Electronic copy available at: http://ssrn.

com/abstract=1370847





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



March 2009








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, Reading University, and Athens
University of Economics and Business, and participants at the European Accounting
Association 2007 Conference. The authors are particularly grateful to two anonymous
reviewers for their constructive and insightful comments and suggestions. Efthimios
Demirakos acknowledges a PhD scholarship from the Propondis Foundation during the early
stages of this research.
Electronic copy available at: http://ssrn.com/abstract=1370847
2
Does valuation model choice affect target price accuracy?

Abstract

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 07/200206/2004. 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 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.

JEL classification: G11; G14; G24; M41

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






3
Does valuation model choice affect target price accuracy?

1. Introduction
Using equity research reports as evidence of how analysts value stocks, this study
examines the empirical performance of an observable outcome of these reports: 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 analyze the predictive performance of target prices derived from two popular valuation
frameworks: price-to-earnings (PE) and discounted cash flow (DCF) models.
In theory, PE and DCF models should produce identical valuations if analysts
implement them consistently: that is, for every PE valuation a discount rate exists that gives
an identical DCF valuation, or equivalently, for every DCF valuation a combined forecast
earnings and peer company multiple exists that gives an identical PE valuation. Our view is
that, notwithstanding the theory, the practical implementation of these models is almost
certain to give rise to different valuations.
Francis et al.s (2000) and Penmans (2001) responses to Lundholm and OKeefe
(2001) offer a similar view on the differences that arise in the practical implementation of
different multi-period valuation models. We expect valuation differences to be more likely
in practice between a single-period valuation model (PE) and a multi-period valuation model
(DCF). For example, assume we interpret the theoretical equivalence of PE and DCF models
as arising through their joint equivalence to the dividend discount model (DDM). PE
models, in general, are consistent with the DDM only if dividend growth is constant and the
analyst identifies an efficiently priced peer company with identical payout ratio, earnings
growth, and risk (reflected in the equity cost of capital). In any practical or pragmatic
application, a PE model is unlikely to be consistent with the DDM.
1

4
We believe that an analysts use of PE or DCF models reflects, at least in part, a
deliberate choice to spend more time focusing on certain factors and parts of the analysis than
others. For example, the practical use of PE models emphasises current market PE multiples
and the particular earnings construct to which the market applies these multiples. It also
emphasises the analysts skill in choosing peer companies with matching payout, risk, and
growth characteristics. Using PE models, the analyst believes that current earnings measures
constitute good proxies for value. In contrast, the practical use of DCF models places less
reliance on current market valuations. Instead, it emphasises the full-information forecasting
of free cash flows over a multi-period finite horizon, the choice of an appropriate finite
horizon, estimation of growth beyond the horizon, and in its standard implementation,
estimation of an appropriate WACC and of the value of non-equity claims on the firm. It is in
the spirit of the practical implementation of valuation models that we compare the
performance of PE and DCF models in this study.
The ideal approach to this analysis is to compare the target prices of DCF and PE
models applied to random samples of companies. Unfortunately, we do not observe these
target prices as analysts do not apply DCF and PE models to companies on a random basis.
Instead, we contend that firm characteristics affect their valuation model choice. For
example, if analysts use DCF (PE) models to analyze more (less) risky firms, and if riskier
firms are harder to forecast, then DCF will have higher forecast errors if we fail to control for
risk. Thus, we explore whether analyst valuation model choices vary across firms with
different characteristics. In particular, we condition our results on a set of firm-, report-, and
industry-specific factors that determine how difficult the valuation task is. We do this on a
large sample of 490 comprehensive equity research reports published over the period July
2002June 2004 that explicitly indicate the valuation model used to derive the target price.
5
A possible criticism of our approach is that we accept analyst reports at face value.
We assume analysts use the models presented in the text of their reports to generate their
investment recommendations, rather than as a way of rationalizing and communicating
recommendations previously reached. We believe that using comprehensive reports and
analyzing how firm-, report-, and industry-specific factors affect valuation model choice
substantially deflects this criticism.
Using descriptive and univariate evidence, we quantify the relative frequency of use,
the target price accuracy, and the forecast errors of PE and DCF models across firms and
reports with different characteristics. We examine the determinants of analyst valuation
choice between PE and DCF models and, using two measures of target price accuracy and
two measures of forecast error, test whether there is any significant difference in the empirical
performance of the two models after controlling for the factors that determine this choice.
We contribute new empirical evidence on valuation model choice, the empirical
assessment of alternative valuation models, and the properties of target prices. We add to
existing findings that analysts make informed valuation model choices. Our evidence
suggests that analysts prefer DCF to PE models when they face more challenging valuation
cases. Our results show that analysts use DCF more frequently than PE models to value small
firms, high-risk firms, loss-making firms, and firms with a limited number of industry peers.
While an unconditional analysis suggests that PE models outperform DCF models, the
performance of DCF models improves after conditioning on these factors, leaving an
insignificant performance difference or a significant outperformance by DCF models.
Analysts also appear to use PE (DCF) models more in bull (bear) markets.
The remainder of this paper continues as follows. The next section offers a review of
the valuation model choice and performance literatures. Section 3 discusses data collection
and research methodology issues. Section 4 presents descriptive evidence on two sub-
6
periods of our sample and univariate tests of differences in the frequency of use and
empirical performance of PE and DCF models across a series of control variables. Section 5
reports and discusses the results of multivariate probit and linear regression models. Section
6 concludes.

2. Prior research
The three major verifiable predictions of sell-side analysts equity research reports are
earnings forecasts, stock recommendations, and target prices. While many studies investigate
analyst earnings forecasts and stock recommendations, target prices have attracted academic
interest only recently.
2
A possible reason for this is a lack of investor interest in target prices.
However, Brav and Lehavy (2003) and Asquith, Mikhail, and Au (2005) provide early
evidence of the price impact of analyst target prices. Brav and Lehavy (2003) find that target
prices are informative both unconditionally and conditional on stock recommendations and
earnings forecast revisions. For example, they report that a one standard deviation increase in
price-scaled target price revisions increases a five-day market-adjusted buy and hold return by
2.9 percent, on average. Similarly, Asquith et al. (2005) report that a 1 percent increase in
target price increases a five-day market-adjusted cumulative return by a highly significant
0.32 percent and that the effect of target price revisions remains significant and stronger than
for earnings forecast revisions after controlling for the latter and for stock recommendations.
When choosing a valuation methodology to justify their target prices, analysts need to
exercise care, as fund managers are their intended audience.
3
Fund managers are powerful
players in the investment community, and analysts need to cultivate a positive reputation with
them to advance their own careers. Financial statement analysis textbooks explain the
relative advantages of multi- and single-period valuation models (e.g., Lundholm and Sloan,
2003; Penman, 2003; Koller et al., 2005). The general conclusion is that multi-period models
better capture long-term value. In contrast, the main message from the literature on valuation
7
model choice in practice is that sell-side analysts prefer single-period earnings models
(Barker, 1999; Block, 1999; Bradshaw, 2002; Demirakos, Strong, and Walker, 2004; Asquith,
Mikhail, and Au, 2005). To explain the popularity of PE over DCF models, some researchers
stress the difficulty of making multi-period forecasts in an uncertain corporate environment
and estimating the appropriate discount rate for DCF models (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).
Glaum and Friedrich (2006) examine the choices of European telecommunication
analysts and find that the popularity of DCF models increased significantly after the end of
the 1990s, when earnings multiples were the main driver of valuations. Imam, Barker, and
Clubb (2008) offer empirical evidence that sell-side analysts increased preference for DCF
models in recent years may be client-driven and influenced by fund managers valuation
preferences. They also find that sell-side analysts are more likely to employ DCF as a
dominant valuation model to analyze high growth firms where it has greatest technical
relevance (Imam et al., 2008: 531).
4

Rosenboom (2007) finds that French underwriters are more likely to use DCF models
in IPO valuation when market returns are high, when market volatility is high, and when the
firm is listing on the Nouveau Marche, which attracts young, high-technology firms with a
limited number of industry peers. He finds underwriters are more likely to use price multiples
to value technology firms and high growth or profitable firms. Deloof, De Maeseneire, and
Inghelbrecht (2009) find that the lead underwriters of a sample of 49 IPOs on Euronext
Brussels prefer DCF to value IPOs and set their offer prices.
5

