Errors and Questionable Judgments in Analysts' DCF Models

42 Pages Posted: 1 Apr 2014 Last revised: 31 Jan 2016

See all articles by Jeremiah Green

Jeremiah Green

Texas A&M University - Department of Accounting

John R. M. Hand

University of North Carolina Kenan-Flagler Business School

Frank Zhang

Yale School of Management

Date Written: January 15, 2016

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

JEL Classification: G12, G17, G32

Suggested Citation

Green, Jeremiah and Hand, John R. M. and Zhang, Frank, Errors and Questionable Judgments in Analysts' DCF Models (January 15, 2016). Review of Accounting Studies, Forthcoming. Available at SSRN: https://ssrn.com/abstract=2418478 or http://dx.doi.org/10.2139/ssrn.2418478

Jeremiah Green

Texas A&M University - Department of Accounting ( email )

430 Wehner
College Station, TX 77843-4353
United States

John R. M. Hand (Contact Author)

University of North Carolina Kenan-Flagler Business School ( email )

McColl Building
Chapel Hill, NC 27599-3490
United States
919-962-3173 (Phone)
919-962-4727 (Fax)

Frank Zhang

Yale School of Management ( email )

135 Prospect Street
P.O. Box 208200
New Haven, CT 06520-8200
United States

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