Analyst expertise and the value of cash holdings

• Date: 01 October 2018
• Author: Louise Yi Lu,Yi (Ava) Wu
• Published date: 01 October 2018
• DOI: http://doi.org/10.1111/jbfa.12356

DOI: 10.1111/jbfa.12356

Analyst expertise and the value of cash holdings

Louise Yi Lu1Yi (Ava) Wu2

1ResearchSchool of Accounting, College of

Businessand Economics, Australian National

University,Canberra, Australia

2Disciplineof Accounting, Business School, The

Universityof Sydney, Sydney, Australia

Correspondence

Yi(Ava) Wu, Room 433, Codrington Building H69,

TheUniversity of Sydney, NSW 2006 Australia.

Email:ava.wu@sydney.edu.au

Fundinginformation

Accountingand Finance Association of Australia

andNew Zealand, Grant/Award Number: 2014-

2015AFAANZ Grant

Abstract

Thisstudy investigates whether analyst expertise mitigates the value

destruction associated with an increase in cash holdings. We find

that analyst expertise increases the marginal value of cash hold-

ings, and that this effect is more pronounced for firms in an envi-

ronment where analysts’ forecasts are more dispersed and for firms

with weakermonitoring from institutional shareholders. Overall, our

results are consistent with our conjecture that analyst expertise

enhances external monitoring, thereby preventing potential misuse

of cash holdings and the associated destruction of cash value.

KEYWORDS

analyst expertise, monitoring, value of cash holdings

1INTRODUCTION

Standard agency theory suggests that, left to their own devices, self-interested managers will misallocate corporate

resources at the expense of shareholders (Jensen & Meckling, 1976). A firm's cash holdings are particularly at risk

because cash is a liquid asset that can be easily assessed and misused by managers with less scrutiny.Recent studies

show that investors value a firm's cash holdings at a sizeable discount when they anticipate that managers are likelyto

misuse corporate resources for their private benefit. Forexample, the value of cash holdings is lower when: firms have

strong anti-takeover protection and small institutional block holdings (Dittmar & Mahrt-Smith, 2007); controlling

shareholders have disproportionally more voting rights than cash flow rights (Masulis, Wang, & Xie, 2009); firms

operate in an opaque environment (Louis, Sun, & Urcan, 2012; Lu, Shailer, & Yu, 2017); firms are listed on stock

exchangeswith weak legal investor protection (Frésard & Salva, 2010); and firms with lower CEO risk incentives (Tong,

2010). Focusing on financial analysts, Chen, Harford, and Lin (2015) find that the marginal value of cash holdings

is higher for firms with greater analyst coverage, while Drobetz, Grüninger, and Hirschvogl(2010) find that analyst

forecast dispersion reduces the value of cash holdings. However, theydo not consider the heterogeneity in analysts’

ability to perform their job. In this study,we add to this line of literature by focusing on analyst expertise.

It is widely believed that stark differences existin analysts’ ability to acquire and process complex information and

these differences affect the quality of analysts’ work and their ability to influence the market (Clement, 1999; Stickel,

1992; Hong, Kubik, & Solomon, 2000; Clement & Tse, 2003). As Nocera (1997) writes, while there are hundreds

of analysts in Wall Street seeking investors’ attention, only a few can be counted on to make money. The financial

press, for example, Institutional Investor, surveys investment managers annually to ratethe performance of analysts;

and investors subscribe to services such as Starmine or Marketperfom, which help identify analysts who provide

1352 c

2018 John Wiley & Sons Ltd wileyonlinelibrary.com/journal/jbfa JBus Fin Acc. 2018;45:1352–1375.

LU ANDWU 1353

better investment performance. Given the importance placed on analyst expertiseby the investment community, it is

important to understand how expertise contributes to investors’evaluations of firms’ use of cash.