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
8
financial statement data (Penman and Sougiannis, 1998). Liu, Nissim, and Thomas (2002)
examine the valuation performance of several multiples, and find that price-to-earnings
multiples based on forward earnings have the greatest accuracy. Asquith et al. (2005) find no
significant relation between the valuation methodology used to generate target prices and
target price accuracy. However, their research design does not control for analysts selecting
their valuation methodologies. Comparing the target price accuracy of alternative valuation
models unconditionally may produce misleading results if analysts tailor their model choice 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 (2007) use a database of analyst earnings and target price
forecasts over the period 19972003. As part of their study, they follow Bradshaw (2004),
and input analyst earnings forecasts to price-to-earnings-growth (PEG) and residual income
valuation (RIV) models to generate pseudo-target prices. They find that RIV is a superior
method for estimating firms fundamental values and for producing accurate target prices.
Finally, Bradshaw and Brown (2006) use a large sample of analyst target price
forecasts from 19972002 from the First Call database. They show that analysts exhibit no
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.
6

.
3. Data collection and empirical research design
Our sample consists of comprehensive equity research reports by sell-side equity
analysts from international investment houses. Reading the content of these reports identifies
9
whether the analyst employs PE or DCF as the dominant model to justify a target price. We
compare the target price in the reports with actual outcomes, employing a mixture of
univariate tests and multivariate models to assess each models predictive performance
unconditionally and conditional on several controls for the 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 sample
industries, firms, and reports. The second subsection presents the design of our empirical
analysis, our multivariate probit and linear regression models, and definitions of the model
variables.
3.1. Equity research reports
We download equity research reports from the Investext database for the period July
2002 to June 2004. The reports cover firms listed on the London Stock Exchange drawn from
a balanced portfolio of nine old and new economy sectors: 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-
indices and the FTSE All-Share index. We search Investext for reports on these firms and
find a total of 8,031 documents. However, Investext contains not only equity research reports
but also industry reports, morning notes, conference calls, and other non-valuation
documents. We focus on firm-specific equity research reports greater than 10 pages in length.
As the majority of equity research reports include an executive summary, the firms
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. Excluding non-
equity research reports and short reports reduces the number of documents to 1,250.
10
In some cases we find reports from the same investment house for the same firm with
the same recommendation and target price. These reports have similar information content,
i.e. similar narrative and valuation discussion. In most cases, these reports are updates for
major corporate events that do not change the analysts 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 excludes
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,
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).
7
As we explain below, for the
current study it is essential to know the firms (current) stock price when an analyst writes a
report.
8
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 and we exclude these
reports. 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 analysts preferred valuation
model is unclear. To identify the analysts preferred valuation model, we first check the
disclosure pages at the end of the report. Among the information on these pages, some
investment houses have recently started to disclose which valuation methodology they use to
reach the target price (e.g. CSFB). We next read the valuation section, the first page, and the
executive summary of the report. If the analyst uses only one valuation model, we consider
11
this to be dominant. If the analyst uses more than one model we search for a clear statement
of the analysts preferred model to justify the reports target price.
9

If we cannot find such a statement in the report we examine the value estimates of the
alternative valuation models. If only one valuation model produces a value estimate, with the
other models simply mentioned in the report without associated value estimates, we pick the
model that produces a value estimate as dominant. If more than one valuation model
produces a value estimate, we compare the difference between each valuation models value
estimate and the target price and pick the model with the smallest difference as dominant.
As we wish to identify reports where either PE or DCF is the dominant valuation
methodology, we exclude reports where an analyst reaches a target price by averaging the
value estimates of two different valuation models. Where a report uses DCF jointly with the
RIV (or Economic Value Added) model and bases its target price on the average of different
value estimates of these models we exclude the report. If the models generate the same
valuation, we include the report in our sample.
10
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) models to value each business division.
This process leads to the exclusion of 213 reports. The final number of reports in our
sample is therefore 490, accounting for 39.2 percent of the total number of comprehensive
firm-specific equity research reports of more than 10 pages in length. Hence, our final sample
comprises reports that use either PE or DCF as dominant valuation models to justify their
target price. PE models include trailing and leading price-to-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
12
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 houses. The total number of firms in our sample is
94, representing 60.26 percentof the firms included in the FTSE All-Share index for our
sample industries. The mean 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.
11
The total number of investment houses is 22 with an average number of 22.27
reports per investment house. Finally, the average number of reports per firm is 5.21.
[Table 1 here.]
3.2. 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
frequency of use, target price accuracy, and forecast error of PE and DCF models across
reports and firms with different characteristics. The results of the univariate analysis inform
the design of our multivariate models. This subsection defines the variables and presents the
probit and linear regression models whose results we report and discuss in the multivariate
analysis section. Table 2 summarizes the dependent and independent variables.
[Tables 2 here.]
We use four variables to measure the empirical performance of target prices from PE
and DCF models: two measures of target price accuracy, met_in and met_end, and two
measures of forecast error, abs_err and miss_err. The first target price accuracy variable,
met_in, measures whether a target price is met at any time within a 12-month forecast
horizon. This variable takes the value one if the reports target price is within the 12-month-
ahead Highest/Lowest stock price range, and zero otherwise.
12
The second target price
13
accuracy variable, 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.
The first forecast error variable, abs_err, is the absolute forecast 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.
13
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 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. The second forecast error variable, miss_err, measures the forecast
error of missed target prices. This variable equals 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.
The variable valmodel plays a central role in our analysis. It equals one if the
analysts preferred valuation methodology is DCF; it equals zero if the dominant valuation
model is PE. Employing valmodel as a dependent variable, 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 models for firms whose current earnings figure is a reliable indicator of
fundamental value. Employing valmodel as an independent variable, unconditionally we
14
predict a negative (positive) relation between valuation model choice and measures of target
price accuracy (forecast error). However, conditional on controls for the difficulty of the
valuation task, we predict an improved performance of DCF models, resulting in a reversal of
these predictions or a decreased significance level of the relations.
When valmodel is the dependent variable of interest, our multivariate analysis
involves estimating a probit regression of the general form
i 0 1 i 2 i 3 i 4 i 5 i
6
6 i 7 i 8 i 8 k i i
k 1
valmodel risk size boldness recm growth
_
profit peers ftse past broker_ k


+
=
= + + + + + +
+ + + +

(1)
When valmodel is the independent variable of interest to explain target price performance, our
multivariate analysis involves estimating a probit model (to explain target price accuracy) or a
linear regression model (to explain target price forecast errors) of the general form
i 0 1 i 2 i 3 i 4 i 5 i 6 i
6
7 i 8 i 9 i 9 k i i
k 1
perf valmodel risk size boldness recm growth
_ _
profit peers ftse forward broker k


+
=
= + + + + +
+ + + + +

+

(2)
where the dependent performance variable is met_in, met_end, abs_err, or miss_err.
An independent variable we use in equations (1) and (2) is risk, measured as the
standard deviation of daily stock returns over a two-year period before the reports
publication.
14
In equation (1) we expect analysts to use DCF models more frequently to value
high risk stocks. High-risk stocks are more likely to have volatile future earnings and cash
flow streams and valuation by PE models 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. Based on option pricing theory, Bradshaw and Brown (2006) predict that target price
accuracy is higher for stocks with higher price volatility.
15
While this prediction is
reasonable, we also expect to find a positive association between a stocks risk and forecast
error. This is because although it is easier for the target price of a highly volatile stock to be
15
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.
Size is another variable that we use in the regressions. Size is the natural logarithm of
the firms market capitalization on 1/7/2002 for reports published in the period 1/7/2002 to
30/6/2003, or on 1/7/2003 for reports published in the period 1/7/2003 to 30/6/2004.
16
We
expect to find that PE models are more popular in valuing large established firms, which are
likely to have sustainable earnings and an easily-recognized set of comparable companies.
17

On the other hand, it is likely to be harder to identify a group of comparable firms with
similar business models for small firms focusing on niche markets. Hence, DCF models are
likely to be more appropriate for capturing the uniqueness of these small firms. We expect to
find 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 often operate in specialist markets and their future performance is more
uncertain.
An important variable in our analysis is target price boldness (boldness). We define
this as the absolute value of the difference between the target price and the current price,
scaled by current price. Target price boldness captures how far from the current market
consensus the analyst forecasts the fundamental value of the company.
18
Glaum and Friedrich
(2006) argue that analysts preferred PE to DCF models 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 models to capture the long-term value of the firm and to find a positive association
between the use of DCF models and robust statements about future stock price performance.
16
We expect the greater its boldness, the less likely a target price is met. Therefore, we predict
a negative (positive) association between target price accuracy (forecast error) and boldness.
In our multivariate analysis, we prefer absolute target price boldness to signed target price
boldness. This is because the relation between signed target price boldness and target price
accuracy is nonlinear if there are many reports with target prices below current prices, as there
are in our sample (109 equity research reports). We offer some descriptive statistics on
signed_boldness in the next section.
A fourth independent variable that we use is the reports recommendation type (recm).
This variable takes the value one if the reports recommendation is positive (e.g. Strong Buy,
Buy, Outperform, Overweight, etc.), or zero if the reports 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
or performance.
19

