Do High Levels of Analyst Following Improve Companies’ Credit Ratings: Evidence from MENA Region?

Introduction

For the stock market to function efficiently, it needs accurate information. Once the appropriate information concerning the firms is merged with the prices, the securities are fairly priced. In fact, financial analysts work on highlighting new information related to the firm which will help them in this process. The investment decisions are usually taken by the stock market participants using the research reports of analysts, their projections, and recommendations as precise information, Lang et al. (2004). Jensen and Meckling (1976) propose that financial analysts, regarded as information intermediaries, have the ability to lessen the agency problems that firms are facing. The market value of an enterprise is a growing function of the width of investor attentiveness as Merton (1987) claims. In order to raise the responsiveness of an investor concerning a company, conventional wisdom recommends one technique to realize this which is boosting the degree of analyst following. Chung and Jo (1996) assert that the value of a business is a positive function of the number of analysts following a company. Moreover, analyst following can have an impact on the company’s valuation by dropping information asymmetries and agency problems. The main objective of those analysts is to find out the information that a company wants to hide so that they guarantee that all the information is accessible to the participants in the stock market. Consequently, they influence the firm’s valuation in a positive way and decrease the asymmetry of the information, thus we believe that the influence on the cost of debt will be favorable. Additionally, the higher the performance of analyst following, the higher the information found out. Hence, the extent of analyst following ought to be a significant factor of relationship between the company’s valuation and the analyst following, Farooq and  Satt (2014).

Through this paper, we are willing to outspread the elements referred to above by verifying if the analyst following boosts the credit rating of a business, which is an essential representation of the evaluation of the company in MENA context. As far as we know, this is the first trial that aims to bind between the two variable, Farooq and Satt (2014) already demonstrated that analysts following can boost firm performance; therefore, we can say that this paper is an extension to our previous work in order to see what if the analysts’ following can go to the extent of not only positive firm performance but also the an improved credit rating. Knowing that analysts are able to expose new information, it is spontaneous to claim that they have the ability to diminish the information asymmetries between foreigners and insiders, Farooq and Satt (2014). Declining the information asymmetries leads to an expensive expropriation skill as well as penalizing managers by decreasing the problems of agency. Thus, analyst following is the most important element that can determine the performance of a company. Moreover, the higher the extent of analyst following, the lower is the information asymmetry as recommended by the conventional wisdom. Consequently, the credit rating should be better when the magnitude of analyst following is higher. According to our fallouts, we can claim that analyst following influences positively the credit rating between the year of 2002 and 2014. Nevertheless, only high quality analyst following results in this positive influence. When lower quality analyst following is involved, we report a negative influence on firm’s credit rating— an unforeseen finding. Our outcomes are partially dependent on previous literature that takes into consideration any technique that helps in resolving information asymmetries between insiders and foreigners as appropriate value for the participants in the stock market. Our results determine that the low level of analyst following affects the firm’s credit rating in a negative way. This is astonishing for the reason that, at most, low analyst following should not influence the firm’s cost of debt. The association between the two in a negative way is counter intuitive.

The negative association between the cost of debt and the earnings per share is another surprising result of our analysis. Within various sub-samples, this association is vigorous. The low information content of reported earnings is the reason for this negative influence. Because the investors are conscious of the misreport information of the firms in the developing markets, they have little faith on reported information, hence, discounting earnings per share. Furthermore, our paper analyzes the effect of analyst following on the reported information related to earnings in order to determine if the extent of analyst following increases the reported earnings information. Indeed, our analysis’ results exhibit that it is true that analyst following increases the reported information concerning earnings, but it does not succeed entirely in strengthening the faith that investors have regarding the reported information. While the size of analyst following goes up, the extent of the negative connection between the performance of the firm and earnings per share decrease pointedly as confirmed by our research’s results.

Our results are essential for creditors. The major difficulty these creditors are facing is their inability to differentiate between good firms and bad ones. Though, according to our results, these creditors may use analyst following to identify which company has the possibility and the ability to be solvent, conversely, which company may not be. Moreover, the analyst following, based on our results, can be used to ameliorate the informativeness of reported earnings. Furthermore, our results confirm that in order to differentiate between real and manipulated accounting information, creditors with analyst following can round off accounting information. It is imperative to indicate here that our paper enhances the debate on the efficiency of alternate/external governance mechanisms. On the other hand, our analysis’ results show that analysts have some value regarding the stock market participants because they provide an augmented analysis that aids in decreasing information asymmetries, hence, ameliorating the firm’s credit rating.

The remnant of the paper will include the following: Section 2 briefly discusses motivation and background for this study. Section 3 summarizes the data and Section 4 encounters valuation of our hypothesis. Section 5 discusses implications of our findings and the paper concludes with Section 6.

Information is the significant point to efficient functioning of the stock markets. Securities get priced correctly when pertinent information about companies get merged into the prices. Financial analysts play an essential role in this process by carrying out new information about companies. These analysts are capable to decrease agency problems within the company Jensen and Meckling (1976). Merton (1987) claims that the market value of a firm is an increasing function of the breadth of investor awareness.

Satt (2015) stated that when a company is perceived to be highly performing in “the eyes” of the financial analyst,  the risk of default is very low, so the more the company is performing the better will be the its credit quality, hence higher the quality credit terms. It is also found that when the overall market believes in the good performance of a company, this latter will have the pressure to keep its positive performance.

This chapter highlights the idea that analyst following is a value that strengthens emerging markets’ mechanisms given that financial analysts play a huge role in resolving some of the corporate governance mechanisms. Providing recent information to the participants of stock market helps analysts decide on the ineffectiveness governance mechanisms. According to Michaely and Womack (1999), analysts are defined as the agents who gather, clarify, and provide stock market participants with both public and private information. Analysts are able to determine information asymmetries by spreading precious information to creditors. Moreover, Amir et al. (1999) proposes that the research of analysts alleviate information insufficiencies that reside in financial statements. This paper discusses the role that analysis play as information providers is very significant (Claessens et al., 2002; Lins, 2003; Dyck and Zingales, 2004; Nenova, 2003). Nenova (2003) claims that firms with information asymmetries described as very high are discounted by creditors. Information asymmetries expose creditors to extreme risk and initiate agency problems within firms. Consequently, any mechanism that will contribute to the lessening of information asymmetries is of major significance to any stock market participant.

In fact, our arguments go in the same flow as the past literature arguments confirming that financial analysts can play the role of an enhancing mechanism for corporate governance in emerging markets, Farooq and Satt (2014). Analysts’ substitution effect is portrayed in Lang et al. (2004) documentation. They illustrate the degree of analyst following that mitigates the unpleasant effect of lower creditors’ protection on valuation. In the same context, Knyazeva (2007) claims that by substituting for corporate governance, analyst following enhances a firm performance. The major argument that is provided here states that analysts’ position as information providers gives creditors the possibility to balance all the misrepresented information by the firm. Conventional wisdom argues that the higher the number of analysts digging for information, the larger are the chances that information is rightly reported and disclosed. As a matter of fact, lower analyst following should influence firm’s credit rating less than higher analyst following. Hence, information asymmetries are not resolved to the point that creditors start valuing analyst following. We can come to the conclusion that information asymmetries draw a constructive but a nonlinear relationship between firms’ cost of debt and analyst following. 

Analysts’ following and the Cost of Debt

Many characteristics are supposed to influence the company’s cost debt, we suspect that analysts’ following is one of the important variables that affect the cost of debt. Giving numerous factors (refer to table 1 for more information about these factors), HIGH analysts’ following refers to the level of analysts following that is above the average; and LOW analysts following refers to the level of analysts following that is below the average. Results revealed that when there is a rise in the score, there is a decline in the cost of debt.