Extant research suggests that analysts often reveal information about firms’ use of corporate resources, and their

research contains prognostications of how such decisions affect their performance. Asquith, Mikhail, and Andrea

(2005) examine the information content of equity analyst reports and find that analysts typically comment on various

firms’ decisions relating to cost efficiencies, business strategies, and mergers and acquisitions activities to justify

their earnings forecasts, recommendations and price targets. According to Graham and Dodd (1940), analysts should

identify flawed ideas and instances where a firm's plan does not match corporateresources. Anecdotal evidence shows

that analysts comment on both firms’ current and future use of cash. For example, in relation to General Electric's

recent stock performance, a JP Morgan analyst directly questioned the firm's dividend policy and its US$ 15 billion

reserve.1In discussing the impact of the newly passed US tax bills on tech companies, a few analysts have already

discussed how bringing back the cash stockpiled offshore could affect these firms’ future dividends, buybacks and

expansion decisions.2

In this study,we argue that analyst expertise enhances external monitoring, thereby preventing potential misuse of

cash holdings and the associated destruction of cash value. This is because compared to analysts with lesser expertise,

analysts with a high level of expertisehave access to more private information and a superior ability to assimilate and

incorporate information into their forecasts (Chung & Jo, 1996; Clement, 1999; Drake & Myers, 2011). As a result,

expertanalysts could not only generate higher-quality information about firms’ investments, but also identify instances

where resources are misused. This information on a firm's use or misuse of resources could facilitate monitoring from

outside individual investors, allowing better design of a contract in which managers will be appropriately penalized

for misusing corporate resources. Therefore, expert analysts can influence managers’ ex-ante investment decisions,

leading to more efficient resource allocation.

Admittedly, it is possible that a conflict of interest may arise between analysts and investors and, as a result, the

analysts’ expertise may not contribute to the value of a firm. Expert analysts may produce biased estimates to curry

favor with management because management is one of the most important sources of analyst information (Brown,

Call, Michael, & Sharp, 2015). Moreover,a survey by Graham, Harvey, and Rajgopal (2005) reveals that about 80% of

top executives admitted to a willingness to cut investment to meet analysts’ earnings estimates. Given the ability of

expertanalysts to elicit stronger market reactions (e.g., Clement & Tse, 2003; Stickel,1992), management is likely to be

under greater pressure to meet their estimates, and so they may forgo positive net value projects that could enhance

long-term firm value. While ultimately an empirical question, these arguments are likely to bias our results against our

directional prediction; that is, that expert analysts enhance the external monitoring of managers’ use of cash, which

results in a higher value of cash holdings.

Totest our prediction, consistent with prior studies (e.g., Dittmar & Mahrt-Smith, 2007; Faulkender & Wang, 2006;

Louis et al., 2012),we employ the value of cash holdings model developed by Faulkender and Wang (2006). Specifically,

we regress excess stock return on change in cash assets and its interaction with our measures of analyst expertise,

while controlling for analyst coverage, analyst dispersion and a battery of other factors that could potentially con-

found our results. Consistent with prior studies (Kirk, Reppenhagen, & Tucker, 2014; Wu & Wilson, 2017), to identify

expert analysts, we calculate a composite score measure based on certain characteristicsthat are found to affect ana-

lyst expertise. These characteristics include analysts’ generalforecasting experience, firm-specific forecasting experi-

ence, brokerage size, All-Star status, and the number of firms and industries followed by an analyst (Clement, 1999;

Kim, Lobo, & Song, 2011; Kirk et al., 2014; Stickel, 1992; Wu & Wilson, 2017). The composite score aims to capture an

analyst's overallexpertise, which encompasses multiple aspects of analyst expertise.

Using a large sample of 25,106 firm-yearobservations forpublicly listed US companies over the period 1994–2015,

we find that analyst expertise substantially increases the marginal value of cash holdings. For example, we find that,

on average, investors’ valuations of cash holdings are larger for firm-years coveredby high-expert analysts than for

1https:|www.reuters.com/article/us-ge-stocks/ges-2018-gains-wiped-out-as-worries-about-turnaround-plan-persist-idUSKBN1F62FV?il=0

2https:|www.thestreet.com/story/14428237/1/apple-overseas-cash-taxes.html