Growth is the firms annualized sales growth rate measured as the geometric average
of its sales growth rate over a period of two years before the reports publication.
20
Valuation
theory suggests that PE models of firms with unstable growth lead to biased valuations, since
summary earnings figures do not capture future growth opportunities. We therefore predict
that analysts prefer DCF to PE models to value firms with unstable growth. As an analyst is
likely to find it harder to predict the target price of a firm with high growth opportunities than
a firm with uniform and stable growth, we expect to find a positive (negative) association
between growth and forecast error (target price accuracy).
The dummy variable profit takes the value one if the firm is profitable in the year
before the publication of the report, and zero otherwise. A PE valuation of loss-making firms
is difficult since the denominator of the earnings multiple is negative and analysts need to
17
produce normalized figures of sustainable earnings. Hence, they may prefer a multi-period
DCF model. We also expect it to be harder to value loss-making firms than profit-making
firms and predict a positive (negative) association between profit and target price accuracy
(forecast error).
The variable peers measures the number of firms in each industry for which we can
find reports.
21
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 to find 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 peers to be positively (negatively) related to target price
accuracy (forecast error).
The variable ftse_past is the return on the FTSE AllShare index over the 12 months
immediately before the reports publication. We include ftse_past in the valuation model
choice regressions and predict a negative association between ftse_past and valmodel. In a
bull market when a market index reaches high levels, an analyst may find it difficult to justify
a target price based on a firms fundamentals; the analyst may have to make unrealistic
assumptions to justify a DCF-based target price (Glaum and Friedrich, 2006: 170). It may be
easier for an analyst to generate a target price based on PE multiples and the high stock prices
of the firms peers.
22
On the other hand, in a bear market, it may be easier for an analyst to
justify a bold target price by reference to a firms fundamentals.
The variable ftse_forward is the return on the FTSE AllShare index over the 12
months immediately after the reports publication. We include ftse_forward in the
performance model specifications. Bradshaw and Brown (2006) use a similar variable and
18
predict a positive relation between stock price and market return. We expect ftse_forward to
be positively (negatively) associated with target price accuracy (forecast error).
Finally, we include broker dummy variables for the six investment houses that
contribute 80 percent of our equity research reports. Sell-side analysts usually adopt an in-
house framework for fundamental analysis. Hence, we expect a brokerage specific effect on
analyst choice between PE and DCF models. On the other hand, Bradshaw and Brown (2006)
find little empirical evidence that there are superior analysts who persistently exhibit
differential ability to predict accurate target prices.
23
Thus we expect an insignificant relation
between the broker dummies and target price accuracy or forecast error.
As the error terms of our valuation choice and performance models may be correlated,
we need to test for selection bias in the valuation model choice that might influence the results
of our target price accuracy and forecast error regressions. We therefore deploy standard
selection techniques to test for potential cross-correlation between disturbances relating to
equations (1) and (2). Denoting as rho the correlation between the error terms in the two
equations, rho measures the correlation between the outcomes after controlling for the
influence of the observable control factors. If we cannot reject the null hypothesis that rho
equals zero, then we can rely on estimates of the single-equation regressions (Greene, 2003:
7105, 7879). In this case, the observable control variables that we use influence the choice
between PE and DCF models but, controlling for these variables, analysts have no additional
private information that influences their choice (Li and Prabhala, 2006).

4. Descriptive and univariate analysis
This section reports descriptive statistics on the choice, target price accuracy, and
forecast error of PE and DCF models across the two sub-periods of our sample, across firms
with different risk, size, profitability and growth characteristics, and across reports with
19
different types of recommendation and target price boldness. We begin with a simple
examination of the frequency of use of DCF models for our 94 sample firms. If firm
characteristics do not affect valuation model choice, the percentage use of DCF (and PE)
models should be equal across firms and equal to the total sample frequency. Table 3 reports
the frequencies. In a total of 490 reports, 231 or 47% use DCF models. However, of 71 firms
that have more than one report, in 38 (54%) of these cases, the frequency of use of DCF
models is more than 80% or less than 20%. Figure 1 charts the frequency distribution of the
71 firms for alternative percentages of DCF model use. If firm characteristics do not affect
DCF or PE model choice the mass of the distribution should be towards the centre. Instead,
there is substantial probability mass in the tails. This provides clear preliminary evidence that
analysts do not employ DCF or PE models randomly to value stocks.
[Table 3 and Figure 1 here.]
In the rest of this section, we discuss descriptive and univariate evidence from Tables
46. Table 4 presents descriptive statistics for the two sub-periods of our sample. Table 5
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 a series of firm- and report-specific control
variables. Table 6 reports Pearson correlations among the study variables.
4.1. Sample period
Our sample reports were published over a period when a marked change in market
returns took place. Table 4 reports descriptive statistics for two sub-periods. In the first sub-
period 1/7/2002 to 30/6/2003, the FTSE All-Share index fell by 10.21%, while in the second
sub-period 1/7/2003 to 30/6/2004, the FTSE All-Share index rose by 18.69%.
[Table 4 here.]
20
Sell-side analysts used PE (DCF) models in 112 (126) reports in the first, bear sub-
period, compared to 147 (105) in the second, bull sub-period. The difference in frequency of
use of the two valuation models is significant at 5 percent (
2
6.244 = , p = 0.013). This
suggests that market conditions might partly explain analyst choice of DCF models. The
difference in market conditions between the two sub-periods is also evident if we consider the
median values of ftse_past. In the bear sub-period, the median value of ftse_past is 20.70
(21.86) percent for reports that use PE (DCF) models. The corresponding median values in
the bull sub-period are 14.86 (15.29) percent.
Table 4 also shows that in the bear sub-period, DCF models are used to support bolder
target prices, based on both boldness measures, and DCF models perform worse than PE
models unconditionally for all measures of performance. In contrast, in the bull subperiod,
the median values of the two boldness measures for DCF and PE models are close and
evidence on differences in the performance of the two model choices is inconclusive.
4.2. Valuation model choice
Table 5 reports overall findings and a breakdown of results across several report and
firm characteristics. It reports the frequency of use, the target price accuracy (met_in and
met_end), and the forecast error (abs_err and miss_err) of PE and DCF models, overall
(Panel A), for the top and bottom quartiles of boldness, signed boldness, risk, size, and growth
(Panels BF), firms with different profitability (Panel G), and reports with different
recommendations (Panel H). It also gives the median values of the top and bottom quartile
control variables. Finally, it reports the results of a series of chi-square and t-tests. In Panel
A these test for differences in the performance of PE v. DCF models overall. In Panels BH
under Valuation model use, the chi-square test is for the difference in valuation model use (PE
or DCF) between the top and bottom quartiles of the control variables or between firms
(reports) with different profitability (recommendation) status. In the remaining columns of
21
Panels BH the tests are for differences in the target price accuracy and forecast error of PE
and DCF models across the top and bottom quartiles of the control variables or across firms
(reports) with different profitability (recommendation) status.
[Table 5 here.]
In this subsection, we focus on the determinants of analyst choice between PE and
DCF models. Table 5, Panel A shows that 52.86 percent of the reports use PE models to
justify their target prices. The remaining 231 reports (47.14 percent) prefer DCF models.
This result contrasts with the findings of Bradshaw (2002) and Asquith et al. (2005), who find
limited use of DCF models in practice.
24

We find that analysts make valuation model choices consistent with our predictions.
Chi-square tests for 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 models significantly more often than
PE models to justify bold target prices (Panels B and C) and to value firms that are high-risk
(Panel D), small (Panel E), and loss-making (Panel G).
Table 6 shows that valmodel is significantly positively correlated with boldness and
risk and negatively correlated with size, peers, and profit. Contrary to expectation there is an
insignificant difference in valuation model choice between the top and bottom growth
quartiles (Table 5, Panel F). Table 6 shows an insignificant correlation between growth and
valmodel. A potential explanation for this is the incidence of firms with negative growth
(21.63 percent of the sample reports). Faced with the task of valuing firms with negative
sales growth, analysts seem to choose DCF models to forecast the effects of business
disposals, restructuring, refocusing, etc.
25
Comparing the top and bottom quartiles to the
middle quartiles, analysts prefer DCF models to value firms with extreme positive or negative
growth (
2
= 3.985, p = 0.046).
22
[Table 6 here.]
Apart from the high incidence of observations with negative growth, our sample also
includes a greater proportion of negative/neutral recommendations (49.8 percent of reports)
compared to studies that examine the period 19972002 using US data
26
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. In Bradshaw and Brown (2006), TP/CP is 1.30 in the first
half of 1997, peaks at 1.46 in the second half of 2000, and falls to 1.20 in the second half of
2002.
27
In our study, the mean (median) value of TP/CP is 1.15 (1.12), indicating a mean
(median) target 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.
28
The mean (median) absolute
difference between target price and current stock price is 20.55 percent (14.29 percent).
29

4.3. Target price accuracy
Table 5, Panel A shows that according to met_in, PE models outperform DCF models
at the 1 percent level. In particular, PE-based target prices are met in 69.88 percent of reports,
while DCF-based target prices are met in 56.28 percent (
2
= 9.750, p = 0.002). Based on
met_end the difference in the models performances is insignificant. PE-based target prices
are met in 38.61 percent of reports compared to a 38.10 percent accuracy of DCF-based target
prices (
2
= 0.014, p = 0.907). Hence, while PE models perform significantly better than
DCF models according to the first accuracy measure, the difference in performance is
insignificant according to the second measure.
30

Table 5 gives 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, signed_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
23
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 either measure of target price accuracy, PE and DCF models perform
significantly better in valuing firms in the lowest compared with the highest boldness quartile
(Panel B). Using signed_boldness, the improved performance of DCF and PE models is
significant only in the case of met_in (Panel C). The performance of DCF models increases
significantly when valuing small compared to large firms (Panel E) and high compared to low
growth firms (Panel F). Possible explanations for these results are the complexities of
forecasting every line item of a large multi-segment firm using DCF models and the inherent
difficulty of valuing companies with negative, unstable sales growth.
PE and DCF models perform better justifying negative or neutral recommendations
compared to positive recommendations according to met_in (Panel H).
31
The target price
accuracy of PE models varies across quartiles in understandable ways: PE models perform
better in valuing low-risk compared to high-risk firms (according to met_end), to value large
mature firms compared to small firms (met_in), to value high growth compared to negative
growth firms (met_in), and to value profit-making compared to loss-making firms (met_end).
Table 6 shows that met_in is negatively correlated with valmodel, indicating that PE
models significantly outperform DCF models. 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 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.

24
4.4. Forecast error
Table 5 also provides descriptive statistics on the forecast error of target prices from
PE and DCF models. Panel A shows that according to abs_err, PE models perform
significantly better than DCF models: reports with PE-based target prices have a mean
absolute forecast error of 24.22 percent compared to 31.36 percent for DCF models, giving a
significant difference (t = 2.580, p = 0.005). But PE-based target prices generate a mean
miss_err of 17.72 percent compared to 20.15 percent for DCF-based target prices, giving an
insignificant difference (t = 0.954, p = 0.170). Based on both measures of forecast error, PE
and DCF models perform better in valuing firms in the lowest boldness and signed_boldness
quartiles (Panels B and C), lowest risk quartile (Panel D), and highest size quartile (Panel E),
and in valuing profit-making firms (Panel G). Based on abs_err, PE and DCF models
perform better in valuing firms in the lowest growth quartile (Panel F). Table 6 provides
additional evidence to support these relationships. Both forecast error measures are positively
correlated with risk, boldness, recm, and growth and negatively correlated with profit and
size.

5. Multivariate analysis
In this section, we report the results of standard robustness tests for selection bias in
valuation model choice. Finding no selection-bias, we proceed to report the results of our
single-equation models of valuation model choice, target price accuracy, and forecast error.
5.1. Tests for selection bias
The target price accuracy and forecast error models do not control directly for
potential selection bias arising from valuation model choice. If analysts choose DCF to value
more challenging investment cases then valmodel may be correlated with the error term in
25
equation (2) and the performance of DCF models may be understated. To deal with this
problem, we first employ selection-style models.
If the outcome is a binary variable (met_end or met_in), we employ a system of
seemingly unrelated bivariate probit models (Greene, 2003: 7105; Stata, 2005a: 1338). To
implement these we include independent variables in the choice model that are not in the
performance model. The system of equations comprises the full choice model including the
broker dummy variables (equation 1) and the simple performance model (equation 2)
excluding the broker dummies. These selection models simultaneously estimate the choice
and performance regressions using maximum-likelihood and model the correlation between
valmodel and the error term directly, in order to eliminate any omitted-variable bias. If rho,
which measures the correlation between the error terms of the choice and performance
equations, is insignificantly different from zero then there is no selection bias and we can rely
on single-equation estimates of equation (2). Table 7, Panel A presents Wald tests of whether
rho differs from zero for the system of seemingly unrelated bivariate probit models (see
Greene, 2003: 712). In both cases, rho is insignificantly different from zero. Therefore, the
single-equation estimates are unbiased.
If the outcome of the performance equation is a continuous variable (abs_err or
miss_err), we use a treatment effects framework (Ettner, 2004; Greene, 2003: 7879; Stata,
2005b: 45665). The system of equations again comprises the full choice model including
the broker dummy variables and the simple performance model excluding the broker
dummies. These selection models estimate the choice and performance regression models
using a two-step consistent estimation procedure.
32
A new hazard variable lambda is
computed, also known as the inverse Mills ratio. Lambda equals the product of rho (the
correlation between the error terms of the two equations) and sigma (the standard error of the
performance regression). As sigma is positive, if lambda is insignificantly different from zero
26
there is no selection bias in the single equation specification (see Ettner, 2004). Table 7,
Panel B presents Wald tests of whether lambda differs from zero for the system of treatment
effects models. In both cases, lambda is insignificantly different from zero and so estimates
from the single-equation specifications are unbiased.
In effect, controlling for the publicly available control variables in the performance
models and the broker dummy variables, an analysts choice of valuation model does not
depend on additional information available only privately to the analyst.
[Table 7 here.]
5.2. Valuation model choice
Table 8 presents results for equation (1), estimating 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, one-year market
return prior to the publication of the report, and broker dummies. The table first presents
results for the model excluding the broker dummy variables. Consistent with expectation,
profit and peers are negative and significant at 5 percent (0.414, p = 0.024) and 1 percent
(0.031, p = 0.001). These results suggest that analysts use DCF models more frequently to
value loss-making firms and firms with a limited number of industry peers. The coefficient
on ftse_past is negative and significant at 5 percent (0.720, p = 0.026) indicating that
analysts use DCF more frequently than PE models to justify target prices in a bear market. In
contrast to our univariate and descriptive results, risk (2.973, p = 0.604) and boldness (0.704,
p = 0.158) are insignificant. However, the positive correlation between risk and ftse_past
(0.180, p < 0.001) and the negative correlation between boldness and ftse_past (0.233, p <
0.001) suggest that the lower is the one-year market return prior to the reports publication the
higher is the target price boldness and the lower is the stock return volatility (see Table 5).
Thus, ftse_past seems to capture the effect of risk and boldness on valuation model choice.
27
The coefficient on size is negative and significant at 1 percent (0.138, p = 0.001) suggesting
that analysts use DCF models to value small firms. Finally, contrary to expectations, we do
not find a significant growth effect on analyst valuation model choice. As discussed in the
descriptive and univariate analysis section, this may be due to the incidence of firms with
unstable negative growth, which makes it more difficult for an analyst to apply PE models.
Introducing broker dummy variables increases the pseudo-R
2
from 8.34 percent to
12.77 percent. Size, profit, and peers remain strongly significant, while ftse_past is now
insignificant. Consistent with expectations, we find a broker effect on valuation model
choice. Analysts from investment houses broker_2 and broker_3 consistently employ PE
models (0.317, p = 0.095) and DCF models (0.599, p = 0.001).
[Table 8 here.]
5.3. Target price accuracy
Table 9 presents results of estimating equation (2) for the two measures of target price
accuracy as functions of valuation model choice and control variables. The first column of
results, for a simple probit regression of met_in on valmodel, shows that valmodel is
significantly negative (0.363, p = 0.002), indicating that in the absence of controls, PE-based
target prices are achieved more frequently than DCF-based target prices.
[Table 9 here.]
We next control for risk, size, sales growth, target price boldness, recommendation
type, profitability, one-year market return subsequent to the reports publication, and number
of industry peers. In the presence of these variables, valmodel is insignificant (0.150, p =
0.257), showing that, as predicted, while PE models perform better unconditionally, their
relative performance is insignificant conditioning on variables that capture valuation task
difficulty. The intuition is that analysts use PE models when it is easier to reach an
28
investment conclusion without the need for a robust, full-blown analysis and full-information
forecasting but they prefer DCF models in difficult cases.
Boldness is negatively associated with target price performance (3.186, p < 0.001),
showing 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 (0.048, p < 0.001), suggesting that the greater the number of firms in an industry the
easier it is for an analyst to predict an accurate target price. Ftse_forward is positively
associated with met_in (4.020, p < 0.001), showing that the greater the one-year market return
after the reports publication, the more likely it is that the target price is met.
Contrary to prediction, growth is positive and significant at 10 percent (0.034, p =
0.054). This might suggest that analysts find it easier to predict correct target prices for firms
with high growth rates. However, as our descriptive and univariate analysis shows, 21.63
percent of our sample firms have negative sales growth making it more difficult for analysts
to analyze their future prospects. None of the other variables is significant. Including control
variables increase the pseudo-R
2
from 1.52 to 19.13 percent. The results remain qualitatively
unchanged after including the broker dummy variables. None of the broker dummy variables
is significant, suggesting that no investment house exhibits consistently superior target price
performance.
The remaining results in Table 9 are for a corresponding probit analysis of met_end.
In a simple regression valmodel is insignificant (0.013, p = 0.907), showing that in the
absence of control variables the difference between PE and DCF models is insignificant when
considering whether the target price is met on the last day of the forecast horizon. This
finding is consistent with the univariate evidence, where a chi-square test of the difference
between the target price accuracy of PE and DCF is insignificant.
29
The descriptive and univariate analysis shows a stark difference in the relative ability
of PE and DCF models to predict accurate target prices when comparing the two measures of
target price accuracy. The simple probit regression results in Table 9 confirm this. 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.
When we include the control variables in the probit regression for met_end, valmodel
changes sign and becomes positive suggesting a positive association between the use of DCF
models and target price accuracy. However, although the p-value decreases, valmodel
remains insignificant (0.127, p = 0.316). The coefficient on risk is negative and insignificant
(7.892, p = 0.193). As in the probit regression of met_in, boldness is negative and strongly
significant, while peers and ftse_forward are positive and strongly significant. The pseudo-R
2

