The financial analyst forecasting literature

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InternationalJournalofForecasting24(2008)34–75
www.elsevier.com/locate/ijforecast
The financial analyst forecasting literature: A taxonomy with
suggestions for further research
⁎
Sundaresh Ramnatha,1, Steve Rockb,2, Philip Shaneb,c,
aSchoolofBusinessAdministration,UniversityofMiami,CoralGables,FL33146,USA
bLeedsSchoolofBusiness,UniversityofColorado,419UCB,Boulder,CO80309,USA
cUniversityofAucklandBusinessSchool,PrivateBag92019,Auckland,NZ,USA
Abstract
Thispaperdevelopsataxonomyofresearchexaminingtheroleoffinancialanalystsincapitalmarkets.Thepaperbuildson
theperspectivesprovidedbySchipper[Schipper,K.(1991).Analysts'forecasts.AccountingHorizons,5,105–131]andBrown
[Brown, L. (1993). Earnings forecasting research: Its implications for capital markets research. International Journal of
Forecasting,9,295–320].Wecategorizepaperspublishedsince1992,describetheresearchquestionsaddressed,andsuggest
avenuesforfurtherresearchinsevenbroadareas:(1)analysts'decisionprocesses;(2)thenatureofanalystexpertiseandthe
distributions of earnings forecasts; (3) the information content of analyst research; (4) analyst and market efficiency;
(5)analysts'incentivesandbehavioralbiases;(6)theeffectsoftheinstitutionalandregulatoryenvironment(includingcross-
country comparisons);and(7) research design issues.
©2007International Institute of Forecasters. Published byElsevier B.V.All rights reserved.
Keywords:Earningsforecasting;Financialanalysts;Financialmarkets;Stockpriceforecasts;Analyststockrecommendations;Analystresearch
reports; Analyst decision processes; Analysts' incentives;Analyst expertise; Analyst inefficiency; Forecast bias; Financial analyst literature
review
1. Introduction locationofeconomicresources.Twoimportantpapers
published in the early 1990s provide perspectives on
This paper provides a taxonomy of research ex- the literature: one appears in Accounting Horizons
amining the roles financial analysts play in the al- (Schipper, 1991) and the other appears in the Inter-
national Journal of Forecasting (Brown, 1993). Our
⁎ Correspondingauthor.LeedsSchoolofBusiness,Universityof paper begins by summarizing the perspectives and
Colorado,419UCB,Boulder,CO80309,USA.Tel.:[phone] directions for future research suggested by Schipper
0423;fax:[phone]. (1991) and Brown (1993).3 We then develop a tax-
E-mailaddresses:[email protected](S.Ramnath),
onomy of the research that has appeared since 1992.
[email protected](S.Rock),[email protected]
(P.Shane).
1 Tel.:[phone];fax:[phone] AlsoseeGivolyandLakonishok(1984)forareviewofanalyst
2 Tel.:[phone];fax:[phone]. forecastingresearchpriorto1984.
0169-2070/$-seefrontmatter©2007InternationalInstituteofForecasters.PublishedbyElsevierB.V.Allrightsreserved.
doi:10.1016/j.ijforecast.2007.12.006
S.Ramnathetal./InternationalJournalofForecasting24(2008)34–75 35
Our goal is to provide an organized look at the and market decisions about firm value. We still have
literature, paying particular attention to the questions much to learn about the heuristics relied upon by
remaining for furtherresearch.4 analysts andthe market.
Since 1992, approximately 250 papers related to The rest of this paper draws attention to these
financial analysts have appeared in the eleven major issues, as well as other issues that have arisen since
research journals that we use to develop our taxon- 1992. The next section provides a summary of the
omy.5 In our review of papers published since 1992, questions identified in Schipper (1991) and Brown
we have found much progress in some of the areas (1993)andthedirectionsforfutureresearchsuggested
identified by Schipper (1991) and Brown (1993), and by those authors, as well as those suggested by the
less progress in others. In particular, the research has authors of the four papers commenting on Brown
evolved from descriptions of the statistical properties (1993).Section3describesourtaxonomy,categorizes
ofanalysts'forecaststoinvestigationsoftheincentives the papers published since Brown (1993), and
and decision processes that give rise to these proper- identifies new research questions that emerge from
ties. However, in spite of this broader focus, much our reading of the literature. Section 4 provides con-
of the analysts' decision processes and the market's cluding comments, highlighting the areas that we
mechanism of drawing a useful consensus from the consider most promising for futureresearch.
combinationofindividualanalysts'decisionsremains
hiddeninablackbox.Furthermore,westillhavemuch 2. Perspectives from Schipper (1991) and
to learn about relevant valuation metrics and mech- Brown (1993)
anisms by which analysts and investors translate
forecasts into equity values. For example, with the Katherine Schipper's (1991) commentary makes
renewed popularity of the earnings-based valuation twomajorpoints.First, shesuggeststhat theresearch
model in the early 1990s, the research turned toward regardinganalysts'earningsforecastsfocusestoonar-
investigating themodel's role inthemarket's conver- rowly on the statistical properties of the forecasts,
sion of analysts' earnings forecasts into stock prices. withoutconsideringthefulldecisioncontextandeco-
Given the unexpected result that this model does a nomic incentives affecting these properties. She takes
relatively poorjob of explaining the variation inmar- the point of view that the analyst's job is to provide
ket prices and analysts' price forecasts and recom- buy-sell-holdrecommendations,andgenerateresearch
mendations, researchers have turned their attention to reports to support those recommendations. Schipper
examining heuristics that might better explain analyst describes analysts' earnings forecasts as one compo-
nent of their research reports, and a means to an end
4 Wefocusontheresearchrelatedtoanalysts'decisionprocesses rather than ends in themselves. She suggests that a
and the usefulness of their forecasts and stock recommendations. more complete description of analysts' economic in-
For broader reviews of archival capital markets research and centives and the role of earnings forecasts in the full
experimentalfinancialaccountingresearch(includingissuesrelated decision context of analysts should lead to richer
toanalysts'forecastsandrecommendations),seeKothari(2001)and
hypotheses regarding the statistical properties of the
Libby,Bloomfield,andNelson(2002),respectively.
5 Ourtaxonomygenerallyexcludespaperspublishedbefore1993 earnings forecasts. The second major point is that the
andafterJune2006,andwealsogenerallyexcludeworkingpapers. research on the statistical properties of analysts'
However,webelievethatourclassificationschemeisbothflexible earnings forecasts focuses on outputs from, rather
and broad enough to enable the interested reader to continue thaninputsto,analysts'decisionprocesses.Thecom-
categorizingnewpapers.Foranexpandedlistofpapers,werefer
mentary calls for more research into how analysts
the interested reader to the Thomson Financial Research Biblio-
actually use accounting information and their own
graphy(Brown2007).Ourtaxonomyfocusesonlyonthepapersin
thatbibliographythatwerepublishedinthe11journalswereview earnings forecastsinmaking decisions.
exhaustively;however,manyofthepapersintheI/B/E/SResearch FromLarryBrown's(1993)reviewpaper,weglean
Bibliographywerepublishedinotherjournals,andmanyremainin four key points. First, he notes that the models that
workingpaperform.WealsorefertheinterestedreadertotheFi-
produce the most accurate forecasts of an earnings
nancialAnalysts'JournalandtheJournalofInvestingforarticles
variable should also produce the best proxies for the
suggesting practical applications of the ideas in the academic
articlesincludedinourtaxonomy. market'sexpectations,assumingmarketefficiencyand
36 S.Ramnathetal./InternationalJournalofForecasting24(2008)34–75
assumingthattheresearchdesigncorrectlymodelsthe research. O'Hanlon (1993) calls for investigations of
valuationimplicationsoftheearningsvariable.Under the degree to which financial analysts' earnings fore-
these assumptions, “predictive ability and association casts distinguish permanent from temporary earnings
aretwosidesofthesamecoin(p.296).”Brownnotes changes. Thomas (1993) suggests that the importance
mixedresultsonthisissueandcallsforfutureresearch ofresearchintohowanalystsmakeearningspredictions
to sort out whether the apparently conflicting results dependsontheanswerstoseveralquestions,including
stem from research design problems or market in- (1) whether analysts' forecasts influence the marginal
efficiency. Second, Brown encourages researchers to investor; (2) whether analysts seek to predict a ‘core’
carefully consider the appropriateness of summary earnings number that will persist in the future; and
filesofI/B/E/Sconsensusforecasts.Althoughthedate (3) whether their incentives are consistent with pro-
of the I/B/E/S report and the coding of the forecast ducing the most accurate forecasts possible. P. Brown
horizon indicates a timely consensus, the consensus (1993)callsforresearchintowhethersomeanalystsare
may contain stale forecasts which have not been up- better forecasters than others, whether the market's
dated since the information event on which the study earnings expectations reflect these differences, and the
intendstoconditiontheforecasts.Brownsuggeststhat degreetowhichconsensusforecastsdrawnfromanalyst
usingtheI/B/E/SDetailfilescanavoidthisproblem.6 tracking services such as I/B/E/S reflect investor
Third,Browncallsforresearchtobetterunderstandthe expectations. Zmijewski (1993) focuses on the need
role of analysts' forecasts in post-earnings announce- for investigations of cross-country variation in the
ment drift. In particular, he calls for research into propertiesofearningsforecastsand their roles inprice
the reasons for variation in the degree and speed of formationincapitalmarkets.
forecast convergence following earnings announce- Based on our reading of Schipper (1991), Brown
ments(i.e.,convergencetowardsaconsensusthatfully (1993)andtherelatedcommentpapers,alongwithan
reflectstheinformationinthepriorearningsannounce- initial look at the research published since 1992, we
ment), and the effect, if any, of forecast convergence organize the research into seven broad topic areas:
on post-earnings announcement drift. Finally, like (1)Whatisthenatureofanalysts'decisionprocesses,
Schipper (1991), Brown calls for research to better and how do analysts rationalize the forecasts and
understand the decision processes of analysts and the recommendations contained in their research reports?
roles of analysts' earnings forecasts, macroeconomic (2)Whatisthenatureofanalystexpertiseandwhatare
and industry factors, and other information in for- the distributional characteristics of individual analyst
mulating stock price forecastsand recommendations. earnings forecasts? (3) How informative are the
Both Brown (1993) and Schipper (1991) call for outputs from analyst research (including earnings
experimentalresearchtoplayamoreprominentrolein forecasts, target price forecasts, stock recommenda-
understanding the uses of accounting and other in- tions, and qualitative contextual analysis)? (4) Do
formation in making stock recommendations, within analysts'forecastsandrecommendationsimpoundin-
the full context of the analyst's decision environment formation about future earnings efficiently? Do stock
and economic incentives. In Brown's words, “joint prices impound the information in analysts' forecasts
efforts by capital markets researchers and behavioral- and recommendations efficiently? (5) How do man-
ists to examine these issues more thoroughly would agement and analyst incentives, along with behavior-
considerablyenhanceourunderstandingoftheroleof al biases, affect the statistical properties of analysts'
analysts in theprice formationprocess (p.315).” forecasts? (6) How does variation in the regulatory
FourauthorscommentedonBrown(1993),andeach environment(overtimeandacrosscountries)affectthe
providesinterestinginsightsandsuggestionsforfuture behaviorofanalysts'forecastsandtheroleofanalysts
incapitalmarkets?(7)Whataresomeresearchdesign
6 MostofthestudiesreviewedbyBrown(1993)reliedoneither and database issues that threaten the validity of
the I/B/E/S consensus or the Value Line data. Some studies also inferences from studies of the behavior of analysts
usedMerrillLynch'sOpinionAlert,StandardandPoors'Earnings
and their forecastsand recommendations?
Forecaster, and Zacks' Investment Research. Others used Detail
The next section is divided into seven subsections
filesfromI/B/E/SandZacks,whichonlybecamereadilyavailable
attheendoftheperiod. that categorize the research papers addressing these
S.Ramnathetal./InternationalJournalofForecasting24(2008)34–75 37
questions, with a selective focus on papers published pertise (Section 3.2) in obtaining and analyzing in-
since Brown (1993) that stimulate our suggestions of formationfromvarioussources,including(1)earnings
avenues for further research in each category of our andotherinformationfromSECfilings,suchasproxy
taxonomy. statements and periodic financial reports; (2) industry
and macroeconomic conditions; and (3) conference
calls and other management communications. From
3. A taxonomy of research related to the role of this information, analysts produce earnings forecasts,
financial analysts in capital markets target price forecasts, and stock recommendations,
along with qualitative reports describing firms' pro-
ThequestionsattheendofSection2naturallyarise spects (Section 3.1). Investors use these outputs from
from the analyst reporting environment shown in analyst research to make trading decisions that affect
Fig. 1, and provide the foundation for our taxonomy. market prices (Section 3.3). If the analyst forecasting
Thesevensubsectionsbelow(3.1through3.7)andthe process and capital markets are efficient, then market
triangles in Fig. 1 correspond to the seven questions pricesandanalysts'forecastsimmediatelyreflectallof
above. As described in Fig. 1, analysts develop ex- the information described in Fig. 1. Inefficiencies
Fig.1.Analysts'ReportingEnvironment.
38 S.Ramnathetal./InternationalJournalofForecasting24(2008)34–75
create predictable analyst forecast errors and stock the research and suggest new questions that might be
price changes (Section 3.4). The decision processes addressed inthe foreseeable future.8
and analyst research output pictured in Fig. 1 also
dependonregulatoryandinstitutionalfactorsthatvary 3.1. Analysts' decision processes
over time and across countries (Section 3.6), as well
as on analysts' economic incentives and behavioral 3.1.1. Questions addressed since 1992
biases(Section3.5).Finally,thelimitationsassociated AsshowninTable1,researchershaveinvestigated
with archival databases, econometric tools, and a number of questions related to analysts' decision
mathematical models create research design issues processessince 1992, including:
that constrain the researcher's ability to observe the
forcesthatultimatelydrivemarketprices(Section3.7). 1. What information affects the development of an-
We launch our taxonomy by listing and categoriz- alysts' earnings forecasts and recommendations?
ing all papers related to analysts and published since (Panel A);
1992 in the following eleven major research journals 2. What information affects analyst following and
spanning accounting, finance and forecasting: The portfolio decisions? (Panel B);
Accounting Review, Contemporary Accounting Re- 3. What environmental, classification and reporting
search, InternationalJournal of Forecasting, Journal quality factors affect analysts' forecasts and re-
ofAccounting andEconomics, Journal ofAccounting commendations? (Panel C);
Research, Journal of Business, Journal of Finance, 4. How do analysts transform information into target
JournalofFinancialEconomics,JournalofFinancial pricesandstockrecommendations?(PanelD);and
and Quantitative Analysis, Review of Accounting 5. What is the role of earnings components in an-
Studies,andReviewofFinancialStudies.7OurTables alysts' decision processes? (Panel E).
3.1 through 3.7 exhaustively categorize and briefly
describe each paper related to analysts and appearing Researchers have used surveys to simply ask an-
inanyoneoftheabovejournalsbetweenJanuary1993 alysts how they process information (e.g., Block,
and June 2006. From that starting point, four areas 1999),contentanalysesofanalysts'researchreportsto
of subjectivity necessarily enter our paper. First, we infer the information analysts rely upon in making
infer important sub-questions within each area of our forecastsandrecommendations(e.g.,Rogers&Grant,
taxonomy. Second, we subjectively select papers to 1997;Bradshaw,2002),andlaboratoryexperimentsto
discuss in the text that facilitate our assessment of study how analysts use information (e.g., Hopkins,
directionsforfurtherresearchineachareaoftheseven Houston,&Peters,2000).Archivalstudiesoffermore
categories of our taxonomy. Third, we list a paper generalizable results, but are limited in their ability
morethanonceifitrelatestomorethanoneofoursub- to penetrate the black box of analysts' actual deci-
questions. Finally, we refer to working papers and sion processes. The challenge is that analysts have a
papers published in journals other than the eleven context-specific task that is very difficult to model,
listed above when they come to our attention and and,consistentwithsuggestionsinBrown(1993)and
directly relate to our ideas for further research. Our Schipper (1991), in recent years we have seen
goal is not to provide exhaustive reviews of (or even relatively more studies using experimental and con-
referencesto)allofthepaperspublishedsince1992or textual approaches to questions about analysts' de-
currently in process, but rather to selectively identify cision processesandincentives.
theaspectsofpapersthatwethinkcapturethepulseof
3.1.2. Suggestions for further research related to
analysts' decision processes
In addition to the obvious use of earnings-related
7 We exclude papers that use analysts' forecasts merely as a information,theresearchsummarizedinTable1,Panel
controlvariableortoproxyforanunderlyingconstruct.Thatis,we
focus on papers studying the roles of analysts in capital market
resourceallocation.Wealsogenerallyexcludediscussioncomments 8 See Ramnath, Rock, and Shane (2006) for a more detailed
onpublishedpapers. reviewoftheresearchcategorizedinourtaxonomy.
S.Ramnathetal./InternationalJournalofForecasting24(2008)34–75 39
Table1
SelectedPapersAddressingQuestionsRelatedtoAnalysts'DecisionProcesses(Section3.1)
Reference Method Keyresult
PanelA.ResearchQuestion3.1.1:Whatinformationaffectsthedevelopmentofanalysts'earningsforecastsandrecommendations?
LevandThiagarajan Archival,variousanalyst Twelve fundamentals-basedearningspersistence indicators,derived from practitioner-
(1993) commentaries,1973-1990. orientedanalystliterature,collectivelyenhancetheexplanatorypowerofanearnings-
returnsregression.
Denis,Denis,and Archival,I/B/E/S, Analyst forecast revisions following dividend changes are consistent with dividend
Sarin(1994) 1962-1988. changes providing information about future cash flows rather than about investment
opportunities.
Previts,Bricker, Contentanalysisof Analystsplaceheavyweightsonearnings-relatedinformation,disaggregatetheinformation
Robinson,andYoung Investextreports, beyondtheGAAP-baseddisaggregationfoundinannualreports,extractnon-recurringitems,
(1994) 1987-1988,1990-1992. andrelyheavilyonmanagementforinformationbeyondannualreports.
Bouwman,Frishkoff, Protocolanalysisof The nature of the informationusedby analystsdependson the phaseof the decision
andFrishkoff(1995) 12buy-sideanalysts. process.Overall,buy-sideanalystswantmoresegmentinformation,longertimeseriesof
historicalsummaryinformation,management-suppliedforward-lookinginformation,
andsell-sideanalystreports.
KasznikandLev Archival,I/B/E/S, Analysts'forecastrevisionsinresponsetodisappointingearningsaccompaniedbywarnings
(1995) 1979-1986. aresignificantlymorenegativethantheresponsestodisappointingearningsunaccompanied
bywarnings,suggestingthatwarningsoccurringbeforenegativeearningssurpriseshave
morepermanentimplicationsforfutureearnings.
ElyandMande Archival,ValueLine, Analysts'earningsforecastrevisionsreflectcorroborativeinformationindividendand
(1996) 1977-1986. earningsannouncements,particularlywhentheearningsinformationisnoisy.
LangandLundholm Archival,Reportofthe The dispersion in analysts' forecasts declines with higher quality annual report
(1996) FinancialAnalysts' disclosures and better investor relations, but not with the quality of other corporate
Federation(FAF) communications(e.g.,quarterlyreports,pressreleases,etc.).Analysts'forecastaccuracy
CorporateInformation improveswiththequalityofothercorporatecommunicationsandinvestor
Committee,1985-1989. relations,butnotwiththequalityofannualreportdisclosures.
Williams(1996) Archival,I/B/E/S, Analystrelianceonmanagementearningsforecastsincreaseswiththeprior“usefulness”of
1979-1986. theforecasts(i.e.,theincrementalcontributionofthepriorforecaststopriorforecastaccuracy).
Maines,McDaniel, Experimentswith56 Analyst confidenceinsegment reportingqualitydependson theconsistencywith the
andHarris(1997) professionalanalysts definitionsofsegmentsusedbythecompanyforinternaldecision-making.
and60MBAstudents.
Rogersand Contentanalysisof Analystsusesubstantialamountsofnon-financialinformationbothwithinandoutsideof
Grant(1997) OneSourcereports, GAAP-basedannualreports.
1993-1994.
EderingtonandGoh Archival,I/B/E/S, Analysts'earningsforecastrevisionsbothleadandlagbondratingdowngrades;partofthe
(1998) 1984-1990. post-downgraderevisionseemstoberelatedtothedowngradeitself,asopposedtoachange
inactualearnings.Bondratingupgradesarefollowedbyupwardanalystforecastrevisions,
althoughactualearningsareunrelatedtoupgrades.
Barron,Kile,and Archival,I/B/E/S, Analystforecastaccuracyimprovesanddispersioninanalysts'forecastsdeclineswith
O'Keefe(1999) 1987-1989. increases in the SEC ratings of the quality of firms' communication through MD&A
disclosures.Theresultsaredrivenbyforward-lookingdisclosuresaboutoperationsand
bothforward-lookingandhistoricalanalysesofcapitalexpenditures.
Healyetal.(1999) Archival,AIMRReports, The key factors valued by analysts are segmental reporting quality; quality and
1980-1990. candidnessinthemanagementdiscussionandanalysis(MD&A)sectionofannualand
quarterly reports; the publication of supplemental disclosures outside of the required
periodicreports;andtheavailabilityofmanagementtoanalysts.
Bowen,Davis,and Archival,Zacksand Prior to Reg FD, the information in conference calls led to improved analyst forecast
Matsumoto(2002) FirstCall,1995-1998. accuracyandreducedthedispersioninanalysts'earningsforecasts,suggestingaformof
selectivedisclosure,sinceconferencecallsweregenerallyclosedtothegeneralpublicprior
toRegFD.
Conrad,Cornell, Archival,I/B/E/S, Analystsareequallylikelytoupgradeordowngraderecommendationsfollowinglarge
Landsman,and 1993-1999. stock price increases, but are more likely to downgrade following large stock price
Rountree(2006) declines.Theresultsareconsistentwith“sticky”downsiderecommendationrevisions.
(continuedonnextpage)
40 S.Ramnathetal./InternationalJournalofForecasting24(2008)34–75
Table1(continued)
Reference Method Keyresult
PanelB.ResearchQuestion3.1.2:Whatinformationaffectsanalystfollowingandportfoliodecisions?
Previtsetal.(1994) Contentanalysisof Analystsprefertofollowfirmsthatsmoothearnings.
Investextreports,
1987-1988,1990-1992.
ChungandJo(1996) Archival,I/B/E/S, Analystfollowinghasapositiveimpactonfirmvalue,andanalyststendtofollowstocks
1984-1987. ofhighqualityfirms.
LangandLundholm Archival,Reportofthe Analystsprefertofollowfirmswithmoreforthcomingdisclosures,particularlyinthe
(1996) FinancialAnalysts' contextofdirectinvestorrelationscommunications,asopposedtopublicdisclosuresin
Federation(FAF) annualandquarterlyreportstoshareholders.
CorporateInformation
Committee,1985-1989.
BotosanandHarris Archival,Nelson's Analyst following increases with firms' decisions to include information on segment
(2000) Directory,I/B/E/S, activityaspartoftheirquarterly(asopposedