The working practice of financial analysts in the Netherlands

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(1)UNIVERSITY OF AMSTERDAM FACULTY OF ECONOMICS AND BUSINESS. The Working Practice of Financial Analysts in The Netherlands. E.J. Brillemans – 0296686 Master Thesis Final Version Date: 27 January 2008 Supervisor: Prof. Dr. B.G.D. O’Dwyer.

(2) The Working Practice of Financial Analysts in The Netherlands E.J. Brillemans. I. Table of Content TABLE OF CONTENT ....................................................................................................................... I ABSTRACT.......................................................................................................................................... 1 SPECIAL THANKS............................................................................................................................. 2 CHAPTER 1: INTRODUCTION ........................................................................................................ 3 1.1 CHAPTER STRUCTURE ................................................................................................................... 3 1.2 SCOPE OF THE STUDY .................................................................................................................... 3 1.3 CONTRIBUTION AND MOTIVATION ................................................................................................. 4 1.4 STRUCTURE OF THE THESIS ........................................................................................................... 5 CHAPTER 2: LITERATURE REVIEW............................................................................................. 7 2.1 CHAPTER STRUCTURE ................................................................................................................... 7 2.2 INFORMATION SEARCH.................................................................................................................. 7 2.3 USE OF VALUATION METHODS .................................................................................................... 11 2.4 INCENTIVES OF ANALYSTS .......................................................................................................... 13 CHAPTER 3: RESEARCH DESIGN ................................................................................................ 17 3.1 CHAPTER STRUCTURE ................................................................................................................. 17 3.2 RESEARCH METHOD ................................................................................................................... 17 3.3 RESEARCH SAMPLE ..................................................................................................................... 18 3.4 DATA ANALYSIS ......................................................................................................................... 20 CHAPTER 4: FINDINGS .................................................................................................................. 22 4.1 CHAPTER STRUCTURE ................................................................................................................. 22 4.2 DATA SOURCES USED ................................................................................................................. 22 4.2.1 Annual Reports and Quarterly Reports................................................................................ 22 4.2.2 Ratio Calculations .............................................................................................................. 24 4.2.3 Formal Management Meetings............................................................................................ 25 4.2.4 Informal Management Meetings.......................................................................................... 26 4.2.5 Changes in Management..................................................................................................... 28 4.3 VALUATION METHODS ................................................................................................................ 29 4.4 INCENTIVES OF ANALYSTS .......................................................................................................... 31 4.4.1 Other Departments of the Company .................................................................................... 31 4.4.2 Compensation of the Analyst............................................................................................... 32 4.4.3 Use of Private Management Information............................................................................. 33.

(3) The Working Practice of Financial Analysts in The Netherlands E.J. Brillemans. II CHAPTER 5: DISCUSSION ............................................................................................................. 35 5.1 CHAPTER STRUCTURE ................................................................................................................. 35 5.2 DATA SOURCES USED .................................................................................................................. 35 5.3 VALUATION METHOD ................................................................................................................. 37 5.4 INCENTIVES OF ANALYSTS .......................................................................................................... 37 5.5 CONTRIBUTION ........................................................................................................................... 40 5.6 RESEARCH E XTENSION ................................................................................................................ 41 LIST OF REFERENCES................................................................................................................... 43 APPENDIX A: INTERVIEW GUIDE............................................................................................... 45.

(4) The Working Practice of Financial Analysts in The Netherlands E.J. Brillemans. 1. Abstract This thesis examines the valuation process of financial analysts in The Netherlands. The research questions are ‘Which data is used by financial analysts for the valuation of stocks and what are the reasons for choosing this data?’, ‘Which valuation models/techniques are primarily used by the analysts and why do they use that models/techniques?’, and ‘What are the incentives of financial analysts in the valuation process in their opinion?’. A qualitative research method is used to examine the research questions. There are eight semi-structured interviews with financial analysts in The Netherlands conducted and the findings of these interviews are compared with previous literature. The contribution of this study is to understand which information and valuation models financial analysts use, in which extend financial analysts think they are influenced by incentives and that the understanding of the working practice of the financial analysts is better. First the data sources that analysts use are discussed. Previous literature concludes that the financial analysts use several different sources of data. The main sources are the annual report (and/or 10-K reports), especially the income statement part of these reports (Biggs 1984, and Previts et al. 1994), information from the management by presentation (Chugh and Meador 1984), and strategic information (Previts et al. 1994). Besides the raw data, the analysts also make different calculations with that data, such as ratios and trend analysis (Biggs 1984). A finding of this research is that the analysts use more quarterly reports instead of annual reports. This is because the quarterly reports are issued more often and faster after the end of a period and the information in quarterly reports are much better then years ago. Another finding is that the analysts use several ratio calculations; however not all the analysts use liquidity ratios, which is in contrast with Biggs (1984). Informal management meetings are also important to the analysts. However they do not get significant information during these meetings, but the information gathered is important for the conceptualization of the analyst about the company. According to the analysts is this information their competitive advantage which is in conformity with Healy and Palepu (2001). Second the used valuation models/techniques are discussed. Block (1999) and Demirakos et al. (2004) conclude that present value techniques are not as widely used in practice as they are in theory, while different studies (Penman 2001 and Palepu et al. 2004) have shown that the use of present value techniques gives a more accurate stock price value. This study does not examine which techniques determine the most accurate outcome, but this study determines the techniques that financial analysts use. The finding of this study is that present value techniques are used by all analysts, and that five analysts use the discounted cash flow (DCF) model as a leading model for their valuation. This is in contrast to Barker (1999), Block (1999), and Demirakos et al. (2004). The analysts use the DCF model, because they think that cash flow is the most important driver for the performance of a company and that the cash flow that a company generates in the future is important to the investors..

(5) The Working Practice of Financial Analysts in The Netherlands E.J. Brillemans. 2 Finally the incentives of the analysts are discussed. According to the literature (Dorfman 1991, Dreman and Berry 1995, Dugar and Nathan 1995, Hayward and Boeker 1998, Lin and McNichols 1998, Hodgkinson 2001, and Fogarty and Rogers 2005) there are several incentives that financial analysts have to face with. Examples of these incentives are the compensation of the analyst, contact with the management, and influence of other departments of the company where the analyst works. The main finding is that the analysts recognize that they are influenced by other departments, but that they will not change their recommendation if they are not convinced. The analysts do not recognize that they have to face with incentives due to the way of compensation. This opinion is in contrast to Dorfman (1991), and Dugar and Nathan (1995). The incentive “the different use of positive and negative private management information” is not recognized by the analysts as an incentive. This is in contrast to Hodgkinson (2001). Possible research extension of this study is to do a longitude case study in one company where analysts work to examine intensively several analysts. Another research extension is to examine if new regulation has a positive influence on the accuracy of analysts stock recommendations. In the past few years there are new regulations activated regarding incentives of financial analysts, for example regulation fair disclosure in the USA. It is interesting to examine by a quantitative method recommendation before and after the introduction of the regulation and the stock price development.. Special Thanks I would like to thank all the interviewees for the available time to speak with them and their provided information. I also would like to thank my supervisor Prof. Dr. Brendan O’Dwyer for the way he made me enthusiastic for qualitative research and for motivating me to go with the research, when it did not go the way I wanted it; especially in the beginning phase of the research, because it was very difficult to find financial analysts who would like to cooperate. Thank you all..

(6) The Working Practice of Financial Analysts in The Netherlands E.J. Brillemans. 3. Chapter 1: Introduction 1.1 Chapter Structure Section 1.2 discusses the scope of the study. The next section discusses the contribution and motivation of the study and the last section outlines the section structure of this thesis.. 1.2 Scope of the Study This master thesis deals with the stock valuation process of financial analysts in The Netherlands. This thesis is a continuation of my bachelor thesis “Stock Valuation: Reliable Valuation Models and Analysts’ Incentives” (Brillemans 2006). In this bachelor thesis contains a literature study about stock valuation by financial analysts. A purpose of this master thesis is to understand the working practice of financial analysts in The Netherlands from their perspective. Therefore the study is done with a qualitative research method. In section 3.2 the research method is discussed further. The research question is divided into three questions. The first question is ‘Which data is used by financial analysts for the valuation of stocks and what are the reasons for choosing this data?’. There is done some research about the used data by financial analysts, i.e. Biggs (1984), Chugh and Meador (1984), and Previts et al. (1994), however they did not examined the reasons of using this data. This study also examined the reasons for using the data. The second research question is ‘Which valuation models/techniques are primarily used by the analysts and why do they use those models/techniques?’. The intention of this study is to determine the valuation models/techniques that analysts actually use and the reason of the analysts to use that models/techniques. The last research question is ‘What are the incentives of financial analysts in the valuation process in their opinion?’. This study determines if the analysts recognize incentives where they have to face with according previous literature (Dorfman 1991,.

(7) The Working Practice of Financial Analysts in The Netherlands E.J. Brillemans. 4 Dugar and Nathan 1995, Hayward and Boeker 1998, Lin and McNichols 1998, Hodgkinson 2001, and Fogarty and Rogers 2005). In general, analysts in The Netherlands work in large banks and in broker companies with different departments. According to Vandenborre (2003) there are taken some actions in the financial world (i.e. in The Netherlands) to mitigate the incentives of financial analysts and as a result the biased recommendations. Therefore there is regulation in The Netherlands that there must be a ‘Chinese Wall’ between the research department and the investment department of a company. This means that the research department must be fully independent of the investment banking department. In some companies where sell-side analysts work, are physical limitations to enter the department (i.e. there is needed a code to enter the department). Beside that, it is also not allowed for the analysts in The Netherlands to do business in the stocks which the analysts’ cover.. 1.3 Contribution and Motivation There is already literature about the information search (Biggs 1984, Chugh and Meador 1984, Previts et al. 1994, Dreman and Berry 1995, Fogarty and Rogers 2005), the models that analysts use for their recommendation (Block 1999, Penman 2001, Palepu et al. 2004, Demirakos et al. 2004), and about the incentives where analysts have to face with (Dorfman 1991, Dugar and Nathan 1995, Easley et al. 1998, Hayward and Boeker 1998, Lin and McNichols 1998, Healy and Palepu 2001, Hodgkinson 2001, Fogarty and Rogers 2005), but in this research it is not only about what information and which model(s) the analysts use, but also why they use that information and model(s). This is examined by a qualitative research method. This research also determines in what extend the analysts have to face with incentives in their opinion and there are some suggestions for further empirical research. Finally, the working practice of the financial analysts is better understood, due to insight that is given by the financial analysts. The most importance findings of this research to this point are that analysts do not recognize any incentive to issue biased stock recommendations. They recognize that an other.

(8) The Working Practice of Financial Analysts in The Netherlands E.J. Brillemans. 5 department (i.e. investment banking department) could influence them, but that they only change their recommendation if they are convinced by arguments. Another finding is that the analysts always use present value techniques, especially the DCF model. This is in contrast to previous literature of Barker (1999), Block (1999), and Demirakos et al. (2004). The topic of this thesis is important and interesting, because it is difficult for private investors to get information by themselves (Hayward and Boeker 1998). Therefore private investors are dependent on the stock valuation of financial analysts. However, the private investors do not exactly know how the financial analyst values a company. The most important reason to do this study is to understand the valuation process of financial analysts in The Netherlands and to understand the reasons for the choices the financial analysts make during the valuation process.. 1.4 Structure of the Thesis Chapter 2 discusses previous literature. Section 2.1 outlines the structure of chapter 2. The next section discusses literature about the information search of financial analysts. Section 2.3 discusses literature about the use of valuation models by financial analysts and the last section discusses the incentives of the analysts according to the literature. Chapter 3 discusses the research design. The first paragraph outlines the structure of chapter 3. The next section discusses the research method and section 3.3 discusses the research sample. The final section discusses the method of data analysis. Chapter 4 of the thesis discusses the findings of the interviews. Section 4.1 outlines the structure of chapter 4. The next section discusses the data sources that financial analysts use. This section is divided in subsection. Subsection 4.2.1 discusses the use of annual reports and quarterly reports and the next subsection discusses ratio calculations. Subsection 4.2.3. discusses formal management meetings. The next subsection discusses informal management meetings and the last subsection the change in management. Section 4.3 discusses the findings of used valuation methods by financial analysts and the last section discusses the findings about the incentives of the analysts..

(9) The Working Practice of Financial Analysts in The Netherlands E.J. Brillemans. 6 This section is also divided into subsection. The first subsection discusses the incentives regarding other departments of the company and section 4.4.2 discusses the incentives regarding the compensation of the analysts. Finally the use of private management information is discussed. A discussion is given in chapter 5. In this section the findings of the interviews are compared with earlier literature and this section involves conclusions about the findings of the interviews. First the section structure of the chapter is outlined. The next section discusses the used data sources by financial analysts and section 5.3 discusses the used valuation method. The next section discusses the incentives of analysts. Section 5.5 discusses the contribution of the thesis and the last section outlines some possible research extensions..

(10) The Working Practice of Financial Analysts in The Netherlands E.J. Brillemans. 7. Chapter 2: Literature Review 2.1 Chapter Structure This chapter discusses some earlier literature about the research of the stock valuation process of financial analysts. Section 2.2 discusses the information search behavior of the analysts and section 2.3 the use of present value techniques during the valuation process. The last discusses incentives where the analysts have to face with.. 2.2 Information Search Biggs (1984) describes the information search behavior of financial analysts. The methodology that is used is a verbal protocol analysis. The decision process that was examined in the research of Biggs (1984) was the financial analysts’ decision processes as they searched raw financial statement information. The task for the financial analysts was to evaluate the financial statements of five companies from the paper industry. Eleven financial analysts participated in the study. The average experience of the analysts was 7.2 years with a range of 5 to 13 year (Biggs 1984). The financial statements that were provided to the financial analysts included ten years’ income statement and balance sheet data and two years’ statement of changes in financial position data. There were not included footnotes or supplementary schedules for practical reasons, because the financial statements included already a large amount of data (Biggs 1984). Biggs (1984) finds that two different information search strategy are used by the financial analysts. One strategy is the historical strategy which is used by seven analysts. The assessment of the earning power is completely based on an analysis of past performance of the companies. The other strategy is the predictive strategy which is used by four analysts. The assessment of the earning power is based on a prediction of a measurement of earning power (i.e. earnings per share) (Biggs 1984). This strategy involves at the beginning the same operations as the historical strategy, but it is extended with the prediction of the future..

(11) The Working Practice of Financial Analysts in The Netherlands E.J. Brillemans. 8 The information search involved on average 67.3% the income statement, 26.1% the balance sheet, and 6.7% the statement of changes in financial position. None of the financial statements were completely searched (Biggs 1984). According to Biggs (1984) it was unlikely that all items would be examined, because many financial statement items tend to be intercorrelated and the financial analysts were able to identify cyclical patterns by focusing on selected years. In the examination of the pattern of individual items, the financial analysts focused within the balance sheet and the statement of changes in financial position, their attention on the accounts net property, plant and equipment, long term debt, stockholders equity, and capital expenditures (Biggs 1984). According to Biggs (1984) is this kind of information search an indication that the importance of long term capital investment and financing in the capital intensive paper industry is recognized. Besides this, the financial analysts also calculate different ratios and trends to assess the companies. The ratio’s were categorized in the categories operating performance ratios, return on investment ratios, capital structure ratios, asset utilization ratios, short-term liquidity ratios, and trend analysis. Biggs (1984) indicates that operating performance and trend analysis occupied the greatest proportion of the information generation activity and short-term liquidity the least. Chugh and Meador (1984) created a process model of the stock valuation by financial analysts (see figure I). They examined this by sending a questionnaire to 1,000 members of the Boston Security Analysts Society. The information sources that the analysts mostly used are annual reports, 10-K reports and management presentations. However, management presentations play a dual role. These presentations help the analysts to judge the quality and depth of management and also providing long term strategic planning information. Analysts regard these meetings as both the medium and the message. The medium for assessing the quality and depth of management and the message for a source of information regarding soundness and the credibility of the strategic planning system (Chugh and Meador 1984). Previts et al. (1994) summarize a study which assessed sell-side financial analyst information use by applying content analysis to a sample of full-text sell-side analyst.

(12) The Working Practice of Financial Analysts in The Netherlands E.J. Brillemans. 9. Figure I Stock Valuation: A Process Model (Chugh and Meador 1984). company reports. They found that income statement and performance-related discussions dominated analysts’ reports. The most used terms relating to the income statement are earnings, earnings-per-share, profit(ability), revenue(s), and income. Information that is not reflected in the most recent income statements, but which are considered is predictive of future earnings, i.e. backorder and shipment data. Expenses are only analyzed at a general level (Previts et al. 1994). According to Previts et al. (1994) analysts often estimates future EPS by disaggregating into operating units and/or geographic areas. They then develop forecasts of the individual units, and then reaggregate the forecasts to form an overall EPS estimate. The company balance sheets are usually evaluated on a cost basis. There are five exception found by Previts et al. (1994). Companies with significant off-balance-sheet assets, thinly traded companies, poorly understood companies, industries with asset quality problems (e.g. banking), and takeover targets are these exceptions. Cash flows appear to be more important to.

(13) The Working Practice of Financial Analysts in The Netherlands E.J. Brillemans. 10 analysts in evaluating smaller companies with the exception of highly leveraged larger companies (Previts et al. 1994). The analysis of Chugh and Meador (1984) indicates that the quality and depth of a company’s management are important in the stock valuation. The meetings with management must be of a substantive nature to be of value in assessing management quality according to the analysts. Analysts would prefer to base their assessment on meaningful information, rather than on general statement of intent (Chugh and Meador 1984). This information is used to get a systematic view of the company along with assessments of the external economic and industry environments. This evaluation is the basis for the foundation for a long-term financial performance (especially earnings per share and return on investment) which determines the investment value analysts place on a stock (Chugh and Meador 1984). Previts et al. (1994) found substantial non-financial information assessment. This non-financial information is market share, competitive position, industry and economic conditions, competitors’ capabilities and products. Other information that also is considered are recent history of the company, its products, product pricing, customers, suppliers, industry, the national and international economy, and the company’s competitive position (Previts et al. 1994). Another important factor is the quality of the management of the company. There is especially attention given to management when changes in management have occurred. There will be considered which changes that new management will do (Previts et al. 1994). The previous research concludes that the financial analysts use several different sources of data. The main sources are the annual report (and/or 10-K reports), especially the income statement part of these reports (Biggs 1984, and Previts et al. 1994), information from the management by presentation (Chugh and Meador 1984), and strategic information (Previts et al. 1994). Besides the raw data, the analysts also make different calculations with that data, such as ratios and trend analysis (Biggs 1984). The literature that is described is all American based. This research will study the working practice of the financial analyst in The Netherlands. There also is not done much research about the working practice of the financial analyst in the last fifteen years..

(14) The Working Practice of Financial Analysts in The Netherlands E.J. Brillemans. 11 There could be some changes in the way of working of the financial analysts after the research that is described. The intention for this research is not only to identify the data that analysts use to value stocks, but also why they use the data that they use. Therefore the first research question of this research relates to this issue. RQ1:. Which data is used by financial analysts for the valuation of stocks and what are the reasons for choosing this data?. 2.3 Use of Valuation Methods Block (1999) investigates the daily practice of financial analysts. His intention was to identify the most widely used approach and not the normative approach. In the CFA curriculum the use of present value analysis have a major focus. But how widely is this present value analysis actually used? Block’s (1999) survey addressed this issue. He sent questionnaires to a random sample of 900 AIMR (the Association for Investment Management and Research) members in the United States in October 1998. 297 usable responses were received. The respondents were grouped into the type of firm for which they worked (brokerage, private money management group, investment management counseling, mutual fund, bank trust department, investment banking, pension fund, and other. The average experience of the sample is 15.3 years and 53.9 percent have a M.B.A. degree and 67.7 percent is CFA charter holder (Block 1999). The results of Block’s (1999) study indicate that present value analysis is not used as widely in practice as they are in theory. In the overall sample only 15.2 percent always use present value analysis and 39.1 percent sometimes. Of the analysts with a M.B.A. degree use only 10.6 percent always and 44.4 percent sometimes present value analysis, while non-M.B.A. degrees 20.4 percent always and 32.1 percent sometimes uses present value analysis. Block (1999) has breakdown the use of present value analysis into industry classification of the respondents. He concludes that in this sample analysts who work for mutual funds and bank trust departments appear to be relatively high users of.

(15) The Working Practice of Financial Analysts in The Netherlands E.J. Brillemans. 12 present value analysis. Another result of Block’s (1999) research is that the participants considered earnings and cash flows more important than book value and dividends as other inputs in analyzing securities. In other literature (i.e. Penman 2001 and Palepu et al. 2004) there is a preference to multi-period valuation models, more specific for discounted cash flows or discounted residual income, than valuations based on single-period comparatives like price multiples. This is in contrast to research on the valuation models used by financial analysts. Barker (1999) reviews this previous literature and concludes that discounted cash flow models are of little practical importance to investment decisions and the price-earnings ratio is of primary importance. Demirakos et al. (2004) studied the valuation practice of financial analysts. They concentrated on analysts’ reports from international investment banks for 26 large U.K.-listed companies drawn from the beverages, electronics, and pharmaceutical sectors. A limitation of this study is that they use analyst reports to identify the used valuation models. It is uncertain if the models in the reports are the actual used models for the valuation of a company. Demirakos et al. (2004) find that the price-earnings multiples remain the most important in the valuation practice, but that others models are also used if the circumstances demand. They also find that the residual income model is not as widely used as the dividend discount model. This could be explained, because the residual income model is less widely accepted than the dividend discount model (Demirakos et al. 2004). This research tries to determine, as the study of Block (1999), the approach to value stocks that is actually used by financial analysts. This research does not identify the approach that is the best according to the academic studies. Block (1999) and Demirakos et al. (2004) conclude that present value techniques are not as widely used in practice as they are in theory, while different studies (Penman 2001 and Palepu et al. 2004) have shown that the use of present value techniques during the valuation of stocks gives a more accurate stock price value. This study does not examine which techniques determine the most accurate outcome, but this study determines the techniques that financial analysts use. This is done by a qualitative research method, to overcome the problem of Demirakos et al. (2004), which is the uncertainty if the used.

(16) The Working Practice of Financial Analysts in The Netherlands E.J. Brillemans. 13 models in the reports are the actual used models to value the stocks. Due to the qualitative research method it is also possible to determine the reasons of the analyst for the use of the model, and not only to determine the model(s) that the analyst uses. Therefore the second research question is: RQ2:. Which valuation models/techniques are primarily used by the analysts and why do they use that model/technique?. 2.4 Incentives of Analysts There are at least two information problems in the capital market. The first information problem is the ‘lemon’ problem. This problem arises due to information differences and conflicting incentives. Therefore there is a demand for information intermediaries (i.e. financial analysts) who engage in private information production to uncover managers’ superior information (Healy and Palepu 2001). Another problem is the agency problem. There are several solutions for this problem, for example optimal contracts between entrepreneurs and investors or set up a board of directors, whose role is to monitor and discipline management on behalf of external owners. Financial analysts also have possibilities to uncover managers’ misuse of firm resources by managers, because they engage in private information production (Healy and Palepu 2001). According to Healy and Palepu (2001) financial analysts add value in the capital market, because they collect beside public information also private (non-public) information. However Easley et al. (1998) show that analysts do not appear to create private information and thus value. They also suggest that analysts may be, at best, noisy signals of information, and, at worst, merely another marketing mechanism to sell stocks. They found that stocks with high analyst following have both higher rates of informed and uninformed trading. There are some questions that arise, because financial analysts are faced with incentives or other influences to bias in their forecasts and recommendations. Dugar and Nathan (1995) examine the incentives facing analysts when the brokerage firm employing them also provides investment banking services to the company about which.

(17) The Working Practice of Financial Analysts in The Netherlands E.J. Brillemans. 14 the analyst issue a valuation. According to Dorfman (1991) compensation of analysts depends on a variety of factors, for example the volume of trading generated by their reports, their ability to secure and retain investment banking clients for their firm, the success of their buy/sell recommendations, and their reputation. These ways of compensation give for analysts’ reasons to bias their forecasts and recommendations. For example when an analyst issue an optimistic earnings forecast and a buy recommendation, the firms broker can call all his investor clients to advice them to buy the stock. However if the analyst issue a pessimistic earnings forecast and a sell recommendation, the firms broker can only call his investor who already have bought the stock of the company to recommend to sell this stock (Dugar and Nathan 1995). In the first case (positive forecast) the chance of an increase in the volume of trading will be a lot higher (and thus also the analysts’ compensation) than in the second case (negative forecast). Therefore the analyst has an incentive to issue biased positive earnings forecasts. Fogarty and Rogers (2005) attempt to get a better appreciation of the social milieu in which accounting information is gathered and rearranged in ways that suggest actions by other participants in the market. They focus on financial sell-side analysts, because they seem to have a considerable impact by their ability judging to influence market participants. The financial analysts are well compensated for their work. But the analysts have to work long hours, have heavy travel requirements, and must have considerable autonomy (Fogarty and Rogers 2005). Evidence suggests (Dreman and Berry 1995) that the compensation is skewed towards analysts with better performance. A large part of their compensation comes in the form of year-end bonuses. These bonuses are based on different factors, i.e. firm profitability, forecast accuracy, and trading volume generated (Fogarty and Rogers 2005). According to Fogarty and Rogers (2005) successful analysts attribute good predictions to a large number of factors. The most important factor is the relationships that they have with a variety of parties, such as suppliers, key customers and government officials. Successful analysts also find it important that managements’ opinions need corroboration. Beside that, it is also.

(18) The Working Practice of Financial Analysts in The Netherlands E.J. Brillemans. 15 important to do independent inquiry to for example uncertainties in technological developments (Fogarty and Rogers 2005). Another issue that arises is the contact with the management of the firm that is valued. Fogarty and Rogers (2005) examined the dependency of financial analysts upon corporate managers for their information. They test this by categorize all data as facts and non-facts. Facts are data that could be verified in the following public available sources: company’s annual reports, Securities and Exchange Commission (SEC) filings, press releases and the Wall Street Journal articles. The type of information is broken down into several categories (see table I). The largest category (operating data) shows the greatest difference between identified and unidentified sources. A lot of public information about companies is available from non-managerial sources. But the operating data is in control of the management. Therefore the financial analysts are depended on the managers for this kind of information (Fogarty and Rogers 2005). If the analyst gets superior information of the management that gives a positive view at the company, the analyst can use this information to make the earnings forecast more accurate without getting problems with the management due to contrary interests. But if the analyst have superior information that it is going badly with the company and issue a pessimistic forecast on a company, they can fall out of favor with the management and therefore lose access to company management and superior information (Hodgkinson 2001). Another relating incentive is the pressure of the investment banking department. Lin and McNichols (1998) and Hayward and Boeker (1998) have examined this. They both find in their samples that affiliated analysts issue more favorable earnings forecast Type of information Operating data. Source identified 752 (15,8%). Unidentified source 1150 (24,2%). Total 1902 (40,1%). Analysis of results Forward-looking information Information regarding management Description of firm Total. 160 (3,4%) 458 (9,6%) 65 (1,4%) 868 (18,3%) 1303 (48,5%). 181 (3,8%) 526 (11,1%) 43 (0,9%) 544 (11,5%) 2444 (51,5%). 341 (7,2%) 984 (20,7%) 108 (2,3%) 1412 (29,7%) 4747 (100,0%). Table I Summary of Content Analysis of “Factual” Information Units Excluding GAAP Information (number of units (percent of the total)) (Fogarty and Rogers 2005).

