Equity valuation and the incorporation of investment risk: insights from sell-side analysts

Abstract: This thesis explores how sell-side equity analysts incorporate investment risk into their valuations and analyses of common stocks. Interviews have been conducted with 20 Swedish analysts from 13 different institutions with the intention of gaining a deeper understanding of their behavior and thought processes. We find that many analysts regard risk as an implicit and embedded part of their holistic view on companies and stocks. From this follows that they rely extensively on qualitative subjective judgment and experience, rather than quantification when assessing risk factors. In addition, the study shows that in line with previous research, many analysts use the CAPM (Sharpe, 1964; Lintner, 1965) for calculating the explicit cost of equity capital. However, they apply the model without deeper reflection and the determination of the input factors is characterized by approximation rather than estimation. In distinction to previous research, we further find that a few analysts use proprietary models based on fundamental risk factors for calculating the cost of equity capital. These models rely extensively on accounting information for determining input factors, the relevance of which has been discussed in Nekrasov & Shroff (2009). However, the proprietary models may also incorporate more qualitative risk factors such as quality of management.