms with sustainable earnings and an easily-recognized set of comparable

companies.15 On the other hand, for small firms focusing on niche markets it is more difficult

to identify a group of directly comparable firms with similar business models. Hence, a DCF

analysis is more appropriate to capture the uniqueness of these small firms.

Another control variable in the various specifications is the report’s recommendation

type (recm). This variable takes the value one if the report’s recommendation is positive (e.g.

Strong Buy, Buy, Outperform, Overweight, etc.), or zero if the report’s recommendation is

neutral or negative (Perform, Underweight, Underperform, Sell, etc.). We classify neutral

with negative recommendations, because investors often view these as weak negatives. We

do not have any formal prediction on the association between recommendation type and

valuation model use and performance.16

Growth is the firm’s annualized sales growth rate measured as the geometric average

of its sales growth rate over a period of two years before the report’s publication.17 We

expect it is more difficult for an analyst to predict accurately the target price of a firm with

high growth opportunities than a firm with uniform and stable growth. We therefore expect a

positive (negative) association between growth and the forecast error (target price accuracy)

measures. Valuation theory suggests that where firms have unstable growth, valuation by PE

leads to biased valuation estimates, since the summary earnings figure does not capture future

15
growth opportunities. We therefore predict that analysts prefer DCF to PE to value firms with

unstable growth.

The dummy variable profit takes the value one if the firm is profitable in the year

before the publication of the report, zero otherwise. We expect that it is more difficult to

value a loss-making firm than a profit-making firm. Hence we predict a positive (negative)

association between profit and target price accuracy (forecast error). In cases of loss-making

firms, a valuation based on PE is difficult since the denominator of the earnings multiple is

negative and the analyst should produce normalized figures of sustainable earnings. Hence,

the analyst might prefer a multi-period DCF model. We therefore predict a negative

association between profit and valmodel.

The variable peers measures the number of firms in each industry for which we can

find reports.18 We expect it is easier for an analyst to employ a relative valuation based on PE

for a firm with many industry peers. Therefore we expect a negative association between

peers and valmodel. Standard financial statement analysis textbooks point to the usefulness

of comparative financial ratio analysis in forecasting. If a company has a well established set

of comparable firms in its industry it is easier for the analyst to make accurate forecasts.

Therefore we expect that peers is positively (negatively) related to the two measures of target

price accuracy (forecast error).

Finally, we include broker dummy variables for the six investment brokerage houses

that contribute 80 percent of our sampled equity research reports. Sell-side analysts usually

adopt their in-house framework for fundamental analysis. Hence, we expect a brokerage

specific effect on the analyst choice between PE and DCF. On the other hand, Bradshaw and

Brown (2006) find little empirical evidence to support the argument that there are superior

analysts, who persistently exhibit differential ability to predict accurate target prices.19 Thus

16
we do not anticipate a significant relationship between the broker dummy variables and the

measures of target price accuracy or forecast error.

As it is possible that the error terms of our valuation choice models are correlated with

the error terms in the empirical performance models, we need to test for potential selection

bias in the valuation method choice that might influence the results of our target price

accuracy and forecast error models. We therefore deploy standard selection techniques to test

for potential cross-correlation between the disturbances in the valuation method choice and

performance models. The coefficient rho measures the correlation between the error terms in

the two equations, the omitted factors. In other words, it measures the correlation between the

outcomes after controlling for the influence of the observable control factors. If we cannot

reject the null hypothesis that the correlation coefficient (rho) between the errors in the

valuation method choice and performance models equals zero, then we can rely on the

estimates of the single-equation models in Table 3 (Greene 2003, pp. 710–715, 780–790). If

this is the case, the observable control variables that we use influence the choice between PE

and DCF but, controlling for these publicly observable variables, analysts have no additional

private information that influences their choice (Li and Prabhala 2006)

3. Descriptive and univariate analysis

This section reports descriptive statistics on the choice, target price accuracy, and

forecast error of PE and DCF across firms with different risk, size, profitability and growth

characteristics, and across reports with different types of recommendation and target price

boldness. In each case, we discuss descriptive and univariate evidence from Tables 4 and 5.

Table 4 presents the frequency with which analysts employ PE or DCF as their preferred

valuation methodology in their reports, and the corresponding target price accuracy and

forecast error for the top and bottom quartiles based on a series of firm- and report-specific

17
control variables. Table 5 reports Pearson correlations among the valuation method choice

variable, the valuation method performance variables, and the other control variables.

[Tables 4 and 5 here.]

3.1. Valuation model choice

Table 4 reports overall findings and a breakdown of results across several report and

firm characteristics. In this subsection, we focus on the determinants of analysts’ valuation

method choice between PE and DCF. Table 4, Panel A shows that 52.86 percent of the

sampled reports justify their target price by PE. The remaining 231 reports (47.14 percent)

prefer DCF. This result contrasts with the findings of Bradshaw (2002) and Asquith et al.

(2005), who find limited use of DCF in practice.20

Consistent with expectations, we find that analysts make intelligent valuation model

choices. Chi-square tests of the difference in model choice between the top and bottom

quartiles based on a series of control variables and between firms (reports) with different

profitability (recommendation) status reveal that analysts use DCF significantly more often

than PE justify bold target prices (Panel B) and to value firms that are high-risk (Panel C),

small (Panel D), or loss-making (Panel F).

Table 5 shows that valmodel is significantly positively correlated with boldness and

risk and negatively correlated with size, peers, and profit. Contrary to expectation we do not

find a significant difference in valuation model choice between the top and bottom growth

quartiles (Table 4, Panel E). Table 5 also shows that there is no significant correlation

between growth and valmodel. A potential explanation for this is the incidence of firms with

negative growth (21.63 percent of the sampled reports). Faced with the task of valuing firms

with negative sales growth, analysts seem to shift to DCF to forecast the effects of business

disposals, restructuring, refocusing, etc.21 Comparing the top and bottom quartiles to the two

18
middle quartiles, we find that analysts prefer DCF to value firms with extreme positive or

negative growth ( χ 2 = 3.985, p = 0.046).

