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Financial Analysts Journal

ISSN: 0015-198X (Print) 1938-3312 (Online) Journal homepage: https://www.tandfonline.com/loi/ufaj20

The Process: The Analysts’ View

Lal C. Chugh & Joseph W. Meador

To cite this article: Lal C. Chugh & Joseph W. Meador (1984) The Process: The Analysts’ View, Financial Analysts Journal, 40:6, 41-48, DOI: 10.2469/faj.v40.n6.41 To link to this article: https://doi.org/10.2469/faj.v40.n6.41

Published online: 31 Dec 2018.

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Full Terms & Conditions of access and use can be found at https://www.tandfonline.com/action/journalInformation?journalCode=ufaj20 by LalC. Chughand JosephW. Meador

The Stock Valuation Process: The Analysts' View

How do analysts evaluatecommon ? A survey of 2,000 membersof the Financial Analysts Federationindicates that analystsconsistently emphasize the termover the term. Expectedchanges in EPS, expectedreturn on , and prospectsfor the relevantindustry were considered the most important variables over the long term;industry prospects,expected changes in EPS and generaleconomic conditions were given greatest weightover the short term. Analysts lookto qualitativefactors such as qualityand depth of management,market dominance and strategiccredibility (ability to achievestated goals) to validatequantitative financial and economicvariables. The majorityof analystssurveyed also felt that corporatestrategic plans and planning systemsare of great importancein the stockvaluation process, but that the informationon strategicplans and planningprovided by managementis of generallylow quality.Analysts view managementpresentations as boththe mediumfor assessingthe qualityand depthof managementand the sourceof informationregarding management's plans.

"The money managers'power acts as a Damoclean a the relative importanceof the specific finan- sword over companies today, forcing chief execu- cial factors used in the determination of tives to keep earnings on a consistently upward stock values; track, quarterby quarter, even if it means frustrat- * the relevance of a company's long-term ing their long-range plans. And because the low strategic plans and strategic planning sys- value assigned to their stocks closes equity markets tems to stock valuation; and to most companies, managements are borrowing more to operate their ." * the quality of informationprovided by com- -"Will Money Managers Wreck the Economy?" panies. BusinessWeek, August 13, 1984, p. 86. H tAS A FRENZIEDsearch by Method for short-term gains distorted manage- We developed, in cooperation with the officers ments' view of their stewardship func- of the Boston Analysts Society, Inc., a tion? The long-term implications for optimal comprehensive stock valuation questionnaire. allocation of resources, industrial performance This was sent to 1,000 members of the Boston and economic growth are extremely serious, SecurityAnalysts Society, Inc. and to 1,000 U.S. especially in view of the increasingly competi- members of the Financial Analysts Federation tive international marketplace within which outside the Boston Society.' U.S. firms now operate. The questionnaire had four sections. The first Theories of stock valuation abound, but hard asked the analyst to rank various economic and evidence on how analysts view performance is financialfactors in terms of their importancefor relatively scarce. We went to the source-secu- stock valuation in the next quarter and in the rity analysts themselves-to find out: next five years. The second section, vari- * the relative importance in the stock valua- 1. Footnotes appear at end of article. tion process of short-term versus long-term Lal Chugh and JosephMeador are Associate Professors of economic, industrial and financial variables; Finance at Northeastern University.

FINANCIAL ANALYSTS JOURNAL / NOVEMBER-DECEMBER1984 0 41

The CFA Institute is collaborating with JSTOR to digitize, preserve, and extend access to Financial Analysts Journal ® www.jstor.org Table I ImportanceAttached by Analysts to VariablesOver Short Term and Long Term*

PercentageDistribution of Responses In the Over the Variable Next Quarter Next 5 Years 1 2 3 1 2 3 GeneralEconomic Conditions 18 43 39 10 35 55 Prospectsof the Relevant Industry 17 36 47 8 19 73 ExpectedChange in EPS 20 41 39 7 17 76 ExpectedChange in Payment 31 44 25 13 48 39 ExpectedReturn on 31 44 25 8 31 61 ExpectedReturn on Equity 26 41 33 7 20 73 Gross 23 55 22 9 44 47 ExpectedRate of Sales Growth 27 53 20 8 37 55 TurnoverRatio 42 50 8 18 56 26

* 1 = little importance; 2 = moderate importance; 3 = great importance.