of 9.59 percent is higher than for the simple probit regression but is substantially lower than
for the equivalent met_in regression. When we include the broker dummies, as for met_in,
none of these variables is significant. Peers, boldness, and ftse_forward remain significant at
1 percent, while risk (9.616, p = 0.112) and size (0.067, p = 0.113) are now marginally
insignificant at 10 percent.
5.4. Forecast error
In Table 10, our interest shifts to measures of forecast error. In a simple regression of
absolute forecast error (abs_err) on valuation model choice, valmodel is significantly positive
(0.071, p = 0.010). This is consistent with the descriptive evidence and suggests that DCF
models lead unconditionally to higher absolute forecast errors.
[Table 10 here.]
Introducing control variables that capture report- and firm-specific effects on absolute
forecast error, the adjusted-R
2
increases from 1.17 percent to 33.96 percent. In the presence
of control variables, valmodel is insignificant (0.001, p = 0.950), as predicted. The
30
coefficient on risk is positive and significant (3.733, 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 difficult for the analyst to correctly forecast the level of stock price
at the horizon itself. Boldness is positive and significant at 1 percent (0.603, p < 0.001).
Recm is significantly negative (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 likely explanation for the result is that given the
change in the performance of the FTSE All-Share Index during our sample period, target
prices that supported negative or neutral recommendations before the change were more
likely to lead to higher forecast errors if a firms stock price moved with the market.
33
None
of the other control variables is significant. Including the broker dummy variables makes
little difference to the results.
The remaining columns of Table 10 report corresponding results for miss_err. In a
simple regression, valmodel is positive but insignificant (0.024, p = 0.342). Including control
variables that capture the effects of report and firm characteristics on miss_err increases the
adjusted-R
2
of the model to 40.34 percent and valmodel changes sign and becomes negative
and significant at 10 percent (0.039, p = 0.080), suggesting that conditioning on control
variables, DCF models outperform PE models. Similar to the abs_err regressions, risk,
boldness, and recm are significant at 1 percent. The only difference is the significance of
peers at 10 percent (0.003, p = 0.065) and ftse_forward at 5 percent (0.444, p = 0.026).
This suggests that valuing a firm with many industry peers generates lower forecast errors. It
also shows that the higher the realized one-year market return after the reports publication,
the lower is the forecast error. Including the broker dummies, valmodel remains negative and
significant at 10 percent (0.040, p = 0.090) and risk, boldness, recm, peers and ftse_forward
31
remain significant. Finally, as in the previous models we find no significant investment house
effect.

6. Concluding remarks
We examine the target price accuracy and forecast error of PE and DCF models using
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 on the absolute forecast
error, suggests that PE models significantly outperform DCF models. However, controlling
for variables that capture the difficulty of the valuation task, the difference in performance of
the two types of model 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_err),
there is no difference in the unconditional performance of PE and DCF models. After
introducing control variables, the performance of DCF models improves substantially and
based on miss_err DCF models perform significantly better than PE models.
Our descriptive and univariate evidence suggests analysts use DCF models
significantly more frequently than PE models to justify bolder target prices and to value high
risk firms, small firms, loss-making firms, firms with extreme negative or positive sales
growth, and firms with a limited number of industry peers. Analysts are also more likely to
use PE models in a bull market and DCF models in a bear market. A multivariate analysis
highlights the importance of size, profitability, number of industry peers, and one-year market
return before the reports publication as determinants of valuation model choice.
32
A limitation of our research methodology is that we accept analyst reports at face
value and assume analysts use the models they present in the text of their reports to make
investment recommendations. We deal with this problem in part by excluding short reports of
only a few pages, focusing instead on comprehensive reports that include a complete
valuation analysis and a clear target price derivation. A second, related limitation is that
analysts may choose not to provide valuation information for very small or risky firms. A
third limitation relates to the main data source we use for equity research reports. Although
Investext is a comprehensive database, some investment brokerage houses do not make their
research publicly available and do not provide reports to Investext.
34

In order to focus on differences between PE and DCF models, we compare the
accuracy and prediction errors of target prices based on either PE or DCF models. An
interesting avenue for further research is the content analysis of reports that combine
alternative valuation models and derive target prices based on averages of the value
estimates.
35
Further insights may emerge from studying the practical implementation of PE
and DCF models. For example, how do analysts define the peer group of the firm when
implementing a PE valuation? 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 a DCF model, are these changes driven by consistent changes in the finite
horizon forecasts or by ad hoc changes to 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 models in recent years is
associated with an increase in the authority and credibility of sell-side equity analysts (a
rational explanation) or with their willingness to appear authoritative and credible by
33
implementing a model that gives them levers to reverse-engineer a subjective intuition or
judgment about the firm and its management (a quasi-behavioral explanation).
Research on the properties of target prices is still at an exploratory stage. It would be
interesting to assess the profitability of investment strategies based on target-price-to-current-
price ratios conditional on the valuation model used to justify the target price. It would also
be interesting to use analyst forecasts or ex-post financial statement data to investigate
whether the valuation model that generates a pseudo-target price closest to the reports 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 (e.g. Starmine) or on
surveys of institutional investors and fund managers (e.g. Institutional Investor). Since target
prices are one of the three easily verifiable outputs of sell-side equity research and the target-
price-to-current-price ratio is a measure of the forecast 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
houses include clear summary statements in the disclosure notes at the end of their reports
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 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 analyst reports
automatically disclosed this information, large-scale databases and investor-related websites
could 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 analyst valuation practices.
34

Table 1. Summary statistics for the sample 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 in Investext in August 2005; the number (%) of valuation reports
greater than 10 pages in length in Investext in August 2005; the number (%) of reports in our sample; the number of firms analyzed; the number of firms in each sector in the
FTSE All-Share Index in August 2005; the % of these FTSE All-Share constituents included in the study; the total number of report pages analyzed in the 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.

