Title: Do Financial Analysts Add Value by Facilitating More Effective Monitoring of Firms’ Activities? (Fee or subscription required.)
Authors: Boochun Jung (University of Hawaii at Manoa), Kevin Jialin Sun (University of Hawaii at Manoa), and Yanhua Sunny Yang (University of Texas at Austin)
Publisher: Journal of Accounting, Auditing & Finance, vol. 27, no. 1
Date Published: January 2012
It has long been held that the monitoring of firms by financial analysts boosts the companies’ value in a number of ways. Analysts can increase transparency, uncover managers’ misuse of firm resources, reduce fraud, and scrutinize managers, thus prompting them to more efficiently allocate corporate assets. By analyzing a company’s performance, analysts can also induce the board of directors to probe managers’ activities and make investments that increase overall value.
But several recent studies have provided evidence of a negative effect of analysts, who often have conflicts of interest that may make them reluctant to reveal instances of mismanagement. In addition, a 2003 paper showed that as analysts’ forecasts have become increasingly important and the targets more difficult to meet, managers have faced additional pressure to pursue short-term earnings goals at the cost of long-term firm value.
Aiming to settle the question, this paper empirically shows that the effects of analyst monitoring have a positive and significant effect on firm value and operating performance, especially in terms of how cash assets are used. Monitoring was also positively linked to profitability with respect to return on assets, earnings, and dividend payouts, and improvements were noted even in long-term performance.
The researchers analyzed a large sample of U.S. firms from 1988 to 2006, combining several databases to obtain information about the companies’ assets, earnings, dividends, liabilities, market value, and stock performance. They also collected information about the analysts who followed each company and the institutional holdings of each company’s stock. On average, each company was followed by five stock analysts, and institutional investors held almost 29 percent of its stock. The authors controlled for several variables, including firm size, profitability, growth potential, and corporate governance.
The authors investigated whether the relationship between analyst monitoring and firm value varied by type of assets. They found that the analysts’ positive effect was driven mainly by their impact on the use of cash, and was much weaker for other assets. The authors also discovered a link between the number of analysts following a company and the company’s performance. Each additional analyst increased the value of a monitored firm by an average of 12 cents for every dollar held in cash, compared with increases of 6 cents for noncash assets and 2 cents for long-term assets.
This disproportionate impact makes sense, the authors say, because the effective monitoring of management performance has more potential to produce beneficial results in terms of cash than it does with regard to other assets. It’s simply easier for managers to use (or misuse) cash, they state, citing previous studies showing that “management has easier access to liquid assets and more discretion and lower transaction costs in their use.”
For example, firms covered by analysts, on average, held less cash than firms not covered by analysts, at 12.7 percent versus 17.4 percent of the companies’ total market value. This jibes with the argument that companies followed by more analysts tend to have easier access to external sources of finance and don’t have as much incentive to hoard their liquid assets.
The authors also examined the relationship between analyst coverage and firms’ subsequent operating performance, as well as firms’ payouts to shareholders (in the form of dividends and stock repurchases). If a higher analyst following does restrain management’s tendency to waste assets, the performance of scrutinized firms should be better, with a larger increase in firm value related to the use of cash assets and a higher payout of cash to shareholders.
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.
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.