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(originally published by Booz & Company)


How Monitoring by Stock Analysts Pays Dividends

The researchers confirmed that theory, finding that scrutinized firms with an influx of cash tended to pay out more to stockholders. “Higher analyst coverage is related to more subsequent payout of extra cash generated in the current period or converted from other current assets to investors,” the authors write. The increased payout, in turn, reduces the amount of cash at managers’ discretion and boosts firm value, they say.

The positive effects of analyst coverage outweigh any negative impact stemming from management’s pressure to meet earnings forecasts, the authors argue. The study did find, for example, that managers being scrutinized by analysts tended to invest more assets in risky projects that resulted in low returns than managers at other companies. But the negative effects of this conduct were more than offset by the overall improvement in performance that analyst coverage produced, particularly related to the firms’ use of cash assets.

The study provided some additional insights. The authors found that analysts working for large brokerage houses typically had less of a positive effect on the use of assets than did analysts at smaller firms. The reason, the authors suggest, is that “they may also have stronger incentives to curry favor from companies they follow for investment banking business.”

In addition, the authors found that more experienced analysts, even at larger firms, generally had a much more positive impact, particularly when it came to cash management. This is consistent with prior research that has found more experienced analysts are more adept at incorporating past information about company performance in their forecasts, and that the stock market values the incremental knowledge garnered by these more experienced monitors.

Bottom Line:
Financial analysts increase the value of firms and encourage them to use assets — particularly cash — more effectively. As the number of analysts increases for a given firm, so, too, does the average operating performance and the size of dividend payouts to shareholders.

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