(19) The Working Practice of Financial Analysts in The Netherlands E.J. Brillemans. 16 (and recommendations) than unaffiliated analysts. The investment department pressures the analyst to issue positive forecasts, because they are afraid that the client company will terminate the investment banking relationship. This is an addition pressure to the analysts beside the incentive to generate volume trading and the superior information of management (Dugar and Nathan 1995). According to the literature there are several incentives that financial analysts have to face with. Examples of these incentives are the compensation of the analyst, contact with the management, and influence of other departments of the company where the analyst works. This study determines if the analysts recognize incentive where they have to face with according the literature. Therefore the last research question is: RQ3:. What are the incentives of financial analysts in the valuation process in their opinion?.

(20) The Working Practice of Financial Analysts in The Netherlands E.J. Brillemans. 17. Chapter 3: Research Design 3.1 Chapter Structure This chapter deals with the research design of this study. In section 3.2 the research method is discussed. The next section discusses the research sample. In section 3.4 the data analysis process is discussed.. 3.2 Research Method For a better understanding of the topic of this research, first there is done a literature study. An overview of previous literature is given in section 2. A qualitative research method is used to answer the research questions. There is chosen for a qualitative research method, because the purpose of this research is to give an insight in the process of valuation of stocks by financial analysts. There are different forms of qualitative research, i.e. questionnaires, observation and interviewing. In this research there is chosen for qualitative research interview approach, because during interviews it is possible to get a very good inside in the thinking a doing process of the interviewee. A purpose of the study is to understand the working practice of financial analysts in The Netherlands from their perspective. According to Kvale (1983) the qualitative research interview is: ‘an interview, whose purpose is to gather descriptions of the life-world of the interviewee with respect to interpretation of the meaning of the described phenomena’. Therefore the qualitative research interview is an appropriate method for this research. There are different kinds of qualitative research interview methods available. In this research is used the semi-structured interview. The reason for semi-structured interviews is that in every interview the same main topics are discussed, but that every interviewee can express themselves free about that topic. It is also possible to go deeper into a subject that is interesting for the interviewer (Patton 2000). Another reason for a semi-structured approach is because there will be collected some factual information (i.e. data used and valuation models/techniques used), but it is uncertain what and how.

(21) The Working Practice of Financial Analysts in The Netherlands E.J. Brillemans. 18 much information the interviewee will be able to provide (King 1994). This method is also chosen, because this kind of interview provides interviewees to express their feelings and thoughts better than in other form of interview methods, i.e. structured interview method (Flick 2006). It is very important to be well prepared before doing the actual interview. A method to prepare the interview is to make an interview guide. Patton (2000) and King (1984) describe very good how to make a good interview guide. This was very helpful for me. The interview guide used during the interviews can be found in appendix A. This interview guide looks like a structured interview, but the questions can be asked in a random order. The interview guide in the appendix is a little bit changed during the eight interviews. I started the interview with some questions about some background information about the interviewee which he/she can answer easily and without potential embarrassment. Therefore the interviewer and the interviewee are given time to relax and feel they are getting to know each other (King 1984).. 3.3 Research Sample A hard part of this study was to contact analysts who would like to give an interview, because no analyst was known by me. To get in contact with analysts, the CFA course was contacted. There is also searched on Internet to get names of analysts. There are thirty analysts contacted by email. If there was no response after one week, there was sent a reminder or they were called. In the first email, I already mention that the interviews will be confidential and that I would like to record the interview. I did this, because it could be possible that the interviewee did not agree or that it was a surprise when I conduct the interview and did not mention. There was a response rate of 83.33% (25 responses out of 30) of the contacted analysts. Of the 25 responses 17 responses (68%) were negative and eight analysts would like to cooperate (32%). There were two main reasons in the negative responses. The first reason was that the analyst was to busy and did not have time to do an interview. This response was given by ten of the negative response (59% of the negative.

(22) The Working Practice of Financial Analysts in The Netherlands E.J. Brillemans. 19 responses). The second reason of a negative reaction was that the analyst was not interested. This reaction was given by seven of the negative responses (41% of the negative responses). All the eight analysts who were interested agreed with recording the interview. Due to the way of the selection of analysts, there is a limitation of this research. There is a possibility that only certain analysts respond with a positive reaction and that therefore the findings of the research are biased to certain analysts. However, the sample of the analysts in this research consists also of three analysts who have an experience of only two or three years (see table II). The interviews were anonymous; therefore the interviewees are coded with the letters A to H. These letters do not have any further meaning. The interviews took place in July and August 2007. Of these eight analysts, three of them are buy-side analyst (analyst A, B and C) and five are sell-side analysts (analyst D, E, F, G and H). There are some differences between buy-side analysts and sell-side analysts according to previous literature. Buyside analysts often work for institutional investors, they do not write reports for the public and they can use the reports of the sell-side analysts for their assessments. Sellside analysts work by brokerage firms and produce research reports for parties interested in publicly traded securities (Fogarty and Rogers 2005). Another difference is Analyst Education A. HBO. Years of work Industries covered Number of experience as analyst companies covered 2 All industries in the whole world 1200. B. University. 7. C. CFA. 7. D. University. 2. E. University. 9. F. CFA. 9. G. University. 8. H. University. 3. Consumer goods and health in the whole world Materials, mining and industrial in the whole world Construction and dredging in the Netherlands Food, beverage and retail in The Netherlands Food and retail in The Netherlands Temporary employment in The Netherlands Retail, technology and navigation in The Netherlands Table II Sample Characteristics. 200 150 8 11 10 3 11.

(23) The Working Practice of Financial Analysts in The Netherlands E.J. Brillemans. 20 that sell-side analysts are specialized in a particular industry, while buy-side analysts are not specialized in an industry (Fogarty and Rogers 2005). According to interviewee A the difference between sell-side analysts and buy-side analysts is that the sell-side analysts need to write a good story based on facts about the company when it does not matter if the conclusions will be a buy, hold or sell recommendation. In contrast, buyside analysts need to make an opinion about a company and analyze an industry and then decide if they have to buy the stock or not. According to interviewee A there is less pressure for a buy-side analyst. For a buy-side analyst it does not matter if he buys a stock of company Y or he buys a stock of company Z, he just have to buy the stock that perform above his benchmark (interviewee A). Through the differences between the sell-side analysts and the buy-side analysts, the buy-side analysts are excluded for the third research question. Due to the differences between the sell-side analyst and the buy-side analyst, the buy-side analysts have to face with other incentives than sell-side analysts. The analysts in the sample have an average working experience as financial analyst of 5.875 years. The range of the working experience is from two till nine years (see table II). Analyst A is covering 1200 companies (see table II). He does a very broad screening of all of these companies and if there are companies that could be interesting according to the results of the screening, he is doing a more detailed investigation (analyst A), Analysts B and C are covering between the 150 and 200 companies (see table II). Of these companies, they are covering about 30 till 40 in more debt and of 10 till 15 companies they do know all the inns and outs (analyst B and C). In table II there is an overview of the industries the analysts are covering.. 3.4 Data Analysis All the interviews were tape recorded. Tape records of the interviews are very helpful during the interview and it is also helpful during the analysis of the interview. It is impossible for the interview to progress smoothly if the interviewer has to stop after.