Apart from the high incidence of observations with negative growth, our sample also

includes a greater proportion of negative/neutral recommendations (49.79 percent of the total

number of reports) compared to studies that examine the period 1997–2002 using US data22

and a lower median target-price-to-current-price ratio. The relationship between target price

and current stock price is important. Brav and Lehavy (2003) find that the long-term average

target-price-to-current-price ratio (TP/CP) is 1.28. Based on the study of Bradshaw and

Brown (2006), TP/CP is 1.30 in the first semester of 1997, peaks at 1.46 in the second

semester of 2000, and falls to 1.20 in the second semester of 2002.23 In our study, the mean

(median) value of this ratio is 1.15 (1.12), indicating a mean (median) stock price change of

15.37 (12.11) percent. This is arguably further evidence of the downward trend of this ratio

in the early 2000s.24 The mean (median) absolute difference between target price and current

stock price is 20.55 percent (14.29 percent).25

3.2. Target price accuracy

With respect to target price accuracy, Table 4, Panel A shows that according to

met_in, PE outperforms DCF at the 1 percent level. In particular, based on the first measure

of target price accuracy, PE-based target prices are met in 69.88 percent of reports, while

DCF-based target prices are met in 56.28 percent ( χ 2 = 9.750, p = 0.002). Based on met_end

the difference in the models’ performances is not significant. PE-based target prices are met

in 38.61 percent of reports compared to a 38.10 percent accuracy of DCF-based target prices

( χ 2 = 0.014, p = 0.907). Hence, while PE performs significantly better than DCF according

to the first measure, their performance decreases significantly according to the second

measure and the difference in the accuracy of the two valuation frameworks is insignificant.26

19
 Table 4 offers a breakdown of target price accuracy results across a number of firm

and report characteristics. It provides an upper and lower quartile analysis of model

performance based on boldness, risk, size, and growth. This shows whether there is a

significant change in the target price accuracy of the models across the top and bottom

quartiles. It also provides a comparison of the accuracy of the models across loss and profit

making firms and reports with positive and negative or neutral recommendation type.

Based on both measures of target price accuracy, PE and DCF models improve their

performance significantly when used to value firms in the lowest boldness quartile compared

with the highest boldness quartile (Panel B). The performance of DCF increases significantly

when valuing small compared to large firms (Panel D) and high growth compared to low

growth firms (Panel E). Possible explanations for these results are the complexities that

analysts face when forecasting every line item of a large multi-segment firm using a DCF

model and the inherent difficulties of valuing companies with negative, unstable sales growth.

PE and DCF models also perform better when used to justify negative or neutral

recommendations compared to positive recommendations according to met_in (Panel G).27

The target price accuracy of PE varies across different quartiles in understandable ways: PE

performs better when used to value low-risk firms compared to high-risk firms (according to

met_end), large mature firms compared to small firms (met_in), high growth firms compared

to negative growth firms (met_in), and profit-making firms compared to loss-making firms

(met_end).

Table 5 shows that met_in is negatively correlated with valmodel, indicating that PE

significantly outperforms DCF. We find no significant correlation between met_end and

valmodel. Both measures of target price accuracy are negatively correlated with the forecast

error measures of performance showing that missed target prices generate higher forecast

errors. Consistent with expectations, the target price accuracy indicators are negatively

20
correlated with boldness and positively correlated with peers. Finally, met_in is negatively

correlated with recm and positively correlated with profit, while met_end is negatively

correlated with risk.

3.3. Forecast error

Table 4 also provides descriptive statistics on the forecast error of target prices from

PE and DCF models. Panel A shows that according to abs_error, PE performs significantly

better than DCF: reports that base their target prices on PE have a mean absolute forecast

error of 24.22 percent, compared to the prediction error of DCF models, which is higher at

31.36 percent (t = 2.580, p = 0.005). Based on miss_error the difference in the models’

performances is not significant. PE-based target prices generate a mean miss_error of 17.72

percent, while DCF-based target prices generate a mean error of 20.15 percent (t = 0.954, p =

0.170). Hence, while PE performs significantly better than DCF according to abs_error, their

relative performance decreases significantly according to miss_error and the difference in the

performance of the two valuation frameworks is insignificant. Based on both measures of

forecast error, PE and DCF perform better in valuing profit-making firms (Panel F) and firms

in the lowest boldness quartile (Panel B), lowest risk quartile (Panel C), highest size quartile

(Panel D), and lowest growth quartile (Panel E). Table 5 provides additional evidence to

support these relationships. Both measures of forecast error are positively correlated with

risk, boldness, recm, and growth and negatively correlated with profit and size.

4. Multivariate analysis

In this section, we first report the results of standard robustness tests for selection bias

in valuation method choice. Finding no selection-bias, we proceed to report the results of our

single-equation models of valuation method choice, target price accuracy, and forecast error.

21
4.1. Tests for selection bias

The target price accuracy and forecast error models do not control directly for potential

selection bias arising from valuation method choice. If analysts choose DCF to value more

challenging investment cases then valmodel may be correlated with the error term in Models

2–5 and as a result the performance of DCF may be understated. To deal with this problem,

we first employ selection-style models. If the outcome of the performance equation is a

continuous variable (abs_error or miss_error), we use a treatment effects framework (Greene

2003, pp. 780–790; Stata 2005b, pp. 456–465). If the outcome is a binary variable (met_end

or met_in), we employ a system of seemingly unrelated bivariate probit models (Greene 2003,

pp. 710–715; Stata 2005a, pp. 133–138). To implement these models we include independent

variables in the choice model that are not in the performance model. Therefore, the system of

equations comprises the full choice model including the broker dummy variables and the

simple performance model excluding the broker dummy variables. These selection models

simultaneously estimate the choice and performance regression models using maximum-

likelihood methods and model the correlation between valmodel and the error term directly, in

order to eliminate the omitted-variable bias. If the estimate of rho, which measures the

correlation between the error terms of the choice and performance equations, is not

significantly different from zero then there is no selection bias effect on the various

specifications of Models 2–5 and we can rely on the estimates of the single-equation

specifications instead of the simultaneous treatment effects and bivariate probit models.

Table 6 presents Wald tests of whether rho is different from zero for the system of seemingly

unrelated bivariate probit models and treatment effects models. In all cases, rho is not

significantly different from zero. Therefore, the estimates from the single-equation

specifications are unbiased. In effect, controlling for the publicly available control variables

22
in the performance models and the broker dummy variables, an analyst’s choice of valuation

model does not depend on additional information available only privately to the analyst.

[Table 6 here.]

4.2. Valuation model choice

Table 7 presents results on the relation between valuation model choice and a set of

independent variables including risk, size, target price boldness, recommendation type, sales

growth, profitability, number of industry peers, and broker dummies. Model 1a presents the

simple version of our model excluding the broker dummy variables. Consistent with

expectations, the coefficients on profit and peers are negative and significant at 5 percent

(−0.400, p = 0.029) and 1 percent (−0.033, p < 0.001). These results suggest that analysts use

DCF more frequently to value loss-making firms and firms with a limited number of industry

peers. The coefficient on boldness is positive and significant at 10 percent (0.906, p = 0.075)

indicating that analysts use DCF more frequently than PE to justify robust target prices. The

coefficient on risk has the opposite sign to predicted but is insignificant (−4.637, p = 0.420).

