International Review of Financial Analysis 28 (2013) 9–19

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International Review of Financial Analysis

Equity valuation models and target price accuracy in Europe: Evidence

from equity reports
Shahed Imam ⁎, Jacky Chan, Syed Zulfiqar Ali Shah
Warwick Business School, University of Warwick, UK

a r t i c l e i n f o a b s t r a c t

Article history: This study examines whether European investment analysts prefer cash flow based valuation models over
Received 6 February 2012 accrual based models, how accurate valuation models are and whether the use of cash flow based models
Received in revised form 4 February 2013 (with or without accrual based models) improve forecast accuracy. We conduct a comprehensive content
Accepted 14 February 2013
analysis of equity research reports for most of the firms on the components list of the Dow Jones Euro
Available online 26 February 2013
Stoxx 50 Index. We find that earnings multiples and the discounted cash flow (DCF) valuation models are
JEL classification:
the two most popular valuation models and the use of accrual based multiple alongside a cash flow based
G24 model improves the forecast error and this is in line with the intuition that accruals add value relevant
G32 information to cash flows. However, we also find that neither cash flow nor earnings multiples are superior to
M41 book value and return on equity (ROE) based models in terms of forecast error. Our results provide support
for the use of book value and ROE based models which provide more precise forecasts and this, in turn,
Keywords: supports the use of accounting based models, i.e., a residual income model.
Accuracy
Crown Copyright © 2013 Published by Elsevier Inc. All rights reserved.
Analysts
Analysts' reports
Valuation models
Target price

1. Introduction suggests with regard to the application of valuation models that

Academic research typically argues that earnings are more relevant
than cash flows for assessing company performance. On the other
hand, it is also argued in the literature that cash flows may be more
reliable than earnings because accruals require judgement and estima-
tion. The use of cash flow as an alternative metric has gained increasing
popularity in the literature (Call, Chen, & Tong, 2009; Dechow, 1994;
DeFond & Hung, 2003; Givoly, Hayn, & Lehavy, 2009; Sloan, 1996). Re-
cently Akbar, Shah, and Stark (2011) indicate that cash flows can have
incremental value relevance relative to either earnings or fund flows
and Call et al. (2009) suggest that analysts' earnings forecasts issued
with cash flow forecasts are more accurate than those not accompanied
by cash flow forecasts. The notion that cash flows are useful in validating
the information in earnings that contain large accruals is consistent with
Penman (2001, 2007) and Penman and Yehuda (2009).1 Penman (2001)
⁎ Corresponding author at: Warwick Business School, The University of Warwick,
Coventry, CV4 7AL, UK. Tel.: + 44 24 765 22842; fax: + 44 2476 150376.
E-mail address: shahed.imam@wbs.ac.uk (S. Imam).
1
In the conceptual framework, the International Accounting Standards Board (IASB)
states that the primary users (present and potential investors, lenders and other creditors)
of financial reporting need information about the resources of the entity to assess an
entity's prospects for future net cash inflows. The framework also confirms that general
purpose financial reports cannot provide all the information that users may need to make
economic decisions.
‘the practical issue is what accounting — cash flow accounting in
discounted cash flow models or accrual accounting in so called resid-
ual income models — best provides a base to which a growth rate can
be applied’.
In this study, we examine whether European investment analysts
prefer cash flow based valuation models over accrual based models,
which valuation models provide small forecast error, and whether the
use of cash flow based models (with or without accrual based models)
improves the target price accuracy. Analysts are important intermedi-
aries in the capital markets. They provide earnings forecasts, recom-
mendations and target prices and previous research finds that these
are important in share price formation (Asquith, Mikhail, & Au, 2005).
Analysts work in equity research departments of brokerage firms and
generate commissions for their employers either by selling information
through their equity research reports or through increased trading
(Bradshaw, 2011; Juergens & Lindsey, 2009; Schipper, 1991 among
others). One of the main contents of an analyst's report is target price
which shows analysts' expectation of share price of a particular company
in 12 months time. There is evidence that investment analysts use target
prices to justify their recommendations (Bradshaw, 2002) and that ana-
lysts' target prices are useful to investors (Brav & Lehavy, 2003). Another
stream of literature investigates analysts' preferences of valuation models
in the UK (Demirakos, Strong, & Walker, 2004; Imam, Barker, & Clubb,
2008) and finds that analysts use both earnings based and cash flow
based models, although multi-period accounting based models are not

1057-5219/$ – see front matter. Crown Copyright © 2013 Published by Elsevier Inc. All rights reserved.
http://dx.doi.org/10.1016/j.irfa.2013.02.008
10 S. Imam et al. / International Review of Financial Analysis 28 (2013) 9–19
very popular among analysts.2 However, there is little direct evidence on
whether the use of cash flow based models and/or accrual based models
result in larger or smaller price forecast error. In this paper, we focus on
target price forecast error as there are numerous papers available on
earnings forecasts and recommendations but less so on target price
forecast error (Bradshaw, 2011).
Previous studies on valuation models accuracy either examine the
absolute and relative valuation accuracy of valuation multiples (Deng,
Easton, & Yeo, 2009; Lie & Lie, 2002; Liu, Nissim, & Thomas, 2002a) or
multi-period valuation models (Francis, Olsson, & Oswald, 2000;
Lundholm & O'Keefe, 2001; Penman & Sougiannis, 1998). However, we
are not aware of any study which examines the price forecast error of
multi-period valuation models as well as multiples. We also consider val-
uation precision of the return on equity (ROE) based model in this study.
In addition, the research in this area has a focus either on the US
(Block, 1999; Bradshaw, 2002) or the UK (Demirakos, Strong, &
Walker, 2010; Demirakos et al., 2004; Imam et al., 2008), with limited
evidence on other European markets. We believe cross-country differ-
ences are important as previous studies find that value relevance of
accounting numbers vary significantly between countries due to the
legal systems (Ball, Kothari, & Robin, 2000; La Porta, Lopez-De-Silanes,
Shleifer, & Vishny, 1997, 1998) and the level of alignment of financial
and tax accounting (Ali & Hwang, 2000).3 For instance, Bartov,
Goldberg, and Kim (2001) find that explanatory power of earnings and
cash flows are substantially lower in Japan and Germany than in the
Anglo-Saxon countries and that earnings are superior to cash flows in
explaining share returns in the US and the UK but the reverse is true for
Japan and Germany. Alford, Jones, Leftwich, and Zmijewski (1993) and
Ali and Hwang (2000) suggest that value relevance of accounting num-
bers is lower for Continental model than for British–American model
countries and in bank oriented economies than in market oriented econ-
omies. Consistent with these findings, Liu, Nissim, and Thomas (2002b)
show that there is considerable variation in the performance of actual
earnings per share (EPS) across countries mainly due to legal and
accounting differences. The US and the UK data show higher value rele-
vance earnings than other countries in their sample. The precision of
valuation based on actual EPS in Canada, Germany and Japan is very
low and the performance of earnings multiples in France is quite good.
Danbolt and Rees's (2001) findings on six European countries (France,
Germany, Italy, the Netherlands, Switzerland, and the UK) reveal that
accounting based models of market to book work relatively well for fi-
nancial firms and that value relevance of earnings is higher in countries
like the Netherlands, the UK and Italy than the other three countries of
their sample. Equally, Arce and Mora (2002) conclude that earnings are
more relevant than book value in Common Law countries (e.g. Canada)
and vice versa for Code Law countries (e.g. Germany).
Since previous studies show that value relevance of accounting
numbers and valuation precision of multiples differs across countries,
we expect that analysts in European countries have different preferences
with regard to valuation models than Anglo-Saxon economies. In this
study, we cover five major European economies: France, Germany,
Italy, the Netherlands and Spain. We believe our study contributes to
the knowledge of valuation models usage and accuracy of models in
non-Anglo-Saxon based economies which are not explored previously.
We aim to extend and contribute to the recent literature on the use
of valuation models by investment analysts in five European countries,
by using a content analysis approach similar to Demirakos et al. (2004).
The research questions are: (i) whether a cash flow based or accrual
based model is the most popular valuation model used by analysts in
2
DeFond and Hung (2003) show that analysts started to provide cash flow forecasts
in addition to earnings forecasts in the 1990s.
3 the book value multiples on ROE significantly improves the valuation
Prior research examines the association between share price and a set of account-
ing variables such as earnings, cash flow (or dividends) and book value. The overall
conclusion is that the value relevance of accounting information has decreased over
time (Collins, Maydew, & Weiss, 1997; Francis & Schipper, 1999; Lev & Zarowin, 1999).
Europe; (ii) which model(s) produces less price forecast error; and
(iii) does the use of accrual based model(s) alongside cash flow based
model(s) provide better forecasts than using these models alone?
We test a number of hypotheses and conclude that earnings mul-
tiples (EM) and the discounted cash flow (DCF) valuation model are
the two most popular valuation models by European analysts. We
also show that book value and return on equity (ROE) based models
generally generate more precise estimates than earnings multiples
(EM), sales multiples (SM) and even multi-period models (i.e. the DCF).
This result suggests that though a multiple based valuation approach
bypasses detailed forecasts and is often used as a substitute for multi-
period models, multiple based models outperform multi-period models
in terms of forecast error.4 Our results also suggest that a change has in
fact taken place in recent years in Europe, with a greater emphasis on
sophisticated DCF for non-financial and ROE based models for financial
sectors, perhaps driven by the post-2000 stock market collapse and sub-
sequent prolonged bear market, and by heavy criticism of the research
quality of investment analysts.
Overall, this study provides an indication of which accounting
variables (e.g. cash flow, earnings, book value) are important to deter-
mine the value of companies in Europe. Indeed our results are important
as they show that accruals add value relevant information to the market.
Our results also show that simple multiple based models complement
multi-period models well in forecasting. Finally, although the residual
income model is not a popular model among analysts, as evident in pre-
vious studies (Demirakos et al., 2004; Imam et al., 2008), the ROE based
model and the book value multiples that analysts use have the same
principles of residual income model and outperform all other models.
Therefore, the result could motivate investors, academics and analysts
to use an accounting based model, i.e. a residual income model more,
as an alternative to the DCF. Our results should also be of interest to
investors since we show that joint use of publicly available earnings
and cash flow forecasts with inexpensive heuristics could help them to
have accurate forecasts for firms' future price.
The paper is organised as follows. Section 2 presents the literature
review. Section 3 discusses research design. Section 4 presents empirical
models and hypotheses. Section 5 presents findings followed by a dis-
cussion in Section 6. Section 7 concludes the paper.
2. Literature review
Valuation models have been the subject of considerable empirical
research in recent years. Theory suggests that all models should give
identical valuations if they are properly constructed. However, the
relative superiority of alternative valuation models in practice and
in academic research is an unresolved issue. Penman and Sougiannis
(1998) provide evidence that the residual income model (RI) model
yields more accurate firm estimates than the dividend discount model
(DDM) and the discounted cash flow (DCF) approach. The debate be-
tween Penman (2001) and Lundholm and O'Keefe (2001) ultimately sug-
gests that in theory there is no difference between the DCF and the RI and
both are equivalent to the DDM and also indicates that these models gen-
erally provide significant explanatory power for share prices. Equally,
Francis et al. (2000) compare the accuracy of the DDM, DCF, and RI and
reveal that the RI is superior to the other two. They find that the RI is sig-
nificantly more accurate (absolute prediction error is 30%) than the DCF
and the DDM (41% and 69%, respectively) and also that the RI explains a
much longer portion of the market price variation (71% explanatory
power as opposed to 51% for the DCF and 35% for the DDM). Recently,
Demirakos et al. (2010) suggest that earnings multiples outperform
DCF models. Equally, Nissim (2011) find that for US insurance compa-
nies, book value multiples perform relatively well and conditioning
4
Asquith et al. (2005) reveal that almost all analysts' reports of their sample have
multiple based valuation analysis.
 S. Imam et al. / International Review of Financial Analysis 28 (2013) 9–19
accuracy of book value multiples. He concludes that over the past de-
cade book value multiples performed significantly better than earnings
multiples.5 Earlier, Deng et al. (2009) and Lie and Lie (2002) also
suggest similar findings. Liu et al. (2002a) show that forward looking
multiples outperform current earnings, cash flow, book value and
sales multiples, although Deng et al. (2009) and Lie and Lie (2002)
suggest that asset multiples generally yields better estimates
(i.e. more precise and less biassed) than do SM and EM especially for
financial firms but also for non-financial firms. Recently Gleason,
Johnson, and Li (2012) find that profitability of target price based on
the residual income model is higher than that of PEG (price earnings
growth) ratio.
Surprisingly in practice, sell-side analysts prefer single-period
earnings models over multi-period models (Asquith et al., 2005; Barker,
1999; Block, 1999; Bradshaw, 2002; Demirakos et al., 2004; Richardson,
Tuna, & Wysocki, 2010). For instance, Asquith et al. (2005) find that
almost 99% of reports mention that analysts use some kind of earnings
multiples (e.g. P/E, EBITDA multiples). In contrast, only 12.8% use the
DCF and 25% use asset multiples. More recently, Imam et al. (2008)
show that analysts use both earnings multiples and DCF. However,
book value multiples are less preferred by the analysts in their study.
The conclusions in previous studies regarding the rationales of valu-
ation models preferences are not conclusive. For instance, although
‘sector’ is one of the explanatory factors in choosing valuation models
as evident in previous studies (Demirakos et al., 2004; Imam et al.,
2008), it is possible that analysts covering similar sectors use different
models (Liu et al., 2002a) suggesting it is a matter of preference of the
users. In other words, it depends on whether the users would like to
look at computations based on earnings or cash flow (Lee, 2003;
Lundholm & Sloan, 2004). Then the question arises, why do users prefer
cash flow to earnings or earnings to cash flow; also, within cash flow or
earnings based models, why are some models more preferred (e.g. P/E)
than others (e.g. Price/Sales or PEG)? Is it anything to do with the valu-
ation precision of these models? Does the joint use of cash flow and
earnings model improve performance of analyst forecasts? Prior studies
offer little evidence on this. Block (1999) suggests that the difficulty of
making multi-period forecasts in an uncertain corporate environment
and estimating the appropriate discount rate, makes multi-period
models unattractive to analysts. Demirakos et al. (2004) suggest that
analysts tailor their valuation methodologies to firms with different
profiles, preferring multi-period models to value companies with vola-
tile earnings streams and unstable growth. Imam et al. (2008) confirm
perceived limitations in the technical applicability of the DCF, which
cause analysts to rely in practice upon valuation multiples.
Academics also argue that analysts' use of models depends on the
preferences of analysts to the extent that some analysts focus on share-
holder value more than enterprise value (Lundholm & Sloan, 2004).
Moreover, financial press and empirical evidence suggest that some
models (e.g. the PEG) are preferred at some stage of economy and busi-
ness cycle although the importance of some models like the P/E remains
constant. This seems to suggest that market condition affects the prefer-
ences of valuation models. Therefore, our investigation of the use of
models across different economies in Europe should contribute to this
literature.
We also contribute to analysts target price accuracy literature in
general.6 Sell-side analyst target price shows analysts' expectations of
whether the stock price is overvalued or undervalued. It also gives a
signal of whether a price correction is likely to take place in the future.
Therefore, it is appealing to market participants and academics. Prior
5
Brief and Zarowin (1999) examine the value relevance of book value and dividends
versus book value and reported earnings. They suggest that book value is the most val-
ue relevant variable among the three variables, i.e. book value, dividends, and earnings.
This is consistent with Collins et al. (1997).
6
Analysts' research outputs have been subject to considerable research interest.
There is a vast literature on analysts' forecast and recommendations. See Ramnath,
Rock, and Shane (2008) and Bradshaw (2011) for reviews.
11
research suggests that analyst target price is important in share
price formation (Asquith et al., 2005; Brav & Lehavy, 2003). Prior re-
search also suggests various factors influencing analysts' forecast accu-
racy such as analyst optimism (Asquith et al., 2005), research intensity
(Bonini, Zanetti, Bianchini, & Salvi, 2010), valuation model preferences
(Demirakos et al., 2010), the text-based information depth of analyst re-
ports (Kerl, 2011), and analyst characteristics (Bilinski, Lyssimachou, &
Walker, 2011). There is however, little direct evidence from Europe
other than the UK on the use of equity valuation models by analysts
and accuracy of these models.
3. Research design issues
We conduct a comprehensive content analysis to examine which
models are predominantly used by European investment analysts,
which model(s) provides less forecast error, and whether the use of
cash flow and/or accrual based models improves the forecast error.
Content analysis is used in a number of studies based on analysts'
research reports. 7 Sell-side analysts provide research reports that are
useful sources of information in the market. These reports provide
in-depth industry and company information along with earnings
forecast, target price and recommendation. Lundholm and Sloan (2004)
suggest that sell-side research reports generally provide precise and con-
fident forecasts. Analysts spend a major portion of their time in writing
and disseminating research reports. Empirical evidence supports the
importance of the recommendations that are available in these reports
(Womack, 1996; Barber, Lehavy, McNichols, & Trueman, 2001 among
others). Moreover, recent studies (e.g. Asquith et al., 2005) suggest that
the text of the report is also a significant source of information as it con-
tains justification of analysts' opinions.
Using the Investext database available through Thomson One
Banker, we compile a sample of equity research reports. The Investext
database contains a range of equity research reports. These reports,
mostly written by the top international brokerage houses, cover the
largest blue-chip companies in the Eurozone, all of which are included
in the Dow Jones Euro Stoxx 50 Index.8 This index represents the
Super sector leaders in the Eurozone, covering countries like France,
Germany, Italy, the Netherlands and Spain. The sectors covered in the
study include Automobiles and Parts, Financial Services, Health Care,
Industrial Goods and Services, Oil and Gas, Personal and Household
Goods, Retail, Media and Technology, Telecommunications and Utilities.
The reports are published by six large international investment houses.
From the Dow Jones website, we first search for the components
list of the Dow Jones Euro Stoxx 50 Index. We then search on the
Investext database for equity research reports available for these
firms from January 2005 until January 2007. We only select compre-
hensive, firm-specific equity research reports of at least 6000 words
(up to 20,000 words), which contain in depth discussion of the valu-
ation. In cases where more than one report from the same brokerage
house exists that fit the selection criteria, the most recent publication
is selected. When more than one brokerage house publishes a report
for the same firm and fits the selection criteria, it is included in the
sample, as this could remove potential bias towards a valuation method
by a specific investment house in a certain firm/sector. A total of 62
equity research reports are finally chosen, covering 45 different firms
representing 90% of all the firms included in the DJ Euro Stoxx 50
index. Although we analyse a small sample of reports, our sample reports
cover 90% of all firms from five European countries in a post-IFRS but
7
In addition to Bradshaw (2002), Demirakos et al. (2004, 2010) and Imam et al.
(2008) who use content analysis to examine analysts' valuation model preferences,
some recent studies such as Kothari, Li, and Short (2009) and Asquith et al. (2005)
use content analysis to examine different research questions.
8
The Euro Stoxx 50 Index is Europe's leading Blue-chip index for the Eurozone, pro-
viding a Blue-chip representation of super sector leaders in the Eurozone.
12 S. Imam et al. / International Review of Financial Analysis 28 (2013) 9–19
pre-financial crisis period. 9 Our sample is comparable to Imam et al.
(2008) and Demirakos et al. (2004) who analysed 98 and 103 reports,
respectively.
Out of 62 reports, three reports cover two cross-listed firms, and
the analysts express the target price in US Dollars for their respective
American Depository Receipts (ADRs). There are also four equity
reports where the target price and its reported current price are incon-
sistent with the historical prices. Although these seven reports are
included in the sample used to investigate the preference of valuation
models, we exclude these from our sample when we examine the
accuracy of their target prices.
We select the analyst's preference of a valuation model(s) as follows:
a) We first analyse the valuation section of each report and examine
whether the analyst indicates preference for the use of any particu-
lar valuation model.
b) When two or more valuation models are mentioned in the report,
the one that is mentioned to generate the target price directly is
considered as the preferred model.
c) In cases where two or more models are used jointly to generate the
target price, both (all) are considered as preferred models. If it is not
clear which valuation model is used, we classify them under the
category of others/unknown.
Table 1 provides a brief description of valuation models mentioned
by analysts in equity research reports. To guide our subsequent analysis,
the models are categorised into three main categories: single period
comparative valuation models or accrual based models, hybrid valua-
tion models, and multi-period valuation models or cash flow based
models. The accrual based valuation models contain widely used multi-
ples such as price-to-earnings multiple and enterprise value/earnings
before interest tax and depreciation allowance (EV/EBITDA) multiple,
among others. The hybrid valuation models are mainly models based
on return on equity (ROE) such as multiples using return on equity
and cost of equity adjusted for growth. The multi-period valuation
models contain the discounted cash flow (DCF) and the Gordon's growth
model.
The process of target price accuracy investigation is as follows:
we first download historical share prices of the sample firms from
the Thomson DataStream. We download the daily share prices of
the sample firms for the 12-month period after the publication of
the respective equity research report. These are from the first day
of the month the report was published to the first day of the same
month the following year.
We first examine whether the target price is met in the 12-month
forecast horizon. Bradshaw (2002) shows that analysts often use
target price to justify their stock recommendations. Based on this
evidence, we set up the conditions for categorising whether the target
price is met. For reports with a buy recommendation, the target price
is met if the maximum price of the company's share during the
12-month forecast horizon is greater than or equal to the target price.
Similarly, for reports with a sell recommendation, the target price is
met if the minimum price of the company's share during the 12-month
forecast horizon is less than or equal to the target price.
The case for hold recommendations is more complicated as hold
recommendations mean that the analyst considers that the share
price is currently fairly valued. According to Bradshaw (2002), in hold
recommendation cases, generally, the target price is expected to be
slightly higher than the current price i.e., the analyst expects a small
positive return, although the difference between current price and tar-
get price is not significant enough to provide a buy recommendation.
Therefore, we also consider the maximum price of the company's
share during the 12-month forecast horizon in determining whether
9 10
Yu and Hsieh (2010) find that attention-driven buying behaviour of investors is
mitigated by the financial crisis of 2007, which indicates that the buying behaviour
of investors is less emotional during a period of financial crisis.
Table 1
Valuation models.
Accrual based models Price to earnings (P/E)
Price to earnings growth (PEG)
Price to sales (P/S)
Price to book value (P/B)
Enterprise value to earnings before interest, taxes,
depreciation and amortisation (EV/EBITDA)
Enterprise value to earnings before interest and taxes
(EV/EBIT)
Enterprise value to earnings before interest, taxes and
amortisation (EV/EBITA)
Enterprise value to net operating profit after taxes
(EV/NOPAT)
Enterprise value to operating Income before Tax and
amortisation (EV/OIBDA)
Enterprise value to sales (EV/S)
Gross operating margin
Embedded value multiple
Hybrid models ROEg/COEg
Return on embedded value
Warranted equity model: a valuation method derived from
the DDM, calculates the forecast P/B using the ROE-g/COE-g
ratio
Cash flow based models Discounted cash flow model
Gordon's growth model (including dividend discount model)
the target price is met. If the maximum value of the actual share price
during the forecast horizon is ±2.5% of the target price, i.e., with a
range of 5% forecast error, we consider the target price as being met.
We also calculate the absolute forecast error for all the cases where
the target prices are not met.
4. Hypotheses development
Valuation theory suggests that the value of a share is equal to
discounted value of all future dividends. This can be applied by forecast-
ing and discounting dividends directly (i.e. dividend discount model),
or by recasting dividends in terms of free cash flow (i.e. discounted
cash flow model), or by recasting dividends in terms of earnings and
book value (i.e. residual income model). Valuation models can be clas-
sified as absolute or fundamental valuation and relative valuation. In
absolute valuation (for example in the case of the DCF), the objective
is to assess the value of the firms, given their fundamentals, i.e. cash
flows, growth and risk. On the other hand, the objective of relative
valuation (for example in the case of the P/E ratio), is to value the com-
panies based on how similar firms are currently priced in the market.10
Valuation models can also be classified as cash flow based (DCF) or
accrual based (earnings multiples) as shown in Table 1.
The dividend discount model (DDM) which is considered as the
fundamental valuation model can be expressed as follows:
 
X∞
Et dtþτ
Pt ¼ : ð1Þ
τ¼1
ð1 þ ke Þτ
Where, Pt is price (market value of equity) at time t; ke is the cost of
equity capital and dt represents dividends (including share buy-backs
and net of new equity contributions by shareholders). This model states
that current share price depends upon the present value of future divi-
dends only, and not upon future share price. The model includes all cash
flows between equity shareholders and the company and focuses on
shareholder value, rather than enterprise value. Another fundamental
cash flow based model is the DCF model. In contrast to the DDM, DCF
estimates the value of the firm's operations Vt (enterprise value,
Bhojraj and Lee (2002) note that absolute valuation models rely on the data from
the given firm. On the other hand, relative valuation models seek to dominate the true
value of a stock by comparing these multiples to those of similar firms.
 S. Imam et al. / International Review of Financial Analysis 28 (2013) 9–19
comprising the value of debt and equity) and use the firms' weighted
average cost of capital (WACC) as the discount rate:
 
X∞
Et FCF tþτ
Vt ¼ : ð2Þ
τ¼1
ð1 þ kWACC Þτ
With some simple re-arrangement of the DDM model and ‘clean sur-
plus’ assumption, the residual income model can be written as follows.
 
X∞
Et xtþτ −bvtþτ−1 ke
P t ¼ bvt þ τ : ð3Þ
τ¼1
ð1 þ ke Þ
The residual income model (or abnormal earnings model) consists
of two terms. First is the book value of equity (bv) and second is the
present value of residual income. This implies that an increase in re-
sidual income causes an increase in the difference between a firm's
estimated value and its book value. Investors will pay a premium
over book value if it is possible to earn a rate of return beyond equity
cost of capital, i.e. if the firm provides positive residual income. The
model is formally equivalent to the DDM, but expresses firm value
in terms of accounting variables. If firms only earn normal earnings
(i.e. earn a normal rate of return on its book value), then the equity
value will simply be the book value. If firms can earn positive (negative)
residual income, the equity value will be more (less) than the book
value. Thus, the derivation of a firm's market value from book value
depends on its ability to generate residual income.11
Earnings, cash flow, and book value are three main accounting
variables that are used in valuation models. For example, earnings
are used in earnings multiples, cash flow in the DCF, and book value
in the residual income model and also in book value multiples. While
valuation theorists continue to debate the preference for various valua-
tion models (Lundholm & O'Keefe, 2001; Penman, 2001), simple single
period models (e.g., P/E) remain the most popular valuation technique
used by analysts (Bradshaw, 2002; Demirakos et al., 2004; Imam et al.,
2008). Recent studies, however, indicate a change in the usage of the
different valuation models and show evidence of an increasing preference
of more sophisticated models, particularly the DCF (Demirakos et al.,
2004; Imam et al., 2008).
We develop four hypotheses related to the valuation models used
by analysts and accuracy of models. As previous research (Demirakos
et al., 2004; Imam et al., 2008) suggests a recent trend in preference
for multi-period cash flow based models (the DCF in particular), our
first hypothesis concerns analysts' preferences of valuation models.
It is also shown in the literature (Imam et al., 2008) that analysts ac-
knowledge the limitations of the single-period earnings multiples
such as price to earnings (P/E). Previous studies also confirm that an-
alysts do not use other accrual based models (residual income model)
and book value is not a very popular metric (Barker, 2000; Imam et
al., 2008). Hence, we anticipate the DCF to be the preferred valuation
model. This leads to our focus on the DCF as the main multi-period
valuation model and the first hypothesis is as follows:
H1. A cash flow based model is the preferred valuation model for an-
alysts over the accrual based model.
Previous studies (Demirakos et al., 2004; Imam et al., 2008) also
suggest that book value based models are not popular among analysts
and value relevance of book value is less than other accounting variables.
Lie and Lie (2002) and Deng et al. (2009) show that book value multiples
outperform earnings multiples although Liu et al. (2002a) suggest that
forward earnings multiples are superior to book value, sales and cash
flow multiples. Penman and Sougiannis (1998) provide evidence that
the residual income model yields more accurate firm estimates than the
11
See Ohlson (1995) and Penman (2007) for a discussion.
13
dividend discount model (DDM) and the discounted cash flow model
(DCF). Therefore, this leads us to test the next hypothesis:
H2. Cash flow or accrual based models outperform book value based
models in terms of forecast error.
Imam et al. (2008) show that although price earnings (PE) is the
most frequently used comparative valuation model, it is almost always
used in conjunction with other valuation models, such as the DCF. Call
et al. (2009) suggest that earnings forecasts are more accurate when an-
alysts issue both cash flow and earnings forecasts compared to when
they only issue earnings forecasts. Therefore, we expect analysts to
use both cash flow and accrual based models jointly which should im-
prove valuation accuracy. We develop the following two hypotheses.
H3a. Analysts prefer to use a cash flow based model in conjunction
with an accrual based model.
H3b. The use of a cash flow based model in conjunction with an ac-
crual based model leads to more precise valuation by analysts.
5. Findings
Table 2 presents descriptive statistics of the overall accuracy of
target prices in the sample research reports. We also consider cases
where the actual share price misses the analyst's target by less than
1%, 3% and 5%. Table 2 (Panel A) shows that the overall accuracy of
the analysts' price target is just under 50%, and increases up to
61.82% when target price misses of less than 5% are considered as
met. This is consistent with previous studies. For instance, Asquith
et al. (2005) find an overall accuracy of 54.3% in the US whereas
Kerl (2011) in Germany reveals 56.5% accuracy. In Italy, Bonini et al.
(2010), however, only find 33.1% accuracy in analyst target price.
Panel B of Table 1 shows that the overall mean absolute error of all re-
ports where the actual price misses its target during the 12-month
forecast horizon is 15.11%.
Hypothesis H1 states that a cash flow based model is the preferred
valuation model to analysts. We first analyse analysts' valuation
model preferences irrespective of whether the model is used in tar-
get price or not. Table 3 presents the frequency of the valuation
models mentioned by analysts in the sample equity research reports.
Table 3 shows that accrual based models appear 71 times whereas
cash flow based models 32 times in sample reports. This is contrary
to our prediction that a cash flow based model is the preferred valuation
model.
As evident from Table 3, earnings multiples (EM) is the most
popular model, appearing a total of 44 times (70%) in the 62 reports
included in the sample. Earnings multiples are mentioned at least
once in every report except in the retail sector report. The DCF is
the most frequently used valuation model after earnings multiples.
The DCF is cited 31 times (50%) in the 62 reports and mentioned at
least once in every report except in the financial services and health
care reports. The third most popular model appears to be a hybrid
valuation model based on the return on equity and cost of equity
adjusted for growth (ROEg/COEg).12 This model is cited 14 times, all
in the financial services sectors. This is consistent with previous studies
(Demirakos et al., 2004; Imam et al., 2008) that analysts in different
industries have different preferences with regard to valuation models
and in the financial services sector the DCF is hardly used. Indeed the re-
sults in Table 3 suggest that cash flow based models are used only in one
financial service sectors report.
12
One report stated, “It compares the return on equity with the cost of equity adjusted
for growth to work out the implicit book value multiple…. This approach is derived from a
dividend discount model with certain underlying assumptions regarding growth and pay-
out…. It translates a flow approach into metrics, which is more relevant for banks.”
14 S. Imam et al. / International Review of Financial Analysis 28 (2013) 9–19

Table 2 out of 31 times (87%). More interestingly, whenever a multi-period

Summary statistics of target price accuracy. valuation model is mentioned in the report, it is more often chosen as
Panel A the preferred model. For instance, of the 32 times a multi-period cash
flow valuation model is used, it is chosen 28 times as the preferred
Target price met? Error allowed (absolute error)
model (87.5%). In contrast, the single period multiples are mentioned
0% 1% 3% 5%
71 times, but are chosen as preferred model only 56 times (78.8%).
Overall No 28 27 23 21 In the accrual based model category, earnings multiples are the
Yes 27 28 32 34
most preferred. Indeed, 36 of out of 56 times earnings multiples are
Total reports 55 55 55 55
Accuracy 49.09% 50.91% 58.18% 61.82%
preferred. Sales multiples are preferred nine times followed by EV
multiples seven times. The results also suggest that of 24 times when
Panel B
book value multiples (both shareholder and enterprise value based)
Summary statistics (missed TP) and ROE based models are mentioned as preferred models, these are
Mean absolute error 15.11% used 23 times in the financial service industry. Of the 32 times whenever
SD of errors 18.69% a model is mentioned as ‘preferred’ in financial service industry reports,
Min. 0.25% it is the book value and ROE based model that receives priority. In turn, it
Max. 75.46%
suggests that analysts in the financial services industry are more homo-
Note: Panel A presents descriptive statistics with regard to target price accuracy in geneous in terms of using valuation models and prefer to value firms on
sample analysts' reports. Panel B presents the mean absolute errors, standard deviation
the basis of book value.
of absolute errors, minimum and maximum error of the reports (0% error allowance)
where target prices were not met in the 12-month forecast horizon. Valuation theorists do not suggest a preference of cash flow over
earnings based models as discussed earlier. Our findings suggest a
focus on both cash flow and earnings models which is consistent
It is also interesting to observe that other than earnings multiples, with the view that cash flows provide information about corporate
accrual models receive little attention in analysts' reports and book performance that is not contained in current earnings and analysts
value multiples (both P/B and EV multiples) are used mainly in the fi- do not ignore the incremental information in cash flows. Consistent
nancial services sector. It seems that for financial firms, ROE based with our findings, DeFond and Hung (2003) suggest that the demand
models play an important role. This is because of the financial nature for cash flow forecast increases when information on earnings is in-
of assets and liabilities of financial firms, the relationship of small size sufficient to assess the value of companies. Like Call et al. (2009),
unrecognised intangibles and the role of regulatory capital especially they also suggest that cash flow forecasting is highly sophisticated
for insurance companies. The results also suggest analysts prefer ROE as it involves the use of various financial statement numbers.
based models over simple book value based models. One reason is Hypothesis H2 states that the cash flow or accrual based models
that book value cannot fully capture intrinsic value. Therefore, a outperform book value based models in terms of forecast error. Table 5
valuation model that simultaneously extracts information from shows the accuracy of the target prices generated by dominant valuation
book value and earnings should be preferable to book value multiples. models. It shows that accrual based valuation models are accurate in 58%
The ROE based approach reflects earnings performance in addition to of cases. The mean absolute forecast error for accrual based models is
book value. 12.87%. Surprisingly, among accrual based models, earnings multiples
It is also apparent that shareholder value focused multiples (earnings produced the least accuracy (44.86%) followed by PEG multiples (50%)
multiple) receive more attention than enterprise value based multiples. although previous research suggests that analysts prefer the EM and
Only seven times out of 71 EV multiples were mentioned. This is not con- PEG models (Bradshaw, 2002; Demirakos et al., 2004). The results also
sistent with Imam et al. (2008) where they find that UK analysts use EV suggest that the forecast error is higher for earnings and sales multiples
multiples. than other multiples. Imam et al. (2008) and Barker (2000) suggest
We reinforce the above findings by examining valuation model that analysts do not use book value in detail in valuation, although our re-
dominance in the reports. Table 4 shows dominant valuation models sults suggest that in fact, book value based models and ROE based models
in reports. It is evident that earnings multiples are chosen 36 out of 44 produce smaller forecast error than earnings multiples and multi-period
times (81.8%) as the preferred model, while the DCF is chosen 27 times cash flow based models.

Table 3
Valuation models appeared in equity reports across sectors.

Sectors Total reports Number of times the following valuation models appeared in the reports Total

Accrual based model Hybrid models Cash flow

based model

EM SM PEG BM EVM ROEg/COEg RoEV WEM DCF GGM

Automobiles & parts 5 5 3 0 0 0 0 0 0 3 0 11

Financial services 22 9 0 0 5 7 14 1 1 0 1 38
Health care 1 1 0 0 0 0 0 0 0 0 0 1
Industrial goods & services 8 9 1 0 1 0 0 0 0 6 0 17
Oil & gas 3 3 0 1 0 0 0 0 0 3 0 7
Personal & household goods 5 3 2 0 0 0 0 0 0 5 0 10
Retail 1 0 1 0 0 0 0 0 0 1 0 2
Media & technology 4 1 0 0 0 0 0 0 0 4 0 5
Telecommunications 8 9 0 3 0 0 0 0 0 5 0 17
Utilities 5 4 3 0 0 0 0 0 0 4 0 11
62 44 10 4 6 7 14 1 1 31 1 119
Total 71 16 32

Note: The table shows the total number of times a valuation model is appeared in the sample reports across all sectors. This table includes all valuation models mentioned at least
once in the equity reports, regardless of whether they are dominant valuation models, or not. If an analyst report computed the target price based on PE only, then it will appear 1
time under “EM”. If the target price was based on PE and DCF, then it will appear 1 time under “EM” and 1 time under “DCF”. There are often more valuation models than number of
reports, as often analysts use two or more valuation models in their reports.
 S. Imam et al. / International Review of Financial Analysis 28 (2013) 9–19 15

Table 4
Dominant valuation models in equity reports across sectors.

Sectors Total reports Number of times valuation models classified as dominant ones Total

Accrual based model Hybrid models Cash flow

based model

EM SM PEG BM EVM ROEg/COEg RoEV WEM DCF GGM

Automobiles & parts 5 5 3 0 0 0 0 0 0 2 0 10

Financial services 22 6 0 0 2 7 14 1 1 0 1 32
Health care 1 1 0 0 0 0 0 0 0 0 0 1
Industrial goods & services 8 6 1 0 1 0 0 0 0 5 0 13
Oil & gas 3 3 0 0 0 0 0 0 0 2 0 5
Personal & household goods 5 3 2 0 0 0 0 0 0 4 0 9
Retail 1 0 0 0 0 0 0 0 0 1 0 1
Media & technology 4 1 0 0 0 0 0 0 0 4 0 5
Telecommunications 8 7 0 1 0 0 0 0 0 5 0 13
Utilities 5 4 3 0 0 0 0 0 0 4 0 11
62 36 9 1 3 7 14 1 1 27 1 100
Total number of times valuation models 56 16 28
classified as dominant ones
Total number of times valuation models 62 44 10 4 6 7 14 1 1 31 1 119
appeared in the reports (Table 3) 71 16 32

Note: The table shows the dominant valuation model(s) used to generate target price in the reports across all sectors. As mentioned in research design section, two or more
valuation models are often used in some reports to justify target price. Therefore, there could be a higher frequency of valuation model dominance (i.e. 100 in Table 4) than the
number of reports (i.e. 62 reports).

The results in Table 5 suggest that whenever a cash flow based
model is chosen as the preferred model (i.e., 23 times), only eight times
the target price is met in the 12-month forecast horizon, representing
an accuracy of only 34.78%. The DCF, the most popular valuation model
by analysts as suggested by previous research, seems to be accurate
only in seven times out of 22 (31.82% accuracy). The mean absolute
forecast error for the DCF is the highest among all models (16.88%).
The hybrid model based on ROE appears to be the most accurate valua-
tion model, with an accuracy of 64.29%, employed 14 times by the ana-
lysts as dominant valuation models. 13 Moreover, the forecast error for
ROE based models is lower than any accrual or cash flow based models
and, therefore, Hypothesis H2 is not accepted. Overall, we observe that
less preferred models appear to produce smaller forecast error. Indeed
the most popular valuation models (earnings multiples and the DCF)
as suggested in previous studies, seem to be the worst in terms of fore-
cast error. Book value multiples and ROE based models do a better job.
Perhaps this suggests that valuation precision is not necessarily a
major concern for analysts in choosing a valuation model but familiarity
of valuation models and client preference drives the use of valuation
models. This is consistent with prior research (Imam et al., 2008).
We also examine cases with 1%, 3% and 5% absolute error allow-
ance. We do not observe any significant changes in the 1% scenario.
However, the performance of cash flow based models increases dra-
matically to 52.17%, earnings multiples to 68% and hybrid models to
71.43% when we allow a 3% forecast error. Of the five reports which
missed the target price by less than 3%, four of those are dominated
by the DCF. This helps this dramatic increase in accuracy. With 5%
error allowance, there is not much improvement over the 3% scenario.
The accuracy increases to 60.87% for cash flow based models whereas
for accrual based models, it increases to 70%. Overall, with 5% error
allowance, both accrual and cash flow based models show a better per-
formance than without any error allowance, though these models do
not perform better than ROE based models in any of the four scenarios.
For instance, with a 5% error allowance, EM and the DCF produce 65.52%
and 59.09% accuracy, respectively, whereas ROE based models produce
an accuracy of 69.23%. Overall, our results suggest that book value and
13
If a target price generated by PE is met, then it will appear 1 time under column
“Yes” of the “EM” row. When a target price is generated by both a PE and DCF, and
the target was met by the actual price, then it will appear 1 time under column “Yes”
of the EM row, and 1 time under column “Yes” of the DCF row.
ROE based models provide less forecast error as compared to earnings
and cash flow based models. Therefore, Hypothesis H2 is rejected.
Hypothesis H3a states that analysts prefer to use a cash flow based
model in conjunction with an accrual based model. Table 6 shows
that of the 28 reports which are dominated by a cash flow based
model, 26 have some reference to accrual based models. This suggests
that whenever a cash flow based model is preferred (28 times), it is
used 26 times in conjunction with accrual based models (93%). The
table also suggests that of the 56 reports which are dominated by
accrual based models, 32 reports (57%) have some reference to being
cash flow based. This suggests that in cash flow model dominated
reports, analysts may use accrual based models, but the reverse is not
always the case. This is mainly due to the fact that financial service
sector reports (22) do not have a reference of cash flow based models.
Overall, Hypothesis H3a is supported in that analysts prefer to use
cash flow and accrual based models jointly. This is consistent with the
notion that accrual accounting is typically argued to make earnings
more relevant than cash flows for assessing firm performance, while
cash flows may be more reliable than earnings because accruals require
judgment and estimation. While earnings forecasting research heavily
focuses on earnings more than cash flows, our findings in Table 6
seem in line with DeFond and Hung (2003) and Call et al.'s (2009) sug-
gestions that analysts use both cash flows and earnings in valuation as a
response to investors' demands.
Hypothesis H3b states that the use of a cash flow based model in
conjunction with an accrual based model leads to more precise valu-
ation by analysts. Table 7 shows the valuation precision of using cash
flow and accrual based models as jointly preferred. 14 Panel A suggests
that the target price is met in 8 out of 23 reports, where accrual based
models are used alongside a cash flow based model to determine
target price. The standard chi-squared test (χ 2 statistic = 1.51) fails
to suggest that the accuracy improves with the use of an accrual
based model alongside a cash flow based model. However, there are
six reports where target prices are missed narrowly (four reports by
less than 3% and two reports by less than 5%). When we consider the
target prices in these 6 reports as being met (Panels B and C), we ob-
serve significant results (χ2 statistic = 2.91, with a p-value of 0.088,
and 3.96 with a p-value of 0.0469 respectively). Panel B shows that
14
See preferred model criteria (c) in the research design section for the classification
procedure.
16 S. Imam et al. / International Review of Financial Analysis 28 (2013) 9–19

Table 5
Dominant valuation models and target price accuracy.

Overall 1% absolute error allowance 3% absolute error allowance 5% absolute error allowance

TP met? Total MAE Accuracy TP met? Total Accuracy TP met? Total Accuracy TP met? Total Accuracy
(%) (%) (%) (%)
No Yes No Yes No Yes No Yes

Accrual based EM 16 13 29 12.87% 44.83% 15 14 29 48.28% 11 18 29 62.07% 10 19 29 65.52%

models SM 3 6 9 12.09% 66.67% 3 6 9 66.67% 3 6 9 66.67% 3 6 9 66.67%
PEG 1 1 2 7.78% 50.00% 1 1 2 50.00% 1 1 2 50.00% 1 1 2 50.00%
BM 0 3 3 N/A 100.00% 0 3 3 100.00% 0 3 3 100.00% 0 3 3 100.00%
EVM 1 6 7 5.37% 85.71% 1 6 7 85.71% 1 6 7 85.71% 1 6 7 85.71%
Total 21 29 50 12.87% 58.00% 20 30 50 60.00% 16 34 50 68.00% 15 35 50 70.00%
Hybrid models ROEg/COEg 5 8 13 9.21% 61.54% 5 8 13 61.54% 4 9 13 69.23% 4 9 13 69.23%
WEM 0 1 1 N/A 100.00% 0 1 1 100.00% 0 1 1 100.00% 0 1 1 100.00%
Total 5 9 14 9.21% 64.29% 5 9 14 64.29% 4 10 14 71.43% 4 10 14 71.43%
Cash flow based DCF 15 7 22 16.88% 31.82% 14 8 22 36.36% 11 11 22 50.00% 9 13 22 59.09%
models GGM 0 1 1 N/A 100.00% 0 1 1 100.00% 0 1 1 100.00% 0 1 1 100.00%
Total 15 8 23 16.88% 34.78% 14 9 23 39.13% 11 12 23 52.17% 9 14 23 60.87%

Note: The accuracy column in overall shows the target price accuracy of dominant valuation model(s). MAE refers to the mean absolute error of only the reports where the target price
missed the actual price, and it measures to the extent the target price was missed on average.

out of 23 reports where both models are used to determine target price,
in 12 reports analysts forecast target prices accurately. Similarly, Panel C
shows that in 14 out of 23 reports analysts are accurate when both cash
flow and accrual based models are used in target price forecasts. This re-
sult supports the prediction that accruals improve the valuation proper-
ties of cash flows and analysts are aware of these value relevant
properties of accruals. This result is, in fact, in line with prior studies
(Call et al., 2009; DeFond & Hung, 2003) that analysts' earnings fore-
casts issued together with cash flow forecasts are more accurate than
those not accompanied by cash flow forecasts and that earnings fore-
casts reflect a better understanding of the implications for current earn-
ings for future earnings when they are accompanied by cash flow
forecasts. Another explanation could be that when analysts use cash
flow forecasts in addition to earnings forecasts in valuation, analysts
need to forecast all three financial statements' data and, therefore,
apply a more thorough approach to valuation analysis. As a result,
they can obtain a better understanding of the time-series properties of
companies' earnings components. A joint use of cash flow and accrual
based models provide analysts a better understanding of the persis-
tence of accruals and cash flows. We believe analysts' cash flow fore-
casts and earnings forecasts complement each other.
6. Discussion
This study extends previous research in this area and provides
further insights into the use of valuation models by analysts and val-
uation accuracy of models. Our findings show that accrual (i.e. EM)
and cash flow based models (the DCF) continue to be the two most
popular valuation models used by analysts, at least in non-financial
sectors. Our results also show that forecast error is significantly
improved when combining accrual based and cash flow based models.
This, in turn, suggests that accruals improve the valuation properties
of cash flows. Our results are in line with the prediction that earnings
forecasts issued along with cash flow forecasts better reflect the impli-
cations of current cash flow and accruals for future earnings than do
earnings forecasts issued in isolation.
Table 6
Cash flow v. accrual based models.
We also show that book value and ROE based models used heavily
in financial services sectors result in smaller forecast error than analyst's
preferred earnings multiples (EM) and the DCF models. However, book
value based models are used less than accrual or cash flow based
models, especially in non-financial sectors. This, in turn, suggests that
the least (most) favoured valuation models of European analysts result
in smaller (larger) price-forecast error. This result provides support for
accounting based models such as a residual income model as book value
and ROE based models share the same principles of a residual income
model and provide more precise forecasts (Penman, 2007).
Our results indicate that because of analysts' lack understanding and
interest with regard to book value (Barker, 2000; Breton & Taffler, 2001)
and book value based models (Imam et al., 2008), they prefer to use
cash flow based models in conjunction with non-book value based
accrual models. This is at least the case for firms in non-financial indus-
tries. We attribute our results to the fact that earnings and sales are
more volatile than book value from one period to another and also to
the fact that it is easier to forecast traditional sectors such as finance
service sectors than sectors with high intangibles. 15
Academics and investment community alike also argue that one of
the criteria for selecting a valuation approach is that it has to be con-
sistent with the analysts' valuation purpose and perspective (Stowe,
Robinson, Pinto, & McLeavey, 2002). Cowen, Groysberg, and Healy
(2005) reinforce this issue by revealing that sales and trading activi-
ties used to fund research create strong incentives for analysts' opti-
mism and also Barker (2001) suggests that both analysts and fund
managers share a common approach to valuation, suggesting a strong
inter-dependence in the working patterns of the two groups. For exam-
ple, analysts' reports influencing fund managers' behaviour, or both
groups being influenced by ‘generally accepted’ valuation methods. It
is possible that fund managers like their analysts to focus both on earn-
ings and cash flows. In other words, fund managers' model preferences
influence analysts' behaviour and this supports Imam et al.'s (2008)
client driven argument. Perhaps, activities with fund managers to fund
research create strong incentives for analysts to focus on both cash
flow and accrual based models and to provide a view that the fund man-
agers expect from them — in the way they want.
We believe that analysts are intelligent users of accounting num-
bers especially with regard to cash flows and earnings. Analysts