(24) The Working Practice of Financial Analysts in The Netherlands E.J. Brillemans. 21 each question to write down what was said. Before the analysis, there can be made full transcripts of the interviews (King 1984). The editing method is used to analyze the interviews. The interpreter enters the transcriptions of the interviews much like an editor searching for meaningful segments, cutting, pasting and rearranging until the reduced summary reveals the interpretive truth of the interview (King 1984). It is very important to be familiar with the data. Therefore it is important to listen to each interview, and not only read the transcriptions, to take into account nuances of speech, tone of voice, and other such information (Irvine and Gaffikin 2006). After that I transcribed the interviews and used the editing method, I arranged the findings into categories, so it was possible to categorize the findings to the research questions. After the categorizing of each interview separately, I compared the findings of all interviews with each other to find similarities in the findings, but also to find differences between the findings (Jones 1985). This is done to ensure that it is possible to write a consistent story about the findings of the interviews. According to Flick (2006) and King (1984) there are two important issues involved in qualitative research. These issues are reliability and validity. This research does also have to deal with these issues. The reliability is ensured by summarizing in short what the interviewee has answered about a topic during the interview and crucial differences were discussed in later interviews. Validity is ensured by comparing the findings of the interviews with each other and these findings are also compared with findings in previous literature..

(25) The Working Practice of Financial Analysts in The Netherlands E.J. Brillemans. 22. Chapter 4: Findings 4.1 Chapter Structure This chapter deals with the findings of the interviews. In section 4.2 the findings of the data sources used by financial analysts are discussed. Section 4.3 discusses the valuation methods used by the financial analysts. The last section discusses the incentives were the analysts have to face with.. 4.2 Data Sources Used This section discusses the data sources that the analysts use for there valuation. Subsection 4.2.1 discusses the annual reports and the quarter reports. The next subsection discusses the ratio calculations used and subsection 4.2.3 discusses the findings of the formal management meetings. The next subsection discusses the informal management meetings and the last subsection discusses the changes in management. 4.2.1 Annual Reports and Quarterly Reports Seven analysts are using annual reports for their valuation, but they do not using it as a primary information flow. They use it for background information and they read it when they are valuing a new company. Analyst C does not use annual reports very often, because his opinion is: “In annual reports the companies try to sell what they did the best. Therefore the information in the annual report is not the most reliable information”. However the other analysts do not agree with this viewpoint. Analyst E: “An advantages of the annual reports is that there can be found a lot of detail. Beside that, it is also used for the background story; the strategy and the development in the market”. All the eight analysts also use the quarterly reports of the companies. Analyst B: “The quarterly reports are more used for the valuation of stocks than annual reports, because the annual reports are issued a couple of months after the end of the book year, which is too late for a valuation and/or recommendation. Beside that, quarterly reports.

(26) The Working Practice of Financial Analysts in The Netherlands E.J. Brillemans. 23 are issued more often and in the quarterly reports are nowadays more information issued by the companies than a couple of years ago”. In the quarterly reports are among other things the following information issued: the balance sheet, profit and loss statement, cash flow statement, macro-economic information, sales development, investments, outlook, and strategy (analyst B, C, E, and G). Analyst F: “Our primarily information source for the valuation are the quarterly reports. We use for 75 percent the quarterly reports to gather our information about a company. The last 25 percent we use the annual reports and especially the footnotes in the annual reports”. According to all the analysts, it is hard to say which accounts of the balance sheet are the most important, because that differs for each company. In general the accounts of the balance sheet with the highest amounts are important for the valuation (analyst B). Analyst D says that it depends on the analyses which will be performed. Analysts E and F say that net liabilities is important and according to analyst G the accounts fixed assets, financial fixed assets, goodwill, and the construction of invested capital are important. According to these analysts the accounts are important, because that accounts do influence the recommendation. Analyst H: “It is also important to analyze when the company is reporting profit when there is not coming in cash to the company. The balance sheet is therefore also used to see if the balance sheet will improve. Another issue is the balance sheet covenants. If a company has these kinds of balance sheet covenants, then these covenants are always analyzed”. The accounts of the profit and loss statement that are important according to the analysts are the accounts with high amounts, i.e. sales, but that is also different for every company. Other accounts that are important are net operating profit after taxes (NOPAT), earnings before interest, taxes, depreciation and amortization (EBITDA), and interest costs. But the accounts where the analysts look to are also dependant on the analysis that the analyst will do (analyst B, D, E, F, G, and H). The cash flow statement of the quarterly reports and the annual reports is also important. As mentioned before, it is important to analyze if the company is reporting profit while they do not receive money. Therefore the analysts look to the operating.

(27) The Working Practice of Financial Analysts in The Netherlands E.J. Brillemans. 24 cash flow and the profit reported in the profit and loss statement. Another issue which is very important to all the analysts is the change in working capital. Analyst D: “The change in working capital is important because it is a part of the valuation method”. The fluctuations in the working capital differ for each company. A factor that can influence the change in working capital is if the company is influenced by seasonality. Analyst A: “You look by each company to working capital. If this working capital does not look good, then there is a problem. However a company with seasonality will have more fluctuation in working capital and as analyst you have to feel this when seasonality is a factor with the company”. 4.2.2 Ratio Calculations The ratios net debt to equity and debt to assets are used for the assessment of the financial health of the company (analyst B). According to analysts D, F and G the liquidity ratios and solvability ratios are important. To see if the company can meet his short term liabilities, the liquidity ratio is calculated. Another ratio to see if the company can meet their debts is the interest coverage ratio. The solvability ratio is calculated to see how much financial space the company has when they have to finance for example a take-over (analyst D). Analyst G uses also the payment-capacity ratio. This is a ratio which calculates how many times a company can pay their interest payments of the generated cash flows. However some analysts (analysts E and F) do not use liquidity and/or solvability ratios very often. They use these ratios only when a company is in financial trouble. Analyst E: “I do not use very often liquidity or solvability ratios, because I can not see the added value. I do not use these kinds of ratios in my analysis, but I can imagine that some analysts use these ratios if a company is in financial trouble, or if the analysts think that the company had refinance problems, or if the business is bad that the company tries to generate cash flows. If a company is a going concern, then I do not use the liquidity and solvability ratios”. A ratio that is important is the analyst consensus ratio, which is a ratio that can be found in Bloomberg. Bloomberg collects for example all the earnings forecasts of all the analysts that are covering a specific company and Bloomberg builds a consensus of all this figures. This consensus ratio is used to find out how the market as a whole.

