Errors and questionable judgments in analysts’ DCF models

Jeremiah Green (), John R. M. Hand () and X. Frank Zhang ()
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Jeremiah Green: Pennsylvania State University
John R. M. Hand: University of North Carolina at Chapel Hill
X. Frank Zhang: Yale School of Management

Review of Accounting Studies, 2016, vol. 21, issue 2, No 7, 596-632

Abstract: Abstract We investigate the number of and reasons for errors and questionable judgments that sell-side equity analysts make in constructing and executing discounted cash flow (DCF) equity valuation models. For a sample of 120 DCF models detailed in reports issued by U.S. brokers in 2012 and 2013, we estimate that analysts make a median of three theory-related and/or execution errors and four questionable economic judgments per DCF. Recalculating analysts’ DCFs after correcting for major errors changes analysts’ mean valuations and target prices by between −2 and 14 % per error. Based on face-to-face interviews with analysts and those who oversee them, we conclude that analysts’ DCF modeling behavior is semi-sophisticated in the sense that analysts genuinely make mistakes regarding certain aspects of correctly valuing equity but also respond rationally to the incentives they face, particularly the reality that they are not directly compensated for being textbook DCF correct.

Keywords: Analysts; Sophistication; DCF; Valuation; Errors; Judgments (search for similar items in EconPapers)
JEL-codes: G12 G17 G32 (search for similar items in EconPapers)
Date: 2016
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Citations: View citations in EconPapers (9)

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DOI: 10.1007/s11142-016-9352-4

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