4.3 EQUITY ANALYSIS TECHNIQUES USED BY ANALYSTS AND FUND MANAGERS
4.3.1 Fundamental analysis
The most prevalent analysis technique used in domestic equity appraisal is fundamental analysis. Definitions of fundamental analysis in academic studies and text books are almost entirely teleological; that is, fundamental analysis is defined by what it doesor what it involves, rather than what itis. Moreover, there is no real consensus on what constitute ‘fundamen- tals’. Most descriptions are consistent in stating that fundamental analysis involves detailed analysis of firm-specific factors such as accounting in- formation, dividend policy and quality of management. They also typically state that this analysis is conducted in the context of the industry and macro- economy in which companies operate. Bauman (1996, p. 1) provides a useful and succinct description when he states that ‘fundamental analysis involves inferring the value of a business firm’s equity without reference to the prices at which the firm’s securities trade in the capital markets.
Unlike the pure discounted dividend (cash flow) approach, fundamen- tal analysis relies on a variety of sources of information, such as finan- cial statements, company management, and industry and macroeconomic data. In fundamental analysis, financial statement information actually de- termines company value; the discounted cash flow approach, on the other hand, views accounting data as mere signals of future dividend payments (Bauman, 1996). However, in common with the dividend discount model, a key characteristic of fundamental analysis is that its ultimate purpose is to arrive at an intrinsic value for the share (or for the company), through the estimation of future economic benefits, discounted at an appropriate level to take account of timing and risk.
Accounting research is increasingly providing a theoretical justification for fundamental analysis by recognising that firm value is a function of accounting book value and expected future earnings, after deduction of a charge for capital (e.g., Peasnell, 1982; Ohlson, 1995).2This research is displacing dividends and cash flow as the important valuation attributes with earnings and book value. Payments of dividends are predicted to reduce the value of the firm as they reduce future earnings generation capabil- ities (Lundholm, 1995). Moreover, the application of fundamental analysis to firm valuation is now perceived as more theoretically appealing than discounted cash flow analysis (Penman, 1992).
2Theoretical models of equity analysis based on accounting profits are discussed in more depth in Chapter 5.
4.3.1.1 Research into the use of fundamental analysis by investors and analysts
An examination of the research on the techniques used by institutional in- vestors reveals clearly that fundamental analysis is the most useful and most widely used technique. This result persists over time, across coun- tries and across research methodologies, including questionnaire surveys and various experimental approaches. The study of Arnold and Moizer (1984) is exemplary. Their research involved a questionnaire survey of UK fund managers and investment analysts. Fundamental analysis was widely regarded as the most useful method of investment appraisal, and was used almost always by 76% of analysts. Within the fundamental ap- proach, Arnold and Moizer found that the P/E ratio was a factor frequently considered by analysts and fund managers. Over 80% of respondents at- tempted to predict a company’s P/E ratio, based on prior and predicted earnings.
Interestingly, Arnold and Moizer found a range of approaches to in- vestment appraisal, from ‘analytical’ to ‘artistic’, thus acknowledging the diversity in fundamental analysis. The analytical approach was the most popular, and typically involved a systematic analysis of the previous ten years’ income statements, including disaggregation of the company’s activ- ities. This analysis was conducted to estimate future earnings. By contrast, the ‘artistic’ approach involved a summary of the annual report, but no systematic forecasting of earnings was conducted.
Moizer and Arnold (1984) found differences between fund managers’
and analysts’ approaches to investment analysis. Analysts followed fewer companies and were more specialised than fund managers. However, despite these differences, both analysts and fund managers considered fundamental analysis to be the most useful appraisal technique. In a related comparative study, Arnoldet al.(1984) contrasted the techniques used by analysts in the UK and the US. They found that although fundamental analysis was preferred by analysts in both countries, US analysts rated it as significantly more useful than their UK counterparts. Fundamental analysis was also the most widely used appraisal technique by US analysts and fund managers in a study by Carter and Van Auken (1990).
Research shows that the use of fundamental analysis has persisted over time. In a study of appraisal methods used post ‘Big Bang’ on the London Stock Exchange, Pikeet al. (1993) found that the P/E ratio and price to cash flow (P/CF) ratio (as central components of fundamental analysis) were perceived as the most useful techniques. Pikeet al.(1993) concluded that the usefulness of the appraisal methods changed little in the decade
between their study and the research of Arnold and Moizer (1984) despite the significant institutional changes that took place on the London Stock Exchange during this period.
The prevalence of fundamental analysis is not confined to the UK, or indeed to Anglo-Saxon countries. For instance, Vergoossen (1993) found that over 90% of analysts and fund managers use fundamental analysis in the Netherlands. The next most widely-used technique was ratio analysis (i.e., a component of fundamental analysis) which was used by 45% of analysts and fund managers. Meanwhile, Olbert (1994) found that fundamental analysis was by far the most dominant appraisal method in the Swedish market as it was used by 91.2% of analysts. In a survey of investment management and appraisal methods in Hong Kong, Wong and Cheung (1999) confirmed that fundamental analysis remains the predominant technique. They also found that the use of fundamental analysis was positively related to the seniority and experience of analysts and the size of the brokerage house or fund management firm.
Although the price/earnings (P/E) ratio is central to fundamental ana- lysis, recent research by Barker (1999a) shows that the extent of P/E use is contingent upon industrial classification. In a study involving both survey and market based data, Barker found that the P/E ratio is used by analysts of companies in the services, industrial and consumer goods sectors. However, for financial companies and utilities, the dividend yield ratio dominates – a finding partially attributed to the predictability of dividends from companies in these sectors.
Examination of the findings of experimental and behavioural studies also reveals that analysts use techniques consistent with the fundamen- tal approach found in questionnaire surveys. In an experiment involving US analysts, Biggs (1984) found that when provided with financial state- ments, analysts used two types of search strategies. The first was historical, which relied on past data and trends, and the second was predictive, which involved developing measures of earnings per share (EPS) and predicting what this will be in 3 to 5 years time. Interestingly, the majority of analysts (81%) used highly-structured search patterns and calculated a set of ratios and trends for all companies before they analysed any of the ratios, consis- tent with the ‘analytical approach’ identified by Arnold and Moizer (1984).
Bouwmanet al.(1987) split the investment decision into two separate stages and investigated the relevance of accounting information in each of these stages. The first stage involves using information to discriminate between companies to be accepted and those to be rejected; the second stage involves estimating the potential for the company to generate future earnings. Bouwman et al. found that the first stage involved the use of
comparable information for screening companies, whereas the second stage involved more qualitative information and segmental analyses.
In an innovative study of US analysts, Hunton and McEwen (1997) exam- ined various dimensions of the investment decision by tracking on a Visual Display Unit (VDU) the information items consulted by analysts when eval- uating company performance. Interestingly, they found that the provision of underwriting services positively and significantly increased analysts’ quar- terly and annual forecast errors, where the bias was positive (consistent with the discussion in Chapter 2 on analysts’ incentives). Furthermore, Hunton and McEwen found that analysts who used directive search strategies (i.e., wherespecificitems were identified and selected from an information set) were more accurate than analysts who used sequential strategies (i.e., where analysts selected the next item on a list), even after controlling for analysts’
experience.
In sum, therefore, empirical research clearly demonstrates that funda- mental analysis is the principal technique in domestic equity analysis. This result has persisted over time, across different countries and between dif- ferent professional groups, i.e., analysts and fund managers.