This contrasts with our univariate and descriptive results. However, the positive correlation

between risk and boldness (0.162, p < 0.001) suggests that analysts feel more comfortable

reporting bold target prices for firms with high return volatility (see Table 5). Thus boldness

seems to capture the effect of risk on valuation model choice. The coefficient on size is

negative and significant at 1 percent (−0.128, p = 0.001) suggesting that analysts use DCF to

value small firms. Finally, contrary to expectations, we do not find a significant growth effect

on analyst valuation model choice (−0.125, p = 0.535).28 By introducing broker dummy

variables in Model 1b, the pseudo-R2 of the model increases from 7.55 percent to 12.53

percent. Size, profit, and peers remain significant at 5 percent, while boldness is now

insignificant. Consistent with expectations, we find an investment house effect on valuation

method choice. Analysts from investment brokerage houses broker_2 and broker_3

23
consistently employ PE (−0.330, p = 0.081) and DCF (0.621, p < 0.001). Analysts from

investment house broker_4 prefer PE, but this choice is significant only at 14 percent.

[Table 7 here.]

4.3. Target price accuracy

Table 8 presents the two measures of target price accuracy as functions of valuation

model choice and several control variables. Model 2a presents the results of a simple probit

regression examining the relation between the dependent variable met_in (first measure of

target price accuracy) and the independent variable valmodel (valuation method choice).

Valmodel is significantly negative (−0.363, p = 0.002), indicating that in the absence of

controls, target prices based on PE are achieved more frequently than DCF-based target

prices. The pseudo-R2 value is low at 1.52 percent, since this model specification includes

only one independent variable.

[Table 8 here.]

In Model 2b, we control for risk, size, sales growth, target price boldness,

recommendation type, profitability, and number of industry peers. In the presence of these

variables, valmodel is insignificant (−0.102, p = 0.436). This result is consistent with

expectation in that although PE performs better unconditionally, its comparative performance

is insignificant conditioning on variables that capture the level of difficulty of the valuation

task. The intuition is that analysts prefer DCF in difficult cases, while they turn to PE in cases

where it is relatively simple to reach an investment conclusion without the need for a robust,

full-blown analysis and full-information forecasting. Boldness and peers are the variables

with the greatest explanatory power. Boldness is negatively associated with target price

performance (−2.895, p < 0.001). This shows that the higher the absolute difference between

the target price and the current stock price, the more unlikely it is that the target price is met.

Peers is positively associated with met_in (0.046, p < 0.001). This suggests that the greater

24
the number of firms in an industry the easier it is for an analyst to predict an accurate target

price. None of the other variables are significant. The overall explanatory power of Model

2b increases substantially compared to Model 2a and the pseudo-R2 is now 15.41 percent.

The results remain qualitatively the same after including the broker dummy variables in

Model 2c. None of the broker dummy variables is significant, suggesting that no brokerage

house exhibits consistently superior target price performance.

Models 3a, 3b, and 3c provide a probit analysis of the second measure of target price

accuracy (met_end) as a function of valuation model choice, including and excluding control

and broker dummy variables. Model 3a shows that valmodel is insignificant (−0.013, p =

0.907). This suggests that in the absence of control variables the difference between the

target price performance of PE and DCF is not significant when considering whether the

target price is met on the last day of the forecast horizon. This finding is consistent with the

univariate evidence, which shows that a chi-square test of the difference between the target

price accuracy of PE and DCF is insignificant.

As pointed out in the descriptive and univariate analysis section, there is a stark

difference in the relative ability of PE and DCF to predict accurate target prices when

comparing the two alternative measures of target price accuracy. According to met_in PE

outperforms DCF at the 1 percent level (Model 2a), while based on met_end, the difference

between the models’ performance is insignificant (Model 3a). A potential explanation for this

result is the focus of PE-based target prices, which may be achieved in the short-term, but fail

to capture longer-term fundamental value.

Model 3b reports the results of the probit model of met_end as a function of valmodel,

risk, size, boldness, recm, growth, profit, and peers. The coefficient on valmodel changes

sign and becomes positive suggesting a positive association between the use of DCF and

target price accuracy. However, although the p-value decreases, valmodel remains

25
insignificant (0.170, p = 0.176). The coefficient on risk has a negative sign and is marginally

insignificant (−9.097, p = 0.126). As in the case of the probit models of the first measure of

target price accuracy, the coefficients on boldness and peers are negative and strongly

significant. The pseudo-R2 of Model 3b is 6.29 percent, which although higher than the

pseudo-R2 of Model 3a, is substantially lower than for Model 2b, which uses the same

independent variables but met_in as the dependent variable. Model 3c includes broker

dummy variables. As in the case of Model 2c, none of the coefficients on analyst dummy

variables is significant. Peers and boldness remain significant at 1 percent, while risk is now

significant at 10 percent (−10.739, p = 0.070), revealing a negative relation between risk and

target price accuracy.29 The overall fit of Model 3c increases marginally and the pseudo-R2

reaches 7.37 percent.

4.4. Forecast error

In Table 9, our interest shifts to measures of forecast error. Model 4a reports the

results of a simple regression of absolute forecast error (abs_error) on valuation model choice

(valmodel). The coefficient on valmodel is positive and significant (0.071, p = 0.010). This

finding is consistent with the descriptive evidence and suggests that the use of DCF leads

unconditionally to higher absolute forecast errors.

[Table 9 here.]

Model 4b includes several control variables that capture report- and firm-specific

effects on absolute forecast error. The adjusted-R2 of the model increases from 1.17 percent

to 33.97 percent by including the control variables. In the presence of control variables,

valmodel is insignificant (0.000, p = 0.997), as expected. The coefficient on risk is positive

and significant (3.693, p = 0.004). This result is not surprising since while target prices for

highly volatile stocks might be more likely to be met within a forecast horizon, it is more

26
difficult for the analyst to correctly forecast the level of stock price at the horizon itself. The

coefficient on boldness is positive and significant at 1 percent (0.607, p < 0.001).

Recm is negative and significant (−0.053, p = 0.021) indicating that the absolute

forecast error is higher for firms with neutral/negative recommendations. We have no formal

ex-ante prediction for recommendation type. A possible explanation for the result is that in a

steadily rising stock market, target prices that support negative or neutral recommendations

are more likely to lead to higher forecast errors if a firm’s stock price moves with the market.

Peers is not significant in this model specification (−0.002, p = 0.377). As in the cases of

Models 2c and 3c, the inclusion of broker dummy variables in Model 4c does not change the

explanatory power of the model substantially, since none of the additional variables is

significant.