(28) The Working Practice of Financial Analysts in The Netherlands E.J. Brillemans. 25 assesses the company performance and what the individual analyst finds about the company (analyst A and B). A ratio that is the most important is the return capital employed according to analyst F. According to this analyst the operational performance is the most accurate with the return capital employed ratio as measure. According to analyst A the return on equity (ROE) ratio is an important ratio, because the ROE expresses a clear relation between financial leverage, profit margin, and asset turnover. Therefore this ratio is very important to him. Ratio calculations are used to compare companies with each other. But no company is exactly the same, therefore theoretical it is not possible to use ratio calculations to compare the companies. Analyst B: “Ratio calculations are easy, because you can get very easy an idea how a company is doing compared with other companies. I have theoretical some objection to compare ratio’s of companies with each other, because you should only compare companies when they are identical to each other. However these companies do not exist and if you use ratio calculation then you compare different things with each other. But the comparison of ratios gives a broad indication, and is applicable to for example a specific sector like banks”. Ratio calculations are used to find warning flags and that is possible when you calculate these ratios. If you find warnings flags it is very important to investigate these warnings flags. Another issue is that the use of ratio calculations depend on what you investigates (analysts A, B, D, E, F, G and H). 4.2.3 Formal Management Meetings There are different kinds of formal meetings. The meetings that the analyst mentions are conference calls and analyst meetings. The conference calls are often after the issue of quarterly reports and of course after the issue of the annual report. The analyst meetings are mostly two times a year, after the half year figures and after the end of the year. A normal analyst meeting is organized as follow: First some financial information about the whole company, after that financial information per division. Next the financial outlook of the whole year or a given period is discussed. After that the strategy is discussed and if there are new initiatives (i.e. new products). There is also a.

(29) The Working Practice of Financial Analysts in The Netherlands E.J. Brillemans. 26 possibility to ask questions to the management. The analyst meetings are very financial according to analysts C and F. During conference calls and analyst meetings, the management tries to give the analyst a feeling about how business is organized, how the business is doing and how it should go further. The analyst also gets a feeling about the quality of the management (analyst G). Analyst D: “It is important that you have read the financial information, because if you do not do that, you will not have a good impression by the management”. If you talk with the management the main objective is to get a good feeling where does the management want to go and what are the possibilities. During the formal meetings you get somewhat the same information as in the press report with somewhat more detail (analyst E). It is also possible to ask specific questions about topics that are for example unclear or that are important for your valuation (analyst A, B and E). Analyst H: “When there is a possibility to ask questions during analyst meetings, it is sometimes the strategy that your competitor analysts do not know the answers about some questions you have, because then they can write it down in their reports and then it look like that they found it out. However, sometimes it is your strategy that they know the question and the answer, because you have already told it to your clients and in your report and then you want to point your competitor analysts to that issue”. During conference calls you can get all the financial information you would like to have if the company comply with the regulation. The financial information is different for each company, but in general at least sales development, margins, investments, and change in working capital are discussed, and it is also possible to ask something about strategy (analyst B). 4.2.4 Informal Management Meetings There are different kinds of informal management meetings. Examples of informal meetings are one-to-one meetings, road shows, a call to the management, and sending an email. A road show is organized by the analyst and he will ask to a company if they want to present themselves to clients of the analyst (possible investors). During these road shows the management presents themselves and their company to possible.

(30) The Working Practice of Financial Analysts in The Netherlands E.J. Brillemans. 27 investors and of course the analyst has also the possibility to talk to the management (analysts B, C, D, E, F, G and H). There are some differences between formal and informal meetings with the management. The most important difference is that it is not allowed for the company to issue information to an analyst what is not public yet (analysts B, C, D, E, F, G and H). Another difference is that informal meetings are one-to-one. So the competitor analysts do not know what the analyst asked and what the management told to the analyst. The informal analysts meetings are also more frequent than formal meetings. However informal meetings with management of multinationals are very rare, because they are not very often available. But it is very easy to call with management of relative small companies (analyst C). During informal meetings it is also possible to ask in more detail. It is also possible to read something about body languages. However, this is not very concrete information. Analyst D: “I do not focus on body language. Of course it is important how a CEO or CFO deliver his message; how certain he is of his message, and if he exudes self-confidence. However this kind of evidence is not concrete, in fact it is not concrete at all”. This opinion is in conformity with analyst E: “Sometimes it is very clear if you put one’s finger on the spot, because the CEO or CFO will get a blush or will get pale. But I am not an expert in this discipline; therefore I can not do anything concrete with this”. One-to-one meetings with the management are one of the most valuable ways to gather information (analysts B, C, D, E, F, G and H). Non-material information is important for the valuation, because it gives the analyst a better opportunity to become to the reality. Analyst E: “All the information that you can gather for the valuation can be useful. About everything which is told by the management has the analyst more questions why it is as described by the management or what are the details behind. Therefore every piece of information, even if it is just some very small detail is important to me”. According to analyst G the information gathered during informal meetings with the management is one of the competitive advantages of the analyst. Analyst G: “At the time that a company releases a press statement, it is very difficult to distinguish oneself of the competitor analyst. Every analyst reads the press statement and every analyst tells.

(31) The Working Practice of Financial Analysts in The Netherlands E.J. Brillemans. 28 the same to his clients. Therefore investors do not act to this information at that time, because at the time that the investors would react, the market already knows the information and the share price is already changed”. 4.2.5 Changes in Management Change in management can be very important for the performance of a company and therefore it is important for the valuation (Analysts B, D, F, G, and H). According to analyst F and G the performance of a company is dependant on the quality of the management. Another issue is the perception of the investor about the quality of the management. If a company have great management according to the market (investors), a change in this management could be important for investors (i.e. sell stocks and in the end a diminishing stock price of the company) and therefore it is important to the analyst (Analysts F and H). Analyst B: “For example, a company is managed very bad in a market were is very much growth potential, because the management did not control the costs very well and that therefore the margins were not as good as they could be. The management is fired and someone who has much more experience in brand management is assigned. These persons would like to put the brand much better in the market. This change in management is very important for the valuation, because this change can have a very important impact on the financial results of the company and is therefore important for the valuation”. This is conformity with the opinion of analyst D: “Change in management is important, because every person have characteristics where he is specialized in. One person is for example very good in reorganize the company, when another person is better in building up the company after a reorganization. So the management (or change in management) in relation to the phase of the company is important for the valuation”. However, according to analyst C it is indeed strange if all or most senior management will leave, but it is not a key issue to him, because other people will do the job. In the end the process is more important than the people (Analyst C). This is in conformity with the opinion of analyst E: “Change in management is not important for the valuation, unless the expectation is that the new management will do important things different or if the management of a company gets oneself talked about, so that a.