ous indicatorsof long-term strategicplans being expected change in dividend payment and asset implemented by a company, was designed to turnover ratio were thought to be of "'great validate the consistency of responses to the importance" by the largest percentage of ana- earlier questions. lysts. In contrast, no variable over a short-run The third section of the questionnaire asked horizon got a rating of "great importance" by the analysts to assess the relative importance of even a majority of the respondents. formal strategic plans and planning systems for The three most important variables for stock four different classes of companies-(1) more valuation over the short run appear to be (1) established and healthy firms, (2) more estab- prospects of the relevant industry, (2) expected lished and troubled firms, (3) less established change in EPS and (3) general economic condi- and healthy firms, and (4) less established and tions. In the short run, environmental, econom- troubled firms. The last section asked analysts ic and industry conditions are relatively more to evaluate the quality and sources of informa- important than data. Least tion on companies' strategicplans and planning important in the short run, according to ana- processes. Here, analysts were also asked for lysts, are (1) asset turnover ratio, (2) expected suggestions for improving the quality and avail- change in and expected return on ability of such information. assets and (3) expected rate of sales growth. Firm-specific data assume greater importance Horizons over the long run. Analysts attach little impor- Analysts evaluating a stock tend to emphasize tance to bursts in sales, asset utilization and the long-run economic and financial perform- dividend payments unless they are supported ance of a company. TableI gives the distribution by favorablelong-term prospects. of the analysts' responses to our questions re- garding the relevant importance of various eco- Surrogates for Investment Horizon nomic and financial variables for both the short Analysts did not consider the surrogate mea- run and the long run. Every variable was ac- sures for a short-term valuation perspective- corded more importance over the long run than introduction of new products and dividend the short run, by a wide margin. Furthermore, -to be very important, Table II reveals. all analysts-whatever their institutional affili- Rather, when determining stock value analysts ations or functional categories-exhibited this appear to look most closely at long-term predic- attitude. tors of qualitativegrowth and earnings, particu- Analysts attached greatest importance, in the larly the quality and depth of management, the long run, to (1) expected change in EPS, (2) company's market dominance and the compa- expected and (3) prospects of ny's history of achieving stated goals (which we the relevant industry. Each of these three fac- call "strategiccredibility"). tors achieved a rating of "great importance"by Analysts are clearly "systemic-process" ori- more than 73 per cent of responding analysts. ented, as opposed to "event" oriented. No Over the long run, all the variables except single operating ratio from the company's finan-

FINANCIAL ANALYSTS JOURNAL / NOVEMBER-DECEMBER1984 O 42 Table II SurrogateMeasures of Short-Termvs. Long- to look to qualitativefactors such as quality and Term Horizons* depth of management, market dominance and strategic credibility to validate fi- PercentageDistribution of quantitative Variable Responses nancial and economic variables. 1 2 3 Short-TermOrientation Assessment Media 23 57 20 The analysts' responses showed that the qual- New ProductIntroduction 23 52 26 Long-TermOrientation ity and depth of a company's management are Quality and Depth of very important in stock valuation. When asked Management 7 19 74 how they assess these characteristics,analysts Company'sMarket Dominance 10 23 67 supplied a variety of answers: "This is both the Company'sHistory of most critical and the most difficult factor to Achieving Stated Goals evaluate"; "intuition"; "cross references"; "re- ("StrategicCredibility") 12 25 63 cent decisions"; "the pattern of management succession"; "talks and "historical rec- * 1 = little importance; 2 = moderate importance; 3 = great visits"; importance. ord of the company"; "management's adapt- ability to change in good times and bad"; and cial statements, nor any single product or mar- "the ability to improve a company's ket event, captures for the analyst the long-term relative to its competition." The most common prospective value of the stock. Analysts appear answers were: to view a company in its entirety-its history, * the performancerecord of management; and in the capabilities position industry. * interviews, meetings and presentations of Analysts ranked the surrogates for a long- management to analysts; and term perspective higher than the comparable * evidence of management's strategic plan- a short-term They surrogates for perspective. ning and ability to meet stated objectives. attached more importance to the regularity of new product introduction and product refine- The analysts emphasized that meetings with ment, for example, than to anticipatedintroduc- management must be of a substantive nature to tion of a new product. Similarly, analysts be of value in assessing management quality. weighted the consistency of dividend payments They felt that such meetings should enable more heavily than dividend yield. them to make judgments about the breadth and quality of the top management team, as well as Table III Cross-CorrelationCoefficients Between Long- its ability to formulate and meet realistic strate- Term Factorsand QualitativeSurrogates for gic goals. Analysts would prefer to base their Long-TermHorizon* assessments on meaningful information, rather Long-TermFactors than on general statements of intent. Prospects Expected of the Relevance of Strategic Plans and Systems Change Expected Relevant The analysts' emphasis on long-term financial SurrogateFactors In EPS ROE Industry strength may indicate the importance they at- Qualityand Depth of Manage- tach to the presence (or absence) of sound ment 0.31 0.36 0.36 MarketDominance 0.41 0.32 0.37 strategic plans and planning systems. Table IV Historyof Achieving shows analysts' responses to questions dealing StatedGoals with strategic plans and planning systems. ("StrategicCredibility") 0.32 0.37 0.35 Over 60 per cent of the analysts viewed plans and * Pearsonrank cross-correlations. In all cases, computed probability planning systems as being of "great impor- of erroris 0.00. tance," except in the case of established, healthy companies. Analysts believed that a Table III presents the significant correlation sound strategicplan (which describes the future coefficients between the long-term quantitative direction of the company, including the reallo- valuation variables and the qualitative, surro- cation of resources and assets) and a sound gate measures. These results indicate that the strategic pjanning system (a system by which analysts placed consistent emphasis on the the company formulatesor reformulatesits stra- long-term horizon. Furthermore, they seemed tegic plan) are importantin evaluating the stock