Model 5a reports the results of a simple regression of the missed forecast error

(miss_error) on valuation method choice. The coefficient on valmodel is positive but

insignificant (0.024, p = 0.342). Model 4b includes control variables that capture the effects

of report and firm characteristics on miss_error. Including the control variables increases the

adjusted-R2 of the model to 38.87 percent. The coefficient on valmodel changes sign and

becomes negative and significant at 5 percent (−0.044, p = 0.044), suggesting that

conditioning on control variables, DCF outperforms PE. As in Model 4b, risk, boldness, and

recm are significant at 1 percent. The only difference with Model 4b is the significance of

peers (−0.003, p = 0.073), which suggests that valuing a firm with many industry peers

generates lower forecast errors. In Model 5c, the coefficient on valmodel remains negative

and significant, but its p-value falls (−0.043, p = 0.065). The effects of risk, boldness, recm,

and peers on forecast error remain significant. Finally, as in the cases of the previous models

we do not find any significant brokerage effect on forecast error.

27
5. Concluding remarks

We examine the target price accuracy and forecast error of PE and DCF. We use two

measures of target price accuracy and two measures of forecast error. An unconditional

analysis based on the first measure of target price accuracy, which indicates whether the target

price is met at some point within a 12-month forecast horizon, and the absolute forecast error,

suggests that PE significantly outperforms DCF. However, controlling for variables that

capture the difficulty of the valuation task, the difference in the performance of the two

models is insignificant.

Based on the second measure of target price accuracy, which measures whether the

target price is met on the last day of the 12-month forecast horizon, and on the forecast error

of target prices that are not met on the last day of the 12-month forecast horizon (miss_error),

there is no difference in the performance of PE and DCF. After introducing control variables

in the probit and linear regression models, the performance of DCF improves substantially

and based on miss_error DCF performs significantly better than PE.

Our descriptive and univariate evidence suggests analysts use DCF significantly more

frequently than PE to justify bolder target prices and to value high risk firms, small firms,

loss-making firms, firms with extreme negative or positive sales growth rates, and firms with

a limited number of industry peers. Our multivariate analysis highlights the importance of

size, profitability, and number of industry peers as determinants of valuation model choice.

Sell-side analyst practices have been heavily criticized in recent years. However, the

empirical findings of this study show that analysts make intelligent valuation model choices

and tailor their valuation methodology to the context of the valuation task.

A limitation of our research methodology is that we accept analyst reports at face

value and assume the models presented in the text of the reports are the models that analysts

actually use to make their investment recommendation. We deal with this problem in part by

28
excluding from our analysis short reports of only a few pages, focusing instead on

comprehensive reports that include a complete valuation analysis of the company and a clear

derivation of the target price. A second limitation of this study relates to the main data source

we use for equity research reports. Although Investext is a very comprehensive database,

some investment brokerage houses do not make their research publicly available and do not

provide reports to Investext.

In this study, we compare the accuracy and prediction error of target prices based on

PE and DCF. Further insights may emerge from studying the practical implementation of

these models. For example, how do analysts define the peer group of the firm when

implementing a valuation by PE? How sophisticated and consistent are the forecasts

embedded in multi-period valuation models? How do analysts estimate the discount rate?

Especially in cases of target price and recommendation revisions, how do analysts adjust their

valuations and their valuation inputs to support the new target price and recommendation?

For example, if an analyst uses DCF, are these changes driven by consistent changes in the

finite horizon forecasts or by ad hoc changes in the estimation of the discount rate and

terminal value or other inconsistent forecast adjustments? This practice-oriented research will

help us better understand whether the increase in the importance of DCF in recent years is

associated with an increase in the authority and credibility of sell-side equity research analysts

(a rational explanation) or with their willingness to appear authoritative and credible by

implementing a model that gives them several notional levers to “reverse-engineer” a

subjective intuition/judgment about the firm and its management (a behavioral explanation).

Research on the properties of target prices is still at an exploratory level. It would be

interesting to assess the profitability of investment strategies based on the target-price-to-

current-price ratio conditional on the valuation model used to justify the target price. It would

also be interesting to use analysts’ forecasts or ex-post financial statement data to investigate

29
whether the valuation model that generates a pseudo-target price closest to the report’s target

price, is the same as the valuation model used in the report to generate the actual target price.

With respect to practical implications of this study, most rankings of sell-side equity

analysts are based on earnings forecasts and stock recommendations (Starmine) or on surveys

of institutional investors and fund managers (Institutional Investor). Since the target price is

one of the three easily verifiable outputs of sell-side equity research and the ratio of target-

price-to-current-price is a measure of the expected ex-dividend return to investors, it would be

interesting to see analyst rankings based on the accuracy of their target prices.

While undertaking this study we encountered several instances where investment

brokerage houses include clear summary statements in the disclosure notes at the end of the

report formally disclosing the valuation methodology used to derive the target price or

indicating that the recommendation type and target price are based on valuation models

discussed in the text of the report. It would significantly increase the quality of the

information flow to capital markets if there was a requirement for analysts to disclose in a

summary statement which valuation model or combination of valuation models they use to

reach a target price. If such a regulatory proposal is adopted, large-scale databases and

investor-related websites can easily make available summary data not only on analyst target

prices but also on the models used to produce these target prices. This would increase the

sophistication of investors’ information environment and our understanding of analysts’

valuation practices.

30
 Table 1. Summary statistics for the sampled firms and reports
The table reports summary statistics on the number of firms and reports in the nine sectors examined: Beverages, Construction and building materials, Engineering and
machinery, Food and drug retailers, Food producers and processors, Electronic and electrical equipment, Information technology hardware, Pharmaceuticals and
biotechnology, and Software and computer services. In order, the columns give: the total number of reports included in Investext in August 2005; the number (%) of
valuation reports with length greater than 10 pages included in Investext; the number (%) of reports in our sample; the number of firms analyzed; the number of firms in each
sector included in the FTSE All-Share Index in August 2005; the % of these FTSE All-Share constituents included in the study; the total number of pages of reports analyzed
in our study; the mean value of pages per report; the number of brokerage houses that contribute reports; the number of reports per brokerage house; and the number of reports
per analyzed company.

