Question

1.1?Critically discuss the role of non-financial information – e.g., intellectual capital information – in analysts’ forecasts, valuation and investment recommendation decisions, and analysts’ formation of a view about the companies they cover. (Need to demonstrate familiarity with relevant literature????

1.2?Discuss the following statement made by a hedge fund manager: “It is not worth the time to develop detailed fundamentals-based forecasts of earnings and free cash flows. It is quicker, easier and as accurate just to use some random walk models to forecast earnings and free cash flows.”

Answer 1

1 The financial analysts ascribe more weight to particular types of non financial information. For instance they considered forward looking information or strategy and product related information more relevant in firm valuation compared to intellectual capital information or social and environmental information.

Types of non financial information-

1. Financial and product related information in annual reports

2. Financial information released in other publications such as quarterly reports, press releases.

3. Investor relations information.

4. Historical non financial information- Business structure, production, customers in annual reports.

5. Web based performance disclosure index including indicators related to financial performance, corporate governance, Customer value, intellectual capital, product efficiency, and social responsibility.

Relavance of non financial information in the decision making process of financial analysts: Information conveyed by firms is relevant when financial analysts rely on it in their equity valuation or in their forecasting work. The globalization, technological evolutions and the transition towards a knowledge economy increase the usefulness of non financial information in judging firm value in addition to financial information. The decline in the relevance of financial information in explaining a firms value leads to the recognition that financial statement information is insufficient to satisfy the information needs of the stakeholders to assess firm's performance. Stakeholders put pressure on firms to report non financial information about rheir strategy, their investments in research and development or their customer satisfaction levels, in order to judge firm performance and to predict future earnings.

Financial analysts add value to investors by translating the bulk of non financial information disclosed by firms into comprehensive information to investors. Although investors needs of the non financial information increased over time, investors have difficulties to interpret the value and the earnings effects of non financial disclosures. The lack of investors knowledge concerning the valuation impact of non financial information increases the incentives for financial analysts to clarify how this information impacts firm performance and firm value.

Two approaches to understand the financial analysts behaviour regarding non financial information.

1. Studies indirectly investigate analysts' 'reliance on corporate non financial information by relating the extent and quality of non financial disclosures to properties of analysts earnings forecasts

2. Other studies directly address financial analysts use of non financial information through questionnaires, interviews or content analysing the reports issued by financial analysts.

The financial analysts employ non financial information in estimating future firm performance and firm value. Firms releasing a larger amaount of non financial information allow financial analysts to report more accurate earnings estimates and to provide less dispersed earnings forecasts. In general financial analysts tend to rely more on forward looking information, strategy relates information and product related information. Financial analyst hardly use intellectual capital information or corporate social responsibility information.

2 The random walk model where current year earnings are the prediction for next year, provides the best forecast of annual earnings.

The random walk provides better out of sample forecasts than do individually estimated models.

Random walk forecasts of earnings are made under the assumption that earnings will not change. The forecasts made at time t for all future earnings are always time t earnings. It is simple random walk model thay uses current year earnings per share as a benchmark.