Auditing and Governance Mechanisms PDF

Module 3 Auditing and other governance mechanisms Other governance mechanisms Learning objectives After studying this section, you should • Understand the role of investment banks in corporate governance • Understand the role of financial analysts in corporate governance 2 Process of issuing eq...

Module 3 Auditing and other governance mechanisms Other governance mechanisms Learning objectives After studying this section, you should • Understand the role of investment banks in corporate governance • Understand the role of financial analysts in corporate governance 2 Process of issuing equity and debt securities • Registering securities with the financial supervisory authority (such as SEC in the US and FIVA in Finland) ˗ An investment bank assists the company in submitting a preliminary prospectus to financial authorities and going through the approval process ˗ The investment bank distributes the final prospectus to investors • Road show: the marketing campaign done by bankers to generate interest and to market the issue • Through assisting with regulatory filings and sales of securities, investment bankers are an important source of information and monitoring of a public company 3 IPOs issued and their average initial return from 1980 to 2008 • Investment banks tend to underprice IPO offerings in a short run • Lowers the risk to the underwriters because underpricing attracts interested customers willing to take a chance on a new public firm 700 80,0% Number of IPOs 600 70,0% Initial IPO Return 40,0% 300 30,0% 200 20,0% 100 10,0% 2008 2007 2006 2005 2004 2003 2002 2001 2000 1999 1998 1997 1996 1995 1994 1993 1992 1991 1990 1989 1988 1987 1986 1985 1984 1983 1982 0,0% 1981 0 1980 Number of IPOs Per Year 50,0% 400 Average First Day Return 60,0% 500 4 Criticisms of investment banks • Investment banks are expected to offer quality companies to investors • However, they sometimes bring inferior companies to the market, especially when prices are elevated • Investment banks have sometimes been active participants in helping companies raise capital by manipulating earnings 5 Financial analysts • Financial analysts generally fall into two categories • Buy-side analysts: analysts hired by institutional investors • Sell-side analysts: brokerage and investment bank analysts • Sell-side analysts are part of the corporate monitoring system because their recommendations are made public • A sell-side analyst look at • Firm’s operating and financial conditions, and immediate and long-term future prospects • Effectiveness of a firm’s management team, and general outlook of the industry in which a firm belongs • They also • Make earnings predictions (Earnings per share, EPS) and give trading recommendation (buy/sell/hold) 6 Quality of analysts’ recommendations • Many analysts make “conservative” earnings predictions • Companies like to meet or beat earnings expectations • Analysts also rely in part on access to companies to get information to do a good job at predicting earnings • So, analysts may make slightly beatable earnings predictions (“under promise, over deliver”) to make companies happy • Are analysts good at picking stocks? • It is still unclear whether analysts are good at picking stocks • Results from academic studies are mixed • But analysts always seem optimistic: much smaller proportion of stocks have a sell than a buy recommendation 7 Potential conflicts of interest • Between sell-side analysts and the firms they analyze ˗ To make accurate recommendations, analysts need access to high quality information ˗ The best source of a firm’s information is the firm itself ˗ Conflict: It is difficult for an analyst who needs access to management to turn around and give the firm a bad rating. • Analysts working at investment banks and investment bankers at the same bank are not supposed to collude or even influence each other when they are evaluating the same firm ˗ Conflict: Analysts that work at investment banks may feel they need to give good ratings to the bank’s customers 8