Number of Reports in Number of firms in Report Characteristics

Investext with FTSE Mean
valuation content All- Total Value of Number of Reports/
and page length Share Number Pages per Brokerage Brokerage Reports
Sector Investext >10 pages % Sample % Sample Index % of Pages Report Houses House /Firm
Panel A: Old Economy Sectors
1 Beverages 831 192 23.10 66 34.38 4 5 80.00 1,644 24.91 12 5.50 16.50
2 Construction 1,008 161 15.97 69 42.86 24 36 66.67 1,290 18.70 9 7.67 2.88
3 Engineering 621 104 16.75 53 50.96 14 21 66.67 1,054 19.89 4 13.25 3.79
Food & Drug
4 617 101 16.37 44 43.56 5 7 71.43 961 21.84 13 3.38 8.80
Retailers
5 Foods 735 82 11.16 33 40.24 7 14 50.00 790 23.94 9 3.67 4.71
Totals 3,812 640 16.79 265 41.41 54 83 65.06 5,739 21.66 18 14.72 4.91
Panel B: New Economy Sectors
1 Electronics 373 52 13.94 21 40.38 7 16 43.75 323 15.38 7 3.00 3.00
2 Hardware 400 79 19.75 33 41.77 6 13 46.15 713 21.61 8 4.13 5.50
3 Pharmaceuticals 2,183 346 15.85 103 29.77 9 15 60.00 1,984 19.26 16 6.44 11.44
4 Software 1,263 133 10.53 68 51.13 18 29 62.07 1,262 18.56 16 4.25 3.78
Totals 4,219 610 14.46 225 36.89 40 73 54.79 4,282 19.03 19 11.84 5.63
All Sectors 8,031 1,250 15.56 490 39.20 94 156 60.26 10,021 20.45 22 22.27 5.21

31
 Table 2. Definitions of variables

Variable Definition / measurement

met_in A variable that takes the value one if the report's target price is met during the 12-month
forecast horizon (i.e. the target price is within the 12-month-ahead Highest/Lowest stock price
range); it takes the value zero if the target price is not met.
met_end A variable that takes the value one if the report's target price is met on the last day of the 12-
month forecast horizon. This variable takes the value one: (a) if the target price is above the
current price and the stock price on the last day of the forecast horizon is greater than or equal
to the target price; or (b) if the target price is below the current stock price and the stock price
on the last day of the forecast horizon is less than or equal to the target price.
abs_error A variable that equals the absolute difference between the target price and the stock price on
the last day of the 12-month forecast horizon, scaled by the current price.
miss_error A variable that equals zero if the target price is met on the last day of the 12-month forecast
horizon. If the target price is missed, it equals the absolute difference between the target price
and the stock price on the last day of the 12-month forecast horizon, scaled by the current
price.
valmodel A variable that takes the value one if the analyst uses some type of DCF model as a preferred
valuation methodology. It takes the value zero if the analyst uses a type of PE-based
comparative valuation (e.g. P/E, EV/EBITDA, EV/EBIT, or PEG) as a preferred valuation
methodology.
risk A variable that equals the standard deviation of the firm's daily stock returns from 1/7/2000 to
31/6/2002 if the report is published in the period 1/7/2002–31/6/2003, or from 1/7/2001 to
31/6/2003 if the report is published in the period 1/7/2003–31/6/2004.
size A variable that equals the natural logarithm of the market capitalization of the firm on
1/7/2002 if the report is published in the period 1/7/2002–31/6/2003, or on 1/7/2003 if the
report is published in the period 1/7/2003–31/6/2004.
growth A variable that equals the geometric average of the firm's sales growth rate over a period of
two years before the publication of the report.
boldness A variable that measures the boldness of the target price and is equal to the absolute difference
between target price and current price scaled by current price.
recm A variable that takes the value one if the report's recommendation is positive (e.g. Strong Buy,
Buy, Outperform, Overweight etc), and zero if the report's recommendation is negative or
neutral (e.g. Perform, Underweight, Underperform, Sell etc).
profit A variable that takes the value one if the firm is profitable in the year before the publication of
the report, or zero otherwise.
peers A variable that equals the number of the sampled firms of each industry.
broker_ j A variable that takes the value one if the report is written by an analyst of the investment
brokerage house j, or zero otherwise.

32
 Table 3. Empirical research design for multivariate analysis
The table presents various probit and linear regression models that use met_in (first measure of target price accuracy), met_end (second measure of target price accuracy),
abs_error (absolute forecast error), miss_error (forecast error for missed target prices), valmodel (valuation model choice dummy variable), risk (standard deviation of daily
stock returns), size (natural log of market capitalization), growth (firm sales growth rate), boldness (boldness of target price), recm (recommendation), profit (profitability),
peers (industry peers) and broker control dummies as variables. Table 2 provides definitions of all the dependent and independent variables used in the multivariate models.

Valuation Method Choice Probit Models

Model 1a: valmodeli = α1 + β1riski + β 2 sizei + β 3boldnessi + β 4 recmi + β 5 growthi + β6 profiti + β7 peersi + ε i
Model 1b: valmodeli = α 1 + β1riski + β 2 sizei + β 3boldnessi + β 4 recmi + β 5 growthi + β6 profiti + β7 peersi + β 8 broker _1i + β 9broker _ 2i + β10broker _ 3i + β11broker _ 4i +
β12broker _ 5i + β13broker _ 6i + ε i

Target Price Accuracy Probit Models

Model 2a: met _ in = a1 + β1valmodeli + ε i
Model 2b: met _ ini = a1 + β1valmodeli + β 2 riski + β 3 sizei + β 4 boldnessi + β 5 recmi + β6 growthi + β7 profiti + β 8 peersi + ε i
Model 2c: met _ ini = a1 + β1valmodeli + β 2 riski + β 3 sizei + β 4boldnessi + β 5 recmi + β6 growthi + β7 profiti + β 8 peersi + β 9 broker _1i + β10broker _ 2i + β11broker _ 3i + β12broker _ 4i +
β13broker _ 5i + β14 broker _6i + ε i
Model 3a: met _ endi = a1 + β1valmodeli + ε i
Model 3b: met _ endi = a1 + β1valmodeli + β 2 riski + β 3 sizei + β 4 boldnessi + β 5 recmi + β6 growthi + β7 profiti + β 8 peersi + ε i
Model 3c: met _ endi = a1 + β1valmodeli + β 2 riski + β 3 sizei + β 4 boldnessi + β 5 recmi + β6 growthi + β7 profiti + β 8 peersi + β 9 bro ker_ 1i + β10bro ker_ 2i + β11bro ker_ 3i + β12bro ker_ 4i +
β13bro ker_ 5i + β14 bro ker_ 6i + ε i

Forecast Error Linear Regression Models

Model 4a: abs _ errori = a1 + β1valmodeli + ε i
Model 4b: abs _ errori = a1 + β1valmodeli + β 2 riski + β 3 sizei + β 4boldnessi + β 5 recmi + β6 growthi + β7 profiti + β 8 peersi + ε i
Model 4c: abs _ errori = a1 + β1valmodeli + β 2 riski + β 3 sizei + β 4 boldnessi + β 5 recmi + β6 growthi + β7 profiti + β 8 peersi + β 9broker _ 1i + β10 broker _ 2i + β11broker _ 3i + β12broker _ 4i +
β13broker _ 5i + β14 broker _6i + ε i
Model 5a: miss _ errori = a1 + β1valmodeli + ε i
Model 5b: miss _ errori = a1 + β1valmodeli + β 2 riski + β 3 sizei + β 4 boldnessi + β 5 recmi + β6 growthi + β7 profiti + β 8 peersi + ε i
Model 5c: miss _ errori = a1 + β1valmodeli + β 2 riski + β 3 sizei + β 4boldnessi + β 5 recmi + β6 growthi + β7 profiti + β 8 peersi + β 9 broker _1i + β10broker _ 2i + β11broker _ 3i + β12broker _ 4i +
β13broker _ 5i + β14broker _ 6i + ε i

