Inside the "Black Box" of Sell-Side Financial Analysts
By Michael Clement
The activities of sell-side security analysts are frequently studied in accounting research. Sell-side financial analysts (hereafter “analysts”) interest academic researchers and investors because of their prominent role in capital markets as sophisticated interpreters and disseminators of financial information. Much of the early accounting research on analysts focused on building better expectations models or the statistical properties of earnings forecasts. Later research of analysts’ reports focused on the investment value of their stock recommendations and earnings forecasts. Despite the vast resources devoted to the study of analyst activities, little is known about analysts’ incentives or what inputs analysts use to make their judgments.
This study uses survey data to investigate the inputs sell-side financial analysts use in their decisions and the incentives that motivate these decisions. We distributed surveys to 3,341 analysts, asking 23 questions covering a wide range of topics including:
- the frequency and usefulness of analyst communication with management,
- the factors that affect analysts’ compensation,
- the consequences of issuing unfavorable earnings forecasts and stock recommendations,
- the relative importance of various inputs to their forecasts and recommendations,
- the types of valuation models they use to support their recommendations,
- the nature of the items they exclude from forecasts of “street” earnings,
- their beliefs about what constitutes high-quality earnings, and
- their perception of what constitutes “red flags” of financial misrepresentation.
We obtained completed surveys from 365 sell-side analysts and conducted follow-up interviews with 18 of these analysts to further our understanding of the factors influencing analysts’ research decisions. Some of the more interesting responses were:
- Analysts reported that private phone calls are their most useful type of direct contact with management for the purposes of generating both their earnings forecasts and their stock recommendations, even more useful than earnings conference calls. More than half of the analysts reported that they have direct contact with the CEO or CFO of the companies they follow five or more times a year.
- Analysts responded that industry knowledge is the most important determinant of their compensation and the most important input into both their earnings forecasts and their stock recommendations.
- Analysts stated that accurate earnings forecasts and profitable stock recommendations have relatively little direct impact on their compensation.
- Analysts said broker votes are far less important to their career advancement than the results of several popular surveys including the Institutional Investor Magazine All-America Team rankings.
- Analysts respond that the most likely consequence of issuing earnings forecasts or stock recommendations well below the consensus is an increase in their credibility with their clients.
- Analysts indicated that they use P/E and PEG valuation models rather than more sophisticated valuation models, such as residual income models.
To our knowledge this survey is the first of its type and we believe the results of the study are beneficial to academic researchers, investors, and analysts.
Michael Clement, KPMG Faculty Fellow in Accounting Education and Professor of Accounting, received his B.B.A. from Baruch College, his M.B.A. from the University of Chicago, and his Ph.D. from Stanford University. His research and teaching interests include financial accounting and capital markets.
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