Reference to No reference to Total 15

Barth, Beaver, and Landsman (1998) reveal that the relative importance of book
alternative models alternative models value and earnings differ across industries due to the degree of unrecognised assets,
Cash flow based models is used 26 2 28 i.e. the greater the amount of unrecognised assets, the lower the relevance of book value.
as preferred models Also for financial distress firms, book value dominates earnings. Papanastasopoulos,
Accrual based models is used as 32 24 56 Thomakos, and Wang (2011) show that the negative relation of net operating assets
preferred models (NOA) with future stock returns is due to a combination of opportunistic earnings man-
agement and agency related overinvestment.
 S. Imam et al. / International Review of Financial Analysis 28 (2013) 9–19
Table 7
Valuation accuracy and use of cash flow v. accrual based models.
Cash flow and accrual Cash flow and accrual Total
based models are used based models are not
jointly to determine used jointly to determine
target price target price
Panel A
Target price met 8 0 8
Target price not met 15 3 18
Total 23 3 26
Panel B (with 3% absolute error allowance)
Target price met 12 0 12
Target price not met 11 3 14
Total 23 3 26
Panel C (with 5% absolute error allowance)
Target price met 14 0 14
Target price not met 9 3 12
Total 23 3 26
Note: The table shows the use of cash flow and accrual based models jointly to determine
target price and associated accuracy. Panel A: χ2 statistic = 1.51, p-value = 0.2835;
panel B: χ2 statistic = 2.91, p-value = 0.0880; and panel C: χ2 statistic = 3.95,
p-value = 0.0469.
understand the potential limitations of valuation that might arise
from using either cash flow or accrual based models alone (i.e. the as-
sumptions could be easily verified) and, therefore, analysts use both
cash flow and accrual models together to hedge their bets. At the
same time, analysts understand the demand of their clients and
working environment well. A joint use of cash flow and accrual
based models gives them more flexibility to justify their recommenda-
tions and target price if anything goes wrong with their forecasts but it
also makes their client comfortable with their valuation analysis which
is important to generate commissions for their employers. Recently,
Groysberg, Healy, and Maber (2011) suggest that analysts' compensa-
tions are not linked to forecast accuracy but to all-star status, stock
picking ability and investment banking activities among others.16 We
believe European analysts, like analysts in other countries, want their
research to be credible to buy-side clients. Although target price accura-
cy is important, as evident in prior studies, and book value seems to do a
better job in terms of forecast accuracy, analysts prefer to focus on
accounting variables (i.e. earnings and cash flows) that suit their com-
fort zone and satisfy their clients. Perhaps, analysts' familiarity with
models and clients' preferences play a significant role in choosing valu-
ation models as evident in earlier studies, but not necessarily the valua-
tion precision. Perhaps a change has, in fact, taken place in analysts'
work in recent years because of volatile economic conditions and
heavy criticism of the credibility of their work.
In our results, the forecast errors are not large for any models and
we observe that forecast error of book value and even sales multiples
are smaller than earnings multiples. Lie and Lie (2002) suggest that
valuations are more precise for larger firms and more accurate for fi-
nancial firms than for non-financial firms. Our sample represents
large firms of the index and we observe that, in our sample, analysts
in the financial services sector use book value based models and pro-
duce more accurate forecasts than others. How should we interpret
this result? One reason for this result could be that financial firms
have substantial liquid assets that are easier to value. Another possible
reason could be that analysts in financial service sectors use fewer
models (only book value and ROE based models) than analysts in
non-financial sectors. Therefore, analysts' task complexity is reduced
when they use fewer models (i.e. the one size fits all approach) and
there is evidence that reduced task complexity helps to improve
16
Giraldo (2011) suggests that when analysts make mistakes predicting performance
of a firm, instead of increasing coverage in order to reduce the size of their mistakes,
research firms pull analysts away from those stocks.
17
forecast error (Francis & Philbrick, 1993; Plumlee, 2003). Further
research in this area would be interesting.
7. Conclusion
The study compares the accuracy of valuation models with the
objective of gaining a better understanding of how analysts value
companies in Europe. Our results suggest that analysts prefer cash
flow based models alongside accrual based models to value compa-
nies in Europe. Academic research and teaching tends to emphasise
fundamental valuation models although, in practice, analysts use
relative valuation models — which typically involve price multiples.
Our results show that although multiples are used as a substitute of
multi-period models (e.g. the DCF) the multiples are not inferior to
multi-period models in terms of absolute forecast error. Therefore, we
contribute to the debate concerning why analysts do not use fundamen-
tal valuation models only.
Unlike prior studies, we show that book value and ROE based models
provide superior performance over cash flow or accrual based models.
Our results are important as the superiority of book value multiples
(and ROE) over forward looking earnings multiples is not consistent
with the intuition that forward looking earnings is more value relevant
than historical accounting information. This result has at least three im-
plications. First, this result contributes to the value relevance literature
(Arce & Mora, 2002; Collins et al., 1997; Francis & Schipper, 1999) that
suggests an increase in value relevance of book value and balance sheet
information, but a decline in value relevance of earnings information. Sec-
ond, this should have policy implications for accounting standard setters
who opt for a balance sheet focused approach in standard setting. Finally,
although the residual income model is not a popular model among ana-
lysts, as evident in previous studies (Demirakos et al., 2004; Imam et al.,
2008), this result provides strong support for using a residual income
valuation model to value companies.
We make some valuable contributions in this paper. Overall, our
study extends the knowledge of the use of valuation models and asso-
ciated accuracy by analysts in Europe. This is important for analysts as
we provide insights on how to improve target price accuracy and
overall quality of their research, thereby improving demand of their
work. These issues should be of considerable interest to regulators
since accounting scandals, the dotcom bubble, and the stock market
collapse (i.e. financial crisis) followed by enforcement of laws by reg-
ulators have raised more questions than answers about investment
analysts' integrity as information intermediaries as well as the quality
of analyst research. The increased use of the DCF in non-financial sec-
tors (and joint use of cash flows and accruals) and ROE based models
in financial sectors in our study might be associated with an increased
credibility of sell-side analysts. Since analysts act as information in-
termediaries, examining analyst activities, help market participants
to understand how capital markets function and the nature of infor-
mation that is impounded in share price. As our study shows how
market participants use valuation models and performance of these
models, it should shed light on how investors' decision-making process-
es are influenced by the use of models and associated accuracy. In other
words, by examining analyst expectations that act as proxy for investor
expectations, companies and regulators might be able to understand
how investors process information and make decisions. Furthermore,
target price is a measure of the potential change in value of the stock
which is valuable to investors. Therefore, an understanding of the use
of models and associated accuracy should provide value relevant infor-
mation to investors.
Academics and the standard setters alike should find comfort with the
evidence that accounting information is an important input of a detailed
and structured forecasting process and analysts' recommendations are
not based on simple heuristics only but on detailed multi-period forecasts
of cash flows and ROE. Moreover, companies should find comfort in the
fact that one of the main outputs of their disclosure process seems to be
18 S. Imam et al. / International Review of Financial Analysis 28 (2013) 9–19
very important in equity valuation. Of particular importance for the com-
panies is that companies can attract analysts, improve the accuracy of
market expectations, reduce information asymmetries and limit market
surprises by adopting more disclosure (Lang & Lundholm, 1996). Our
results also shed light on the balance sheet focused approach which has
implications for accounting standard setters, especially, it shows the qual-
ity of book value in forecasts and associated benefits of using cash flow
and accrual accounting numbers jointly. Overall, the results provide
important insights into the role of accounting variables in investment
decisions.
There are some shortcomings in this study. First, the results and in-
ference in this study are based on a small sample size. Further insights
may be obtained by performing the same analysis on a larger sample
size. Second, our study is based on content analysis and we assume
that sell-side analysts value firms using the valuation models stated
in their equity research reports. At a basic level, whatever valuation
models are discussed, if any, it could simply be packaging. We do not
know whether valuation models used in the reports are only a market-
ing tool for analysts. In fact, all previous studies do suffer from this.
Future research could test for the accuracy of target price using both
multi-period valuation models and single period comparative models
while controlling for size, profitability and industry. It will also be
interesting to understand how this valuation error affects analysts'
coverage and their information environment. Finally, it would be inter-
esting to study the effects on the accuracy and usage of different valua-
tion models during the recent global financial crisis.
Acknowledgment
The authors would like to thank the editor, reviewers and Prof.
Richard Taffler for helpful comments.
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