33
 Table 4. Descriptive analysis
The table reports the frequency with which analysts employ PE or DCF as their preferred valuation methodology
in their reports, and the corresponding target price accuracy and forecast error for the top and bottom quartiles
based on boldness (Panel B), risk (Panel C), size (Panel D), and growth (Panel E), and across firms with
different profitability status (Panel F) and reports with different recommendation type (Panel G). Panel A
presents the overall results for all the sampled reports. See Table 2 for variable definitions. Column headings
refer to the actual number of reports that use PE or DCF as dominant valuation model; the % of all the reports in
each quartile/category that employ PE or DCF as dominant valuation model; the median value of the control
variables (boldness, risk, size, and growth); the first measure of target price accuracy (met_in); the second
measure of target price accuracy (met_end); the mean value of the absolute forecast error (abs_error); and the
mean value of the forecast error for the missed target prices (miss_error). The table also reports the significance
of differences in the frequency of use and empirical performance of PE and DCF across different
quartiles/categories based on a series of control variables. It presents chi-square tests and t-tests of the difference
in valuation method use, target price accuracy and forecast error between the top and bottom quartiles based on a
series of control variables and between firms (reports) with different profitability (recommendation) status.
*/**/*** indicate significance at the 0.10/0.05/0.01 levels. N/S indicates an insignificant difference.

Valuation method use Target price accuracy measures Forecast error measures

No. % χ2 Median met_in χ2 met_end χ2 Abs_error t miss_error t

Panel A. Overall
PE 259 52.86% 69.88% *** 38.61% N/S 24.22% *** 17.72% N/S
DCF 231 47.14% 56.28% 38.10% 31.36% 20.15%
Panel B. Boldness
Top quartile
PE 48 39.02% *** 31.42% 43.75% *** 20.83% *** 40.97% *** 35.19% ***
DCF 75 60.98% 46.67% 34.67% *** 24.00% *** 47.18% *** 35.97% ***
Bottom quartile
PE 76 61.79% 3.64% 85.53% 46.05% 18.42% 11.34%
DCF 47 38.21% 3.60% 80.85% 57.45% 26.19% 11.15%
Panel C. Risk
Top quartile
PE 52 42.28% *** 4.55% 65.38% N/S 25.00% *** 42.40% *** 34.87% ***
DCF 71 57.72% 4.30% 54.93% N/S 36.62% N/S 45.84% *** 27.31% **
Bottom quartile
PE 72 58.54% 1.69% 76.39% 48.61% 14.34% 9.30%
DCF 51 41.46% 1.68% 45.10% 23.53% 21.38% 18.47%
Panel D. Size
Top quartile
PE 85 69.11% *** 40546 69.41% * 37.65% N/S 14.65% *** 11.04% ***
DCF 38 30.89% 17760 36.84% * 10.53% *** 21.41% *** 20.53% *
Bottom quartile
PE 54 43.90% 207 53.70% 25.93% 33.09% 27.58%
DCF 69 56.10% 315 53.62% 36.23% 39.83% 27.29%
Panel E. Growth
Top quartile
PE 62 50.41% N/S 40.82% 77.42% ** 40.32% N/S 39.74% *** 29.44% *
DCF 61 49.59% 37.64% 60.66% * 45.90% *** 42.37% * 26.39% N/S
Bottom quartile
PE 57 46.34% −6.22% 59.65% 31.58% 24.36% 19.03%
DCF 66 53.66% −12.60% 45.45% 24.24% 31.99% 20.89%

34
 Table 4. Descriptive analysis (cont.)

Valuation method use Target price accuracy measures Forecast error measures
No. % χ2 met_in χ2 met_end χ2 abs_error t miss_error t
Panel F. Profitability
Profit-making Firms
PE 225 57.84% *** 71.11% N/S 40.89% * 20.48% *** 14.02% ***
DCF 164 42.16% 57.93% N/S 38.41% N/S 26.29% *** 17.16% **
Loss-making Firms
PE 34 33.66% 61.76% 23.53% 48.92% 42.19%
DCF 67 66.34% 52.24% 37.31% 43.76% 27.49%
Panel G. Recommendation
Positive
PE 123 50.00% N/S 59.35% *** 38.21% N/S 25.63% N/S 19.29% N/S
DCF 123 50.00% 47.97% *** 33.33% N/S 35.74% ** 24.13% ***
Negative/Neutral
PE 136 55.74% 79.41% 38.97% 22.94% 16.30%
DCF 108 44.26% 65.74% 43.52% 26.37% 15.62%

35
 Table 5. Pearson correlations
The table reports the Pearson correlation matrix for the variables: valmodel (valuation method choice), met_in
(first measure of target price accuracy), met_end (second measure of target price accuracy), abs_error (absolute
forecast error), miss_error (forecast error for missed target prices), risk (standard deviation of daily stock
returns), size (natural logarithm of firm’s market capitalization), boldness (target price boldness), recm (type of
recommendation), growth (firm’s sales growth rate), profit (profitability), and peers (number of industry peers).
See Table 2 for variable definitions. */**/*** indicate significance at the 0.10/0.05/0.01 level (two-tailed
probability values in italics).

valmodel met_in met_end abs_error miss_error risk size boldness recm growth profit
Met_in −0.141***
0.002

Met_end −0.005 0.590***

0.907 0.000

Abs_error 0.117*** −0.238*** −0.126***

0.009 0.000 0.005

Miss_error 0.043 −0.490*** −0.527*** 0.737***

0.341 0.000 0.000 0.000

Risk 0.125*** −0.045 −0.085* 0.309*** 0.257***

0.006 0.326 0.059 0.000 0.000

Size −0.163*** 0.037 −0.008 −0.228*** −0.168*** −0.524*

0.000 0.409 0.851 0.000 0.000 0.000

boldness 0.187*** −0.360*** −0.199*** 0.509*** 0.558*** 0.162*** −0.221***

0.000 0.000 0.000 0.000 0.000 0.000 0.000

Recm 0.058 −0.205*** −0.0536 0.102** 0.101** −0.078 −0.010 0.414***

0.204 0.000 0.2364 0.024 0.025 0.085 0.833 0.000

growth −0.045 −0.054 −0.0316 0.270*** 0.298*** 0.062 −0.064 0.200*** 0.052
0.325 0.232 0.4859 0.000 0.000 0.172 0.155 0.000 0.249

profit −0.196*** 0.085* 0.056 −0.300*** −0.245*** −0.567*** 0.353*** −0.234*** −0.013 −0.071
0.000 0.060 0.187 0.000 0.000 0.000 0.000 0.000 0.773 0.116

peers −0.125*** 0.183*** 0.136*** −0.018 −0.053 0.052 −0.329*** 0.000 −0.024 0.046 0.061
0.006 0.000 0.003 0.696 0.241 0.247 0.000 0.995 0.603 0.314 0.180

