What Valuation Models Do Analysts Use?

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 multi-period 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 multi-period 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 detailed set of hypotheses