The use of intellectual capital information by sell-side analysts in company valuation

Abstract

This paper investigates the role of intellectual capital information (ICI) in sell-side analysts’ fundamental analysis and valuation of companies. Using in-depth semi-structured interviews, it penetrates the black box of analysts’ valuation decision-making by identifying and conceptualising the mechanisms and rationales by which ICI is integrated within their valuation decision processes. We find that capital market participants are not ambivalent to ICI, and ICI is used: (1) to form analysts’ perceptions of the overall quality, strengths and future prospects of companies; (2) in deriving valuation model inputs; (3) in setting price targets and making investment recommendations; and (4) as an important and integral element in analyst–client communications. We show that: there is a ‘pecking order’ of mechanisms for incorporating ICI in valuations, based on quantifiability; IC valuation is grounded in valuation theory; there are designated entry points in the valuation process for ICI; and a number of factors affect analysts’ ICI use in valuation. We also identify a need to redefine ‘value-relevant’ ICI to include non-price-sensitive information; acknowledge the boundedness and contextuality of analysts’ rationality and motives of their ICI use; and the important role of analyst–client meetings for ICI communication.

Keywords:

• corporate reporting
• interviews
• intellectual capital
• sell-side analysts
• investment recommendations
• valuation

Acknowledgements

The authors are grateful for the comments and suggestions received from participants at the IAAER International Accounting and Auditing Conference held in Amsterdam in 2012, Professor John Holland and two anonymous reviewers on previous versions of this paper.

Disclosure statement

No potential conflict of interest was reported by the authors.

Notes

1. However, occasionally analysts may devise price targets to justify ex post their preconceived investment recommendations (Bradshaw 2002).

2. Further indirect evidence of investors’ use of ICI is reported in value-relevance studies which document positive association between various IC indicators (e.g. R&D, software development costs, brand equity, patents, customer satisfaction and loyalty, organisational capital) and share price (see Abhayawansa and Guthrie 2010 for a review of this literature).

3. RIV is derived from the classical dividend discount model by replacing the dividends with their accounting articulation under the assumption of ‘clean-surplus’ accounting (Peasnell 1982, Ohlson 1995). The ‘clean-surplus’ accounting assumes that no item affects the book value of equity directly, bypassing the income statement, i.e.: , where BV is the book value of equity and d is dividends. Substituting into the classical dividend discount model produces the residual income valuation model in its general form: where is the residual earnings for the forecast year τ.

4. Importantly, however, residual earnings will correctly account for the value created by off-balance-sheet intangibles only if the firm is in steady state (i.e. there is no growth in intangible assets).

5. The rationale for analysts’ valuation model preferences is not yet well understood (Ohlson 1995, Imam et al. 2008, 2013), but such decisions may reflect analysts’ individual preferences (Lundholm and Sloan 2004) and the influence of institutional investors (Imam et al. 2008).

6. This conceptualisation of IC was formed based on a thorough review of the IC literature and professional pronouncements on IC measurement and reporting.

7. Holland (2006) comments that fund managers have become increasingly interested in qualitative ICI and analysts are major source of this information. Whilst not directly attributable to IC, recent research evidence shows that analysts’ industry knowledge (of which ICI is an integral part) is highly valued by analysts’ clients (Brown et al. 2014).

Additional information

Funding

This research was funded through the research grant scheme of the Accounting and Finance Association of Australia and New Zealand (AFAANZ), awarded in 2010.