Sector
Documents
in Investext
Equity Research
Reports with page
length > 10 pages in
Investext %
Equity
Research
Reports in
Sample %
Firms in
Sample
Firms in
FTSE All-
Share
Index %
Total
Number
of Pages
Mean
Value of
Pages per
Report
Number of
Brokerage
Houses
Reports/
Brokerage
House
Reports
/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
4
Food & Drug
Retailers
617 101 16.37 44 43.56 5 7 71.43 961 21.84 13 3.38 8.80
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



35
Table 2. Definitions of variables

Variable Definition / measurement
abs_err 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.
boldness A variable that measures the boldness of the target price and is equal to the absolute
difference between the target price and the current price scaled by the current price.
broker_ j A variable that takes the value one if the report is written by an analyst from investment
brokerage house j, or zero otherwise.
ftse_past A variable that equals the percentage change in the FTSE AllShare total return index
over a period of one year immediately before the publication of the report.
ftse_forward A variable that equals the percentage change in the FTSE AllShare total return index
over a period of one year immediately after the publication of the report.
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.
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 and the value zero otherwise. 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_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.
miss_err 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.
peers A variable that equals the number of the sampled firms in each industry.
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.
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).
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 1/7/200231/6/2003, or from
1/7/2001 to 31/6/2003 if the report is published in the period 1/7/200331/6/2004.
signed_ boldness A variable that measures the (signed) boldness of the target price and is equal to the
difference between the target price and the current price scaled by the current price.
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 1/7/200231/6/2003, or on 1/7/2003 if the
report is published in the period 1/7/200331/6/2004.
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.


36
Table 3. Frequency of use of DCF (PE) models across sample firms
The table reports the frequency with which analysts employ DCF models for each of 94 sample firms. The
frequency of use of PE models is the complement of the frequency of use of DCF models. The table reports the
company sample number, the (unofficial) company name, the number of analyst reports, the number of reports
employing DCF models, and the frequency of DCF model choice as a percentage of the total number of reports
for the firm.

# Firm Obs DCF % # Firm Obs DCF % # Firm Obs DCF %
1 Ass. British Foods 1 1 100 33 Domnick Hunter 1 0 0 65 RM 2 0 0
2 Abacus 1 0 0 34 Enodis 6 6 100 66 Royalblue 2 1 50
3 Acambis 4 4 100 35 First Technology 4 0 0 67 SABMiller 20 14 70
4 Aga Foodservice 2 2 100 36 FKI 6 5 83 68 SAGE 13 13 100
5 Alizyme 1 1 100 37 GlaxoSmithKline 22 3 14 69 Sainsburys 15 4 27
6 Alliance UniChem 5 2 40 38 Greggs 1 1 100 70 Scottish & Newcastle 19 11 58
7 Allied Domecq 13 9 69 39 Halma 3 3 100 71 Shire Pharmaceuticals 13 7 54
8 Anite 2 0 0 40 Hanson 14 7 50 72 SIG 3 2 67
9 ARM Holdings 15 6 40 41 ICM 1 0 0 73 SkyePharma 9 5 56
10 AstraZeneca 35 5 14 42 IMI 5 3 60 74 Somerfield 4 0 0
11 Autonomy 3 0 0 43 Innovation 1 0 0 75 Spectris 4 4 100
12 AVEVA 2 0 0 44 Invensys 9 3 33 76 Spirax Sarco 4 4 100
13 Balfour Beatty 2 0 0 45 iSOFT 2 0 0 77 Spirent 5 2 40
14 Barratt Developments 2 0 0 46 Kier Group 2 0 0 78 SurfControl 2 1 50
15 Bellway 1 0 0 47 LogicaCMG 13 7 54 79 Sygen 1 0 0
16 Berkeley 1 0 0 48 Marconi 8 8 100 80 Tate & Lyle 3 2 67
17 Bodycote 5 2 40 49 Marshalls 1 0 0 81 Taylor Woodrow 1 0 0
18 Bovis Homes 3 0 0 50 McAlpine 1 0 0 82 Tesco 16 6 38
19 BPB 5 0 0 51 McCarthy 2 0 0 83 Tomkins 6 4 67
20 BSS 1 0 0 52 MISYS 9 3 33 84 Travis Perkins 2 1 50
21 Cadbury 11 6 55 53 Morgan Crucible 3 3 100 85 Ultraframe 2 2 100
22 CAT 12 12 100 54 Morrisons 8 2 25 86 Unilever 8 4 50
23 Charter 1 0 0 55 Morse 1 0 0 87 Vitec 2 0 0
24 Chloride 1 1 100 56 Mowlem 1 0 0 88 Weir 3 1 33
25 Computacenter 4 2 50 57 Northern Foods 5 4 80 89 Westbury 1 0 0
26 Cookson 6 6 100 58 Northgate 1 1 100 90 Wilson Bowden 2 0 0
27 CSR 1 0 0 59 Persimmon 3 0 0 91 Wimpey 2 0 0
28 Dairy Crest 4 3 75 60 Pilkington 3 0 0 92 Wolfson 2 0 0
29 Detica 1 1 100 61 Protherics 2 2 100 93 Wolseley 12 5 42
30 Diageo 14 10 71 62 Psion 2 1 50 94 Xansa 4 0 0
31 Dimension Data 5 3 60 63 Redrow 2 0 0
32 Domino 1 0 0 64 Renishaw 1 0 0 Totals 490 231 47
37
Table 4. Sample period
The table reports the frequency with which analysts employ PE or DCF as their preferred valuation model in their reports and the corresponding target price accuracy and
forecast error measures across two sample periods. It also reports median values of ftse_past (the past year return of the FTSE AllShare Index), ftse_forward (the forward
year return of the FTSE AllShare Index), boldness (target price absolute boldness) and signed_boldness (target price signed boldness). See Table 2 for variable definitions.

Panel A: 1st Sample period (1/7/200230/6/2003): FTSE AllShare Total Return Index change = 10.21%
Reports % ftse_past ftse_forward boldness signed_boldness met_in met_end abs_err miss_err
PE 112 47.06 20.70% 14.73% 13.53% 11.19% 70.54% 41.07% 17.45% 6.47%
DCF 126 52.94 21.86% 15.23% 23.20% 23.01% 53.17% 37.30% 24.38% 12.05%

Panel B: 2nd Sample period (1/7/200330/6/2004): FTSE AllShare Total Return Index change = 18.69%
Reports % ftse_past ftse_forward boldness signed_boldness met_in met_end abs_err miss_err
PE 147 58.33 14.86% 12.71% 12.73% 9.64% 69.39% 36.73% 16.90% 9.46%
DCF 105 41.67 15.29% 13.11% 12.90% 9.45% 60.00% 39.05% 17.15% 8.04%
38
Table 5. Descriptive statistics
The table reports the frequency with which analysts employ PE or DCF as their preferred valuation model in
their reports, and the corresponding target price accuracy and forecast error for the top and bottom quartiles of
boldness (Panel B), signed boldness (Panel C), risk (Panel D), size (Panel E), and growth (Panel F), for firms
with different profitability status (Panel G) and for reports with different recommendation type (Panel H). Panel
A presents the overall results for all the sampled reports. Columns give: the median value of the control
variables (boldness, signed_boldness, risk, size, and growth); the number of reports (No.) that use PE or DCF as
dominant valuation model; the % of reports in each quartile/category that employ PE or DCF as dominant
valuation model; 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_err); and the mean value of the forecast error for
the missed target prices (miss_err). The table also reports the results of chi-square tests and t-tests. In Panel A
these are for the performance of PE v. DCF; in Panels BH under Valuation model use, the chi-square test is for
the difference in valuation model use (PE or DCF) between the top and bottom quartiles of the control variables
or between firms (reports) with different profitability (recommendation) status, while in the remaining columns
of Panels BH the tests are for differences in the target price accuracy and forecast error of PE and DCF models
across the top and bottom quartiles of the control variables or across firms (reports) with different profitability
(recommendation) status. These significance results are indicated against PE in Panel A, centered against
PE/DCF in Panels BH under Valuation model use, and against the first PE and DCF rows in the remaining
cases. */**/*** indicates significance at the 0.10/0.05/0.01 level. N/S indicates an insignificant difference. See
Table 2 for variable definitions.

Valuation model use Target price accuracy measures Forecast error measures
Median No. %
2
diff

met_in
2
diff

met_end
2
diff

abs_err
diff
t
miss_err
diff
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 31.42% 48 39.02 43.75% *** 20.83% *** 40.97% *** 35.19% ***
DCF 46.67% 75 60.98
***
34.67% *** 24.00% *** 47.18% *** 35.97% ***
Bottom quartile
PE 3.64% 76 61.79 85.53% 46.05% 18.42% 11.34%
DCF 3.60% 47 38.21 80.85% 57.45% 26.19% 11.15%
Panel C. Signed boldness
Top quartile
PE 30.61% 49 39.84 38.78% *** 20.41% N/S 41.02% *** 34.57% **
DCF 46.19% 74 60.16
***
35.14% *** 27.03% N/S 45.94% *** 33.94% ***
Bottom quartile
PE 6.58% 72 58.54 79.17% 30.56% 23.15% 19.35%
DCF 8.09% 51 41.46 58.82% 21.57% 25.39% 20.61%
Panel D. Risk
Top quartile
PE 4.55% 52 42.28 65.38% N/S 25.00% *** 42.40% *** 34.87% ***
DCF 4.30% 71 57.72
***
54.93% N/S 36.62% N/S 45.84% *** 27.31% **
Bottom quartile
PE 1.69% 72 58.54 76.39% 48.61% 14.34% 9.30%
DCF 1.68% 51 41.46 45.10% 23.53% 21.38% 18.47%
Panel E. Size
Top quartile
PE 40546 85 69.11 69.41% * 37.65% N/S 14.65% *** 11.04% ***
DCF 17760 38 30.89
***
36.84% * 10.53% *** 21.41% *** 20.53% *
Bottom quartile
PE 207 54 43.90 53.70% 25.93% 33.09% 27.58%
DCF 315 69 56.10 53.62% 36.23% 39.83% 27.29%


39
Table 5. Descriptive analysis (cont.)


Valuation model use Target price accuracy measures Forecast error measures
Median No. %
2
diff

met_in
2
diff

met_end
2
diff

abs_err
diff
t
miss_err
diff
t
Panel F. Growth


Top quartile


PE 40.82% 62 50.41 77.42% ** 40.32% N/S 39.74% *** 29.44% *
DCF 37.64% 61 49.59
N/S
60.66% * 45.90% *** 42.37% * 26.39% N/S
Bottom quartile
PE 6.22% 57 46.34 59.65% 31.58% 24.36% 19.03%
DCF 12.60% 66 53.66 45.45% 24.24% 31.99% 20.89%
Panel G. 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 H. Recommendation
Positive


PE

123 50.00 59.35% *** 38.21% N/S 25.63% N/S 19.29% N/S
DCF

123 50.00
N/S
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%
40
Table 6. Pearson correlations
The table reports the Pearson correlation matrix for the variables: valmodel (valuation model choice), met_in (first measure of target price accuracy), met_end (second
measure of target price accuracy), abs_err (absolute forecast error), miss_err (forecast error for missed target prices), risk (standard deviation of daily stock returns), size
(natural logarithm of firms market capitalization), boldness (target price boldness), recm (type of recommendation), growth (sales growth rate), profit (profitability), peers
(number of industry peers), ftse_past (past year return of FTSE AllShare Index), and ftse_forward (forward year return of FTSE AllShare Index). See Table 2 for variable
definitions. */**/*** indicate significance at the 0.10/0.05/0.01 level.

valmodel met_in met_end abs_err miss_err risk size boldness recm growth profit peers ftse_past
met_in 0.141***

met_end 0.005 0.590***

abs_err 0.117*** 0.239*** 0.126***

miss_err 0.043 0.490*** 0.527*** 0.737***

risk 0.125*** 0.045 0.085* 0.309*** 0.257***

size 0.163*** 0.037 0.009 0.228*** 0.168*** 0.524*

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

recm 0.058 0.205*** 0.054 0.102** 0.101** 0.078 0.010 0.414***

growth 0.045 0.054 0.032 0.270*** 0.298*** 0.062 0.064 0.200*** 0.052

profit 0.196*** 0.085* 0.060 0.300*** 0.245*** 0.567*** 0.353*** 0.234*** 0.013 0.071

peers 0.125*** 0.183*** 0.136*** 0.018 0.053 0.052 0.329*** 0.000 0.024 0.046 0.061

ftse_past 0.120*** 0.013 0.005 0.205*** 0.144*** 0.180*** 0.175*** 0.233*** 0.071 0.035 0.072 0.168***
ftse_forward 0.093** 0.156*** 0.178*** 0.045 0.118*** 0.020 0.013 0.065 0.046 0.111** 0.036 0.054 0.206***

41
Table 7. 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 choice equation (1), including broker dummy variables and the
performance equation (2), excluding broker dummies. Panel A reports Wald tests of whether rho, estimating the
correlation between the error terms of the choice and performance equations, differs from zero. If rho is
insignificantly different from zero there is no selection bias and we can rely on estimates of the single-equation
models. If the outcome variable is continuous (abs_err or miss_err) we use a treatment effects approach to
estimate the choice equation (1), including broker dummy variables, and the performance equation (2), excluding
broker dummies. Panel B reports Wald tests of whether lambda, which is the product of rho (the correlation
between the error terms of the two equations) and sigma (the standard error of the outcome equation), differs
from zero. If the hazard variable lambda is insignificantly different from zero there is no selection bias and we
can rely on the estimates of the single-equation models.

Panel A: Seemingly unrelated bivariate probit models
Wald test: rho = 0 met_in met_end
Value of rho
0.815 0.199
Chi-square
0.321 0.150
p-value 0.571 0.698

Panel B: Treatment effects models (two-step estimation)
Wald test: lambda = 0
abs_err miss_err
Value of hazard lambda
0.040 0.044
Chi-square 0.53 0.83
p-value 0.466 0.362
























42
Table 8. Valuation model choice probit models

The table reports the results of probit regressions of valmodel (valuation model choice) on a series of variables
including risk, size, boldness, recm, growth, profit, peers, ftse_past and broker dummy variables; the variables
risk, boldness, growth and ftse_past are decimal numbers (not percentages). The sample consists of 490 reports
(observations) published in the period 01/07/200230/06/2004 for 94 UK listed firms. The table reports
estimates of maximum-likelihood probit regressions in the form of equation (1). Two-tailed probability values
(in italics) are calculated based on robust Huber/White standard errors. See Table 2 for variable definitions and
Section 3.2 for a discussion of predicted signs.

Valmodel valmodel
Independent variable Predicted sign
Coefficient p-value Coefficient p-value
risk
+
2.973 0.604 3.796 0.522
size 0.138 0.001 0.108 0.009
boldness
+
0.704 0.158 0.593 0.216
recm
?
0.003 0.984 0.038 0.795
growth
+
0.117 0.568 0.072 0.258
profit 0.414 0.024 0.471 0.013
peers 0.031 0.001 0.024 0.019
ftse_past 0.720 0.026 0.413 0.214
broker_1

0.079 0.753
broker_2

0.317 0.095
broker_3

0.599 0.001
broker_4

0.310 0.183
broker_5

0.059 0.810
broker_6

0.119 0.678
Intercept

1.604 0.001 1.316 0.012



Number of obs.

490 490
Wald chi-squared

52.84 51.38
p-value

0.000 0.000
Pseudo Rsquared

8.34% 12.77%











43
Table 9. Target price accuracy probit models

The table reports the results of probit regressions of met_in and met_end on valmodel (valuation model choice), control variables, and broker dummy variables; the
variables risk, boldness, growth, and ftse_forward are decimal numbers (not percentages). The sample consists of 490 reports (observations) published in the period
01/07/200230/06/2004 for 94 UK listed firms. Two-tailed probability values (in italics) are based on robust Huber/White standard errors. The table reports estimates of
maximum-likelihood probit regressions in the form of equation (2). See Table 2 for variable definitions and Section 3.2 for discussion of predicted signs. The expectation
on the sign of valmodel changes from negative to positive when we introduce control variables.

met_in met_in met_in met_end met_end met_end
Independent variable
Predicted
sign
Coefficient p-value Coefficient p-value Coefficient p-value Coefficient p-value Coefficient p-value Coefficient p-value
valmodel
/ +
0.363 0.002 0.150 0.257 0.203 0.137 0.013 0.907 0.127 0.316 0.126 0.336
risk
+
2.837 0.645 2.251 0.722 7.892 0.193 9.616 0.112
size
+
0.024 0.596 0.027 0.566 0.040 0.319 0.067 0.113
boldness

3.186 0.000 3.295 0.000 2.274 0.000 2.387 0.000
recm
?
0.081 0.575 0.061 0.684 0.168 0.230 0.191 0.193
growth

0.034 0.054 0.033 0.056 0.026 0.133 0.026 0.145
profit
+
0.035 0.855 0.044 0.823 0.056 0.771 0.029 0.882
peers
+
0.048 0.000 0.050 0.000 0.028 0.003 0.029 0.004
ftse_forward + 4.020 0.000 4.003 0.000 3.573 0.000 3.554 0.000
broker_1

0.261 0.294 0.149 0.545
broker_2

0.242 0.227 0.199 0.306
broker_3

0.028 0.892 0.027 0.887
broker_4

0.288 0.254 0.120 0.614
broker_5

0.170 0.500 0.283 0.261
broker_6

0.166 0.576 0.349 0.249
Intercept

0.521 0.000 0.226 0.690 0.087 0.885 0.289 0.000 0.299 0.569 0.062 0.909
Number of obs.

490 490 490 490 490 490
Wald chi-squared

9.7 100.56 102.55 0.01 53.98 59.83
p-value

0.002 0.000 0.000 0.907 0.000 0.000
Pseudo R-squared

1.52% 19.13% 19.71% 0.00% 9.59% 10.61%



44
Table 10. Forecast error OLS models

The table reports the results of linear regressions of abs_err (absolute forecast error) and miss_err (forecast error for missed target prices) on valmodel, control variables, and
broker dummy variables; the variables abs_err, miss_err, risk, boldness, growth, and ftse_forward are decimal numbers (not percentages). The sample consists of 490 reports
published in the period 01/07/200230/06/2004 for 94 UK listed firms. The table reports estimates of linear regressions based on equation (2). Two-tailed probability values
(in italics) are calculated based on robust Huber/White standard errors. See Table 2 for variable definitions and Section 3.2 for a discussion of predicted signs. The
expectation on the sign of valmodel changes from positive to negative when we introduce control variables.

abs_err abs_err abs_err miss_err miss_err miss_err
Independent vriable
Predicted
sign
Coefficient p-value Coefficient p-value Coefficient p-value Coefficient p-value Coefficient p-value Coefficient p-value
valmodel
+ /
0.071 0.010 0.001 0.950 0.000 0.996 0.024 0.342 0.039 0.080 0.040 0.090
risk
+
3.733 0.004 3.513 0.007 2.939 0.008 2.925 0.008
size

0.002 0.779 0.006 0.397 0.003 0.584 0.004 0.587
boldness
+
0.603 0.000 0.597 0.000 0.694 0.000 0.691 0.000
recm
?
0.053 0.021 0.056 0.018 0.070 0.001 0.073 0.001
growth
+
0.022 0.875 0.022 0.871 0.020 0.779 0.020 0.770
profit

0.059 0.234 0.054 0.272 0.029 0.499 0.026 0.526
peers

0.002 0.397 0.002 0.409 0.003 0.065 0.003 0.079
ftse_forward 0.139 0.518 0.148 0.499 0.444 0.026 0.439 0.032
broker_1

0.006 0.869 0.012 0.714
broker_2

0.038 0.266 0.018 0.534
broker_3

0.027 0.529 0.010 0.790
broker_4

0.013 0.704 0.026 0.423
broker_5

0.043 0.471 0.022 0.709
broker_6

0.042 0.658 0.054 0.151
Intercept

0.242 0.000 0.130 0.162 0.174 0.081 0.177 0.000 0.109 0.166 0.117 0.162
Number of obs.

490 490 490 490 490 490
F-value

6.63 39.81 9.07 0.91 17.27 10.53
p-value

0.010 0.000 0.000 0.342 0.000 0.000
Adjusted R-squared

1.17% 33.96% 33.86% 0.02% 40.34% 39.96%



45
Figure 1. Frequency of use of DCF models for individual stocks
The figure displays the frequency of firms with alternative percentage use of DCF models (for
71 sample firms with at least two reports).
0
5
10
15
20
25
10% 30% 50% 70% 90%
% of reports empl oyi ng DCF model s
N
u
m
b
e
r

o
f

f
i
r
m
s

46
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49
Footnotes

1
Gleason, Johnson, and Li (2007, footnote 19) express a similar view.
2
For a comprehensive literature review see Ramnath, Rock, and Shane (2006).
3
Green (2006) states that institutional investors pay significant amounts to obtain real time access to brokerage
firm research through providers, such as First Call. He finds that early access to stock recommendations
provides brokerage firm clients with incremental investment value. Barker (2001) suggests that analyst reports
influence fund manager behavior, while Imam, Barker and Clubb (2008) provide evidence that the need for
analysts research to be credible to fund managers influences their valuation model choices.
4
Viebig, Poddig, and Varmaz (2008) assemble a collection of chapters written by investment bankers on the
equity valuation models they use in practice, including proprietary and sophisticated DCF models.
5
Comparing the determinants of valuation model choice by sell-side analysts and underwriters requires care due
to differences in the motives of the two groups. Underwriters are justifying an offer price to achieve a successful
IPO, while sell-side analysts are typically supporting a buy recommendation for a stock. Deloof et al. (2009) cite
differences in the quality and objectives of IPO prospectuses and equity research papers among the factors that
explain potential differences in the results of IPO and equity research studies.
6
Bonini, Zanneti, Biachini, and Salvi (2008) reach a similar conclusion when analyzing equity research reports
for Italian listed firms published during 20002005.
7
In some cases, the analyst publishes another report, with a target price in GBP on the same day or in the
following days, which we include in the sample. The majority of the excluded reports are for pharmaceutical
firms (e.g. AstraZeneca, GlaxoSmithKline).
8
We use the current price to calculate boldness (defined below) and the two measures of forecast error.
9
Typical statements are "DCF-based target price", "DCF-driven target price", "our preferred valuation
methodology is ", "we set our target price based on ".
10
We also include reports that use these terminologies interchangeably.
11
For example, the average report length for the study of Asquith et al. (2005) is 6.3 pages.
12
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 firms adjusted stock price to its unadjusted stock price on the date
of the reports 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 stock prices to
estimate the range. Data on stock prices are from Datastream.
13
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).
14
Risk equals the standard deviation of daily stock returns from 1/7/2000 to 30/6/2002 for reports published in
the period 1/7/2002 to 30/6/2003, or from 1/7/2001 to 30/6/2003 for reports published in the period 1/7/2003 to
30/6/2004.
15
However, contrary to expectation they find that target prices are more difficult to meet for firms with higher
price volatility. They argue that this result is due to the high correlation between price volatility and TP/CP.
16
Data on market values (Datatype: MV) are from Datastream.
17
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.
18
In the analyst earnings forecast literature, a typical definition is that a forecast is bold if it is above both the
analysts previous forecast and the consensus forecast, or below both (e.g. Clement and Tse, 2005). Our
definition of target price boldness bears a closer relation to measures in the target price literature based on the
ratio of target price to current stock price (TP/CP). Bradshaw and Brown (2006) condition much of their
analysis on this variable. Bonini et al. (2008) refer to TP/CP 1 as the implicit return.
19
However, we expect target prices that support neutral recommendations to be 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.
20
To estimate sales growth rates, we use data on sales from Worldscope (Net Sales or Revenues: WC01001).
21
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.
22
From a theoretical perspective there should exist a sufficiently low discount rate to give an identical DCF
valuation to a PE-based valuation based on bullish multiples. The discussion in the text reflects the practical
reality of how analysts implement these valuation models. The evidence from the interviews of Glaum and
50

Friedrich (2006) is consistent with the contextual factors that Imam et al. (2008) report as motivating analysts
valuation model choice.
23
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).
24
Possible explanations for the difference between our study and Bradshaw (2002) and Asquith et al. (2005)
include differences in the length of the sample equity research reports, differences in the sample period (Glaum
and Friedrich, 2006), institutional differences in the equity research output between the City of London and Wall
Street (Breton and Taffler, 2001), and the fact that we required attribution of valuation model choice in the
reports.
25
The proportion of loss-making firms is higher among firms with negative growth: 46.22 (13.54) percent of the
sample reports of negative (positive) growth firms. Hence, this difference in valuation model choice might also
be due to profitability differences between the top and bottom growth quartiles.
26
In Asquith et al. (2005) the proportion of neutral/negative recommendations is 29.2 percent.
27
Similarly, in Gleason et al. (2007), TP/CP increases from 1.24 to 1.40 in the period 19972000 and declines to
1.26 in 2003.
28
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.
29
In our sample, 22.24 percent of the reports have a target price below the current price compared to only 8.3
percent in Gleason et al. (2007) and 2.7 percent in Asquith et al. (2005). In particular, our sample contains 109
reports with a target price below the current price (48 reports with neutral recommendations, 60 reports with
negative recommendations and one report with a positive recommendation).
30
This might indicate that DCF models better capture a firms long-term value, while PE-based target prices
focus on the short-term and fail to fully impound information about future performance. Subsequent sections
provide a more in-depth analysis of the dynamics of target price setting and performance.
31
See also footnote 19.
32
See Edwards (2004) for an application of this treatment effects framework.
33
Note that boldness controls for the effect of optimistic target prices that are likely to support positive
recommendations. Table 6 shows that boldness and recm have a 0.414 correlation.
34
The data collection for this study took place in August 2005. Investext changes its collection of equity
research reports based on collaborations with investment banks.
35
We are grateful to an anonymous reviewer for suggesting an analysis of the accuracy and prediction errors of
target prices derived from a mixture of valuation models.