(32) The Working Practice of Financial Analysts in The Netherlands E.J. Brillemans. 29 change in management is expected. The change of a management is only important if the new management will change some important things in the process”.. 4.3 Valuation Methods This section discusses the findings of the interviews about the valuation methods that are used by the financial analysts. Analyst A uses a model that is developed by the company where he works which is a secret model. He uses that model, because the person that developed that model has a lot of experience and has used all the other models also. However the experience was that the specific own developed model is more accurate in the valuation than other models, i.e. the dividend discount model and the discounted cash flow model. Therefore he uses this own specific model which is an accurate model in the past according to analyst A. The discounted cash flow model (DCF) is a leading model for five analysts (B, C, D, E and F). The outcomes of the calculation of the DCF model is not the most important according to analyst B. Analyst B: “The feeling about the value of the company is more important then the outcome of the calculation of the DCF model. Second, it is very important that it is possible to run different scenarios, to see what the impact is of a certain event, i.e. a decrease of profit margin, on the value of the company”. Theoretical, cash is the only thing what have value to the investor. The cash flows that the company will generate in the future are very important to the investor (Analysts B and C). Another argument is that cash flow is probably the most important driver for the performance of the company. Therefore the discounted cash flow model is leading for the five analysts (B, C, D, E and F). All the analysts know the disadvantage of the DCF model. The outcome of the DCF model is very dependant on the input. Analyst F: “It is possible to generate every possible outcome of the DCF model that the analyst wants by influencing the input. Therefore every input, or change of input in compare with the last time, has to be well-.

(33) The Working Practice of Financial Analysts in The Netherlands E.J. Brillemans. 30 founded and the analyst has to be able to explain his/her DCF model. In my opinion the DCF model has to be submitted to very strict rules to be useful”. Therefore if the DCF submitted to strict rules, the DCF model is according to the five analysts the model that is the most accurate relative to all other models/methods. Despite of that analyst C use the DCF model as a leading model, he thinks that it is very hard to project cash flows for more than two years. Analyst C: “I guess you can do reasonable valuation always for a decent year and for the year after. But after these two years it is quit challenging to be very accurate. You know what the cash flow will be the next two years and for the years after you have to assume how fast a company can and will growth if it is doing business in a certain sector. Then the experience of the analyst will influence this assessment. In general how more experience you have as an analyst, how better your assumptions will be. What you do is to make a good assessment of the company’s course right now and what is more important you can act when this course will change”. All the analysts use multiples. The multiples are used as a comparison to historic averages and/or to compare the multiples of companies with each other. A multiple alone do not say anything, a multiple has value when it is compared. The analysts use different kind of price multiples. The multiples that are used are: price/earnings multiple (P/E), price/cash flow multiple (P/CF), price/book value multiple (P/B), price/sales multiple,. price/market. multiple. (P/M),. equity. value/sales. multiple,. equity. value/EBITDA multiple (analysts A, B, C, D, E, F, G and H). As already mentioned in section 4.2.2. Ratio Calculation, the analysts do know the disadvantages and restrictions of comparing companies with each other. Another issue is that at the time of making the multiple analyses the analyst sees if the stock of the company is cheaper or more expensive than other companies, but it does not say anything about the future (Analyst D). According to analyst G historical relations of industries are rather firm. Analyst G: “The multiples will almost always be between the upper and the lower limit of the band width of the historical relation. If the multiple will exceed the lower or upper limit, it is.

(34) The Working Practice of Financial Analysts in The Netherlands E.J. Brillemans. 31 very important to investigate why this is the case. Therefore it is very important to use also multiples for the valuation of a company”.. 4.4 Incentives of Analysts This section discusses the incentives were the analysts have to face with. In subsection 4.4.1 the incentive of other departments of the company is discussed. The next subsection discusses the compensation of the analyst and the last subsection discusses the use of private management information. 4.4.1 Other Departments of the Company According to analyst D, other departments, i.e. investment banking department or the sales department, do not really try to influence him. Analyst D: “The investment banking department is interested in a fair analysis of the analyst to make a good wellfounded decision. Of course, the investment department would like to issue stocks for a certain company, but they will understand that if the analyst is not positive about the development of the stock price, that it will not be smart to issue that stocks, because it could damage the reputation of the firm (of the investment department and the analyst) if the price of the issued stocks will diminish far under the price of the issue. But if the analyst is uncertain about if it is a good decision to issue stocks then the investment department would try to influence the decision of the analyst to a decision to issue the stocks for that certain company”. However according to analysts D, E, G, and H they will only change or adjust their decision if they believe the arguments of the investment banking department. Research is in principle independent, but of course it is a commercially business (Analyst D). According to analyst E it would not be smart if you think as analyst that you would not be influenced. It is a very subjective business: there are very subjective elements of value stocks and there are different subjective elements with the decision if a stock is in your opinion a buy, hold, or a sell. Another department that tries to influence is the sales department (Analyst E) just as the influence of the investment banking department. Analyst E: “I think that an analyst has more knowledge about a company than the.

(35) The Working Practice of Financial Analysts in The Netherlands E.J. Brillemans. 32 knowledge of the company of the sales people. But it is possible that the salespeople see something that you did not see. It is also possible that an argument of you is refuted by the salespeople and that is therefore less relevant for the assessment of a certain company”. In the company of analyst F the trade people and sales people are forbidden to influence the analysts, because the opinion of the analyst must be fully independent of any other department. Analyst F: “The analysts in our company do have all the freedom to determine every conclusion or decision that in their opinion is the best conclusion or decision. They will never be scored on the fact that their opinion is somewhat different than the opinion of the salespeople or trading people”. 4.4.2 Compensation of the Analyst All the sell-side analysts have a compensation based on a fixed and a variable part. The relative proportion of the variable part is in general between the 20% and 100% of the fixed part of the compensation. The big range of this percentage is because it is a cyclical business and some years it could go very good, but other years it is going much poor. Therefore in a very good year the variable part can be 100% of the fixed compensation, but in a year that it is going badly, the variable part is not higher than 20% of the fixed part or even lesser. The variable part of the compensation of the analysts is based on different factors. For all the sell-side analysts the variable part is based on the number of publication, the number of contacts with clients, the number of road shows organized and attended to. The variable part of the compensation of analyst F is also based on some quantitative measures as the number of pages written, quality of the recommendation, thus was the recommendation in accordance with the development of the stock price, and the number of phone calls to investors. For analyst H the variable part of the compensation is based on the quantitative measures as the earned commissions of the stocks/funds followed, how much money the traders of the company of the analyst lost, because of your recommendation. Analyst H: “Despite of that the compensation is based on, among other things, the earned commissions, there is not pressure on the recommendations, because in the end there will be more commissions for funds/stocks if the.

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