FINANCIAL ANALYSTS JOURNAL / NOVEMBER-DECEMBER1984 O 43 Table IV ImportanceAnalysts Attach to StrategicPlans and Planning Systems in Stock Valuation*

PercentageDistribution of Responses MoreEstablished LessEstablished Companies Companies Healthy Troubled Healthy Troubled 1 2 3 1 2 3 1 2 3 1 2 3 A. A company's strategicplan-i.e., a plan that describes the future direction of the company including the reallocation of assets and resources. 1. How importantis a company's strategicplan that you 8 47 45 4 18 78 5 24 71 9 14 77 believe to be sound? 2. How importantis a company's strategicplan that you 11 33 56 13 9 78 10 18 72 13 6 81 believe to be unsound? B. A company's strategicplanning system-i.e., a system by which the company formulatesor reformulatesits strategic plan. 1. How importantis it that a company has a sound 9 44 47 6 16 78 7 31 62 10 11 79 strategicplanning systemin place? 2. How importantis it that a company does not have a 13 29 58 8 16 76 8 26 66 10 10 80 sound strategicplanning systemin place?

* 1 = little importance;2 = moderateimportance; 3 = great importance. of both established and less established compa- Table V Quality and Sources of StrategicPlanning nies. And when valuing troubled companies, Information analysts viewed strategic plans and planning as PercentageDistribution of Responses critical. Bland Sources of Information Generalities Highly of Little Moderately Relevant In order to assess the nature of the informa- Use Useful and Timely tion gap between analysts and management, we Qualityof Strategic 34 50 16 asked respondents specific questions about the Planning quality and availability of information, its Information sources, and how the flow of informationrelat- ing to a company's strategicplans and planning Sourcesof Strategic Little Moderate Great systems could be improved. Table V reports the PlanningInformation Importance Importance Importance results. Annual Reportsand 22 50 28 Only 16 per cent of the respondents found 10-KReports information on strategic plans and planning Presentationsby 9 42 49 Top Management systems to be highly relevant and timely in Newspapers and 36 50 14 terms of quality. Over one-third regarded such Other Publications informationas bland generalities of little use. In view of the importance analysts assign strategic planning in the stock valuation process, corpo- management) and the message (as a source of rate management should probably consider up- information regarding the soundness and the grading the quality of informationthey provide. credibility of strategic plans and planning sys- The principal source of strategic planning tems). The analysts' responses contrast sharply information is presentations to analysts by top with managements' apparent view of such pre- management. The analysts do not view news- sentations. relations personnel seem to papers and other publications as being of any regard them primarily as opportunities for stock great value, and rate annual reports and 10-K promotion. 2 reports as only "moderately useful." Analysts suggested a number of ways to Management presentations play a dual role. improve the quality and availability of strategic They help analysts judge the quality and depth planning information-more disclosure about of management, as well as providing long-term strategic plans in discussions, meetings, annual strategic planning information. Analysts evi- and other reports; interviews; and more com- dently regard these meetings as both the medi- prehensive responses to specific queries. Some um (for assessing the quality and depth of analysts felt that it is their responsibility to

FINANCIAL ANALYSTS JOURNAL / NOVEMBER-DECEMBER1984 0 46 obtain more information. Others recommended Table VI CorrelationCoefficients on the Relevanceof a boycott of companies unwilling to offer such Discounted Dividend Model To Stock Valuation* information. Interestingly, 20 per cent of the respondents Consistency felt that managements, for competitive reasons, Dividend of Dividend should not make information on strategic plans Yield Payments and planning systems available. Most analysts, ExpectedChange in Dividend 0.35 0.26 PaymentsDuring Next Quarter however, favored increased disclosure. They ExpectedChange in Dividend 0.37 0.37 cited most frequently as a medium for greater PaymentsDuring Next 5 Years disclosure "discussion during management pre- sentations, meetings, and interviews with the * Pearsoncross-correlations. In all cases, probabilityof errorcalculat- analysts"; "greater discussion in annual re- ed to be 0.00. ports" also received substantial support. ed questions are corroboratedby cross-correla- How Analysts Evaluate Stocks tion analysis of responses to separate sections of Do analysts use a to the questionnaire (see Table VI). value stocks? Their responses to the question- On the other hand, the analysts' high rank- naire suggest not. As noted, expected change in ings of long-term earnings prospects and the dividend payment during the next quarter and surrogate predictors of financial strength, as during the next five years, as well as dividend well as the high cross-correlations, reveal a yield, were regarded by analysts as among the substantialinterest in expected growth in quali- least important factors in the stock valuation ty earnings. The survey evidence thus lends process. The low rankings of all dividend-relat- considerablecredence to the earnings approach,

Table VII Stock Valuation:A Process Model*

INFORMATIONSOURCES ASSESSMENTMEDIA Presentations PerformanceRecord of Annual Reports Management 10-KReports Presentations,Meetings and Interviews Evidence of Sound StrategicPlanning and PREDICTORSOF Ability to Meet Stated FINANCIALPERFORMANCE Objectives

Quality and Depth _ _l of Management

______l b Sound Strategic Plan and Planning System MarketDominance StrategicCredibility

ENVIRONMENT Prospects of Systemic View of the Relevant the Company Industry

Long-TermFinancial Performance

|EPS ROE|

STOCKVALUE

* Reprinted,by permissionof the publisher,from Lal C. Chugh and JosephW. Meador,"Break the barrierbetween you & your analyst," FinancialExecutive, September 1984, p. 19.

FINANCIALANALYSTS JOURNAL / NOVEMBER-DECEMBER1984 E 47 rather than the discounted dividend approach, and depth of management. to stock valuation. By processing all such information, along In our opinion, the analysts' approach to with assessments of the external economic and stock valuation can best be described by the industry environments, analysts develop a sys- process flow chart depicted in Table VII. This temic appraisal of the firm. This evaluation model demonstrates how analysts incorporate becomes the foundation for a forecast of long- their assessments of industry and economic term financial performancein terms of EPS and environments, their methods of processing in- ROE, which determine the investment value formation, and their available sources of infor- analysts place on a stock. U mation to develop an integrated prediction of financial performance. The predictive process is based primarily on Footnotes the quality and depth of management, market 1. The Boston survey elicited a response rate of 23 dominance, presence of a sound strategic plan per cent and the U.S. survey one of 17 per cent. and planning system, and the strategiccredibil- The figures in this articleare based on the national ity of a company. In assessing the quality and survey. There were no significant differences be- depth of management, analysts look at manage- tween the two surveys. The questionnaire and ment's performance record, presentations, evi- complete set of responses are available from the dence of sound strategicplanning, and abilityto authors. meet stated objectives. A sound strategic plan The authors also surveyed members of the Na- and planning system serve two functions-as tional Investor Relations Institute to elicit the cor- independent variables in the prediction of fi- porate view. They report on their results in "Break the barrierbetween you & your analysts," in the nancial performance and as media for evaluat- September 1984 issue of FinancialExecutive. ing the quality and depth of management. Pre- 2. Robert E. Kennedy and Mollie H. Wilson, "Are sentations by management offer analysts an Investor Relations Programs Giving Analysts opportunity to learn about strategic plans and What They Need?", Financial Analysts Journal, planning systems and to evaluate the quality March/April1980, pp. 63-69.

FINANCIALANALYSTS JOURNAL / NOVEMBER-DECEMBER1984 O 48