Advance Questions

Information content of equity analyst reports
Required reading: Page 245-259, 276-281

The following questions would help you read through this paper and prepare for the discussion of this paper in class. 1. How does a typical analyst report look like? What are the major signals that you can use / construct for trading purpose?

Analyst report: is the culmination of a process that includes the collection, evaluation, and dissemination of information related to a firm’s future performance. * The majority of analyst report includes 3 key measures: * 1) earnings forecast * 2) stock recommendation (buy/sell/hold) * 5 Distinct Recommendations: strong buy, buy, hold, sell, strong sell (For each recommendation, assess whether to upgrade, iterate or downgrade) * 3) price target * These reports frequently present extensive quantitative and qualitative analysis supporting the summary measures. (R2, regression, etc)

When we read analyst reports, we have to be suspicious, since their analysis differ and might have access to only popular information.

2. How to measure the accuracy of price targets? Can you construct other measures of your own?

We consider a price target prediction to be accurate if the analyzed firm’s stock price equals or exceeds the 12-month projected price at any time during the year following the release of the report.

Construction of other measures: you can take the average of the 12 month and see the difference with the target price.

3. How to quantify the justifications for an analyst’s opinion about the underlying firm?

Table 1, Panel B: positive and negative remarks recorded for 14 different criteria (revenue growth, earnings growth, new product introductions, new projects, cost efficiencies, expectations met, mergers and acquisitions, repurchase programs, industry climate, management, international operations, leverage, competition, and risk).

Construct a “strength-of-arguments” variable (STR_ARG), which aggregates the number of positive remarks less the number of negative remarks from Table 1, Panel B. (Positive comments are given a value of +1, while negative ones are given -1).

Variables EARN_REV (% change in the analyst’s projected earnings forecast for a firm), and STR_ARG are highly and positively correlated. This suggests positive earnings forecast revisions are generally supported by more optimistic analyst statements.

4. How to measure the market’s reaction to the release of analyst reports?

We measure it with Five-day Market-adjusted Cumulative Abnormal Return (CAR) centered on the report release date. (-2 days, +2 days)

TGT_REV (% change in the analyst’s projected price target), and STR_ARG are highly and positively correlated. This suggests market unconditionally reacts more to the analyst’s qualitative arguments than to the actual earnings.

5. How to distinguish whether analyst report provides new information to the market or whether it merely reiterates or interprets information previously released?

We identify any simultaneous release of information concerning earnings, dividend changes, stock splits, changes in business expectations, equity issues, debt issues, mergers and divestitures, major management changes, credit rating changes, lawsuits, and significant new contracts and/or product introductions.

6. What are the major valuation models used by analysts? Does the valuation model matter for forecast accuracy?

Most analysts use simple earnings multiple valuation model. There is no correlation between the valuation methodology or to their forecast accuracy. Most methodologies fall in three categories:

* 1) 99.1% of analyst reports use earnings multiple. * Ex: PE Ratio, Relative PE Ratio, Earnings before Interest, Tax, depreciation, EBITDA multiples * 2) 12.8% of analyst reports use any variation of discounted cash flow to compute price targets. * 3) 25.1% of analyst reports use asset multiple.

7. How does this paper differ from previous literature? What’s its major contribution?

This paper differs from other work, such as Brav and Lehavy (2003) and Bradshaw (2002), in that: * We examine the complete text of a large sample of actual analyst reports and our analysis provides information beyond earnings forecasts, recommendations, and price targets. Our R2 of nearly 26% is three or four times larger than that of other studies that use only partial content from analyst reports. * We demonstrate other information, such as the strength of the analyst’s justifications, is also important and when incorporated in our analysis reduces, and in some models eliminates, the significance of the information available in earnings forecasts and recommendation revisions. * This report says the target price, and content (justification) is important and the way the market responds to the report.

Its major contributions are: * We show analyst reports do not merely repeat other corporate releases of information but also provide new and independent analysis to the market. * We demonstrate information in reports is more important for downgrades than for upgrades. * We show only elements that matter for reiterations are target prices and the strength of accompanying arguments.