36
 Table 6. Tests for selection bias
If the outcome variable is binary (met_in or met_end) we use a system of seemingly unrelated bivariate probit
models to simultaneously estimate the performance model (excluding broker dummy variables) and the choice
model (including broker dummy variables). If the outcome variable is continuous (abs_error or miss_error) we
use a treatment effects approach to simultaneously estimate the performance model (excluding broker dummy
variables) and the choice model (including broker dummy variables). The table reports Wald tests of whether
rho, estimating the correlation between the error terms of the choice and performance equations, is different
from zero. If rho is not significantly different from zero there is no selection bias and we can rely on estimates
of the single-equation models of Tables 7–9.

Seemingly unrelated bivariate probit models Treatment effects models

Target price accuracy Forecast error
Wald test: rho=0 met_in met_end abs_error miss_error
Value of rho −0.637 −0.370 −0.017 −0.006
Chi-square 1.083 0.652 0.000 0.000
p-value 0.298 0.419 0.958 0.979

37
 Table 7. Valuation method choice probit models

The table reports the results of probit regressions of valmodel (valuation method choice) on a series of variables
including risk, size, boldness, recm (type of recommendation), growth, profit, peers, and broker dummy
variables. The sample consists of 490 reports (observations) published in the period 01/07/2002–31/06/2004 for
94 UK listed firms. Two-tailed probability values (in italics) are calculated based on robust Huber/White
standard errors. */**/*** indicate significance at the 0.10/0.05/0.01 levels. The table reports estimates of the
maximum-likelihood probit regression equations presented in Table 4. See Table 2 for variable definitions, and
Section 2.2 for a discussion of predicted signs.

Model 1a Model 1b
Predicted valmodel valmodel
sign
Independent Variables Coefficient p-value Coefficient p-value
risk + −4.637 0.420 −4.708 0.425
size − −0.128*** 0.001 −0.100** 0.015
boldness + 0.906* 0.075 0.699 0.144
recm ? −0.026 0.853 0.026 0.859
growth + −0.125 0.535 −0.072 0.268
profit − −0.400** 0.029 −0.466** 0.014
peers − −0.033*** 0.000 −0.024** 0.016
broker_1 0.089 0.721
broker_2 −0.330* 0.081
broker_3 0.621*** 0.001
broker_4 −0.337 0.144
broker_5 −0.053 0.829
broker_6 0.123 0.667
intercept 1.575*** 0.001 1.276** 0.015

Number of obs 490 490

Wald chi-squared 39.22 78.01
p-value 0.00 0.00
Pseudo R–squared 7.55% 12.53%

38
 Table 8. Target price accuracy probit models
The table reports the results of probit regressions of met_in (first measure of target price accuracy) and met_end (second measure of target price accuracy) on valmodel
(valuation method choice variable), several control variables, and broker dummy variables. The sample consists of 490 reports (observations) published in the period
01/07/2002–31/06/2004 for 94 UK listed firms. Two-tailed probability values (in italics) are calculated based on robust Huber/White standard errors. */**/*** indicate
significance at the 0.10/0.05/0.01 levels. The table reports the estimates of the maximum-likelihood probit regression equations presented in Table 4. See Table 2 for variable
definitions and Section 2.2 for discussion of predicted signs. The expectation on the sign of valmodel changes from negative to positive when we introduce control variables
in Models 2b, 2c, 3b, and 3c.

Model 2a Model 2b Model 2c Model 3a Model 3b Model 3c

Predicted
met_in met_in met_in met_end met_end met_end
signs
Independent Variables Coefficient p-value Coefficient p-value Coefficient p-value Coefficient p-value Coefficient p-value Coefficient p-value
valmodel −/+ −0.363*** 0.002 −0.102 0.436 −0.169 0.207 −0.013 0.907 0.170 0.176 0.150 0.253
risk + 1.281 0.831 1.068 0.862 −9.097 0.126 −10.739* 0.070
size + 0.023 0.598 0.029 0.521 −0.035 0.378 −0.058 0.162
boldness − −2.895*** 0.000 −3.013*** 0.000 −2.039*** 0.000 −2.177*** 0.000
recm ? −0.075 0.595 −0.053 0.717 0.173 0.204 0.198 0.166
growth − 0.013 0.461 0.013 0.443 0.007 0.682 0.008 0.652
profit + −0.074 0.699 −0.088 0.651 −0.099 0.602 −0.083 0.666
peers + 0.046*** 0.000 0.049*** 0.000 0.026*** 0.005 0.028*** 0.004
broker_1 −0.202 0.405 −0.106 0.660
broker_2 −0.239 0.219 −0.215 0.255
broker_3 0.091 0.649 0.046 0.809
broker_4 −0.250 0.288 0.124 0.581
broker_5 −0.198 0.424 0.254 0.293
broker_6 −0.104 0.728 0.376 0.205
intercept 0.521*** 0.000 0.363 0.499 0.440 0.438 −0.289*** 0.000 0.205 0.681 0.405 0.443

Number of obs 490 490 490 490 490 490

Wald chi-squared 9.700 74.340 79.890 0.010 34.210 42.820
p-value 0.002 0.000 0.000 0.907 0.000 0.000
Pseudo R-squared 1.52% 15.41% 16.11% 0.00% 6.29% 7.37%

39
 Table 9. Forecast error OLS models
The table reports the results of linear regressions of abs_error (absolute forecast error) and miss_error (forecast error for missed target prices) on valmodel (valuation method
choice variable), control variables, and broker dummy variables. The sample consists of 490 reports (observations) published in the period 01/07/2002–31/06/2004 for 94 UK
listed firms. Two-tailed probability values (in italics) are calculated based on robust Huber/White standard errors. */**/*** indicate significance at the 0.10/0.05/0.01 levels.
The table reports the estimates of the linear regression equations presented in Table 4. See Table 2 for variable definitions and Section 2.2 for a discussion of predicted signs.
The expectation on the sign of valmodel changes from positive to negative when we introduce control variables in Models 2b, 2c, 3b, and 3c.

Model 4a Model 4b Model 4c Model 5a Model 5b Model 5c

abs_error abs_error abs_error miss_error miss_error miss_error
Predicted p-
Independent Variables sign Coefficient p-value Coefficient p-value Coefficient p-value Coefficient p-value Coefficient p-value Coefficient value
valmodel +/− 0.071** 0.010 0.000 0.997 0.001 0.965 0.024 0.342 −0.044** 0.044 −0.043* 0.065
risk + 3.693*** 0.004 3.476*** 0.007 3.065*** 0.005 3.035*** 0.006
size − −0.002 0.786 −0.006 0.411 0.003 0.615 0.003 0.664
boldness + 0.607*** 0.000 0.601*** 0.000 0.683*** 0.000 0.681*** 0.000
recm ? −0.053** 0.021 −0.056** 0.018 −0.071*** 0.001 −0.074*** 0.001
growth + 0.022 0.876 0.022 0.873 0.022 0.776 0.022 0.764
profit − −0.060 0.230 −0.056 0.265 −0.025 0.564 −0.021 0.617
peers − −0.002 0.377 −0.002 0.400 −0.003* 0.073 −0.003* 0.082
broker_1 −0.004 0.912 0.005 0.868
broker_2 −0.038 0.263 −0.017 0.559
broker_3 −0.023 0.568 −0.019 0.600
broker_4 0.014 0.684 −0.029 0.360
broker_5 0.042 0.478 0.025 0.661
broker_6 0.043 0.649 −0.059 0.132
intercept 0.242*** 0.000 0.150* 0.084 0.193** 0.050 0.177*** 0.000 0.045 0.571 0.058 0.498

Number of obs 490 490 490 490 490 490

F-value 6.630 15.690 9.890 0.910 17.870 10.380
p-value 0.010 0.000 0.000 0.342 0.000 0.000
Adjusted R-squared 1.17% 33.97% 33.85% −0.02% 38.87% 38.53%

40
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Footnotes

1
For a comprehensive literature review see Ramnath, Rock, and Shane (2006).
2
Bonini, Zanneti, and Biachini (2006) reach a similar conclusion analyzing equity research reports for Italian
listed firms published during 2000–2003.
3
Bradshaw and Brown (2006) analyze the accuracy of target prices from 1997–2002, while Asquith et al. (2005)
focus on 1997–1999. In their study of target prices from 1997–1999, Brav and Lehavy (2003) refer to the
unusual history of this period and call for additional out-of-sample evidence.
4
“The old research model is dead. That may be the only certainty right now.” (Nocera 2004).
5
In some cases, the analyst publishes another report, with a target price in GBP on the same day or in the
following days, which is in the sample. The majority of the excluded reports are for pharmaceutical firms (e.g.
AstraZeneca, GlaxoSmithKline).
6
We use the current price to calculate boldness and the two measures of forecast error.
7
We also include reports that use these terminologies interchangeably.
8
The average report length for the study of Asquith et al. (2005) is 6.3 pages.
9
Where a firm makes a capital change (e.g. a stock split) during the 12-month forecast horizon, we adjust the
target price by multiplying by the ratio of the firm’s adjusted stock price to its unadjusted stock price on the date
of the report’s publication. We use adjusted stock prices to estimate the 12-month-ahead Highest/Lowest stock
price range. Where there is no capital change, we make no adjustments and use unadjusted prices to estimate the
range. Data on stock prices are from Datastream.
10
As the current price, we use the stock price available to the analyst before the publication of the report. The
first page of the report indicates the current stock price along with the target price. Where a firm makes a capital
change (e.g. a stock split) during the 12-month-ahead forecast horizon, we adjust the target and current stock
prices accordingly (see previous footnote).
11
We prefer absolute target price boldness to the target-price-to-current-price ratio (TP/CP) because the relation
between TP/CP and target price accuracy is nonlinear if there are many target prices below current prices.
12
Risk equals the standard deviation of daily stock returns from 1/7/2000 to 31/6/2002 if the report is published
in the period 1/7/2002 to 31/6/2003, or from 1/7/2001 to 31/6/2003 if the report is published in the period
1/7/2003 to 31/6/2004.
13
However, contrary to expectation they find that target prices are more difficult to meet for firms with higher
stock price volatility. They argue that this result is due to the high correlation between price volatility and
TP/CP.
14
Data on market values (Datatype: MV) are from Datastream.
15
From another perspective, large successful firms that are “national champions” in their industry sectors might
have few comparable UK companies. However, analysts compare these firms with international companies. For
example, analysts compare Tesco to Carrefour, GlaxoSmithKline and AstraZeneca to the “Global Big-Pharma”
industry, Shell and BP to the “Global Big-Oil” industry, etc. These companies are global players, with similar
business and financial models, facing similar risks and opportunities.
16
However, we expect target prices that support neutral recommendations are more easily achieved at some
point during the 12-month forecast horizon, because they are often set at a level close to the current stock price.
17
To estimate the sales growth rates, we use data on firms’ sales from Worldscope (Net Sales or Revenues:
WC01001).
18
We also use the number of firms that are constituents both of the FTSE industry specific index and the FTSE
All-share index in August 2005. The results are qualitatively similar with this alternative measure.
19
However, there are analysts who exhibit differential ability to make profitable earnings forecasts and stock
recommendations. For a literature review see Bruce and Bradshaw (2003).
20
As previously suggested, possible explanations for the difference between our study and Bradshaw (2002) and
Asquith et al. (2005) include differences in the length of the sampled equity research reports, differences in the
sample period (Glaum and Friedrich 2006), and institutional differences in the equity research output between
the City of London and Wall Street (Breton and Taffler 2001).
21
The proportion of loss-making firms is higher among firms with negative growth: 46.22 percent of the
sampled reports for negative growth firms versus 13.54 percent for firms with positive growth. Hence, this
difference in valuation model choice might also be due to profitability differences between the top and bottom
growth quartiles.
22
In Asquith et al. (2005) the proportion of neutral/negative recommendations is 29.2 percent of the sampled
reports.
23
Similarly, in Gleason et al. (2006), TP/CP increases in the period 1997–2000 and declines to 1.24 in 2003.

43
24
However, it might also be due to institutional differences between the US and the UK. As discussed earlier,
our sample has a greater number of neutral/negative recommendations, which reduces the mean (median) value
of this ratio.
25
In our sample, 22.24 percent of the reports have a target price below the current price compared to only 7
percent in Gleason et al. (2006) and 2.7 percent in Asquith et al. (2005).
26
This might indicate that DCF better captures the long-term value of the firm, while target prices based on PE
focus on the short-term and fail to impound fully information about future performance. Subsequent sections
provide a more in-depth analysis of the dynamics of target price setting and performance.
27
See also footnote 16.
28
See also the discussion in the previous section.
29
This result is consistent with the findings of Bradshaw and Brown (2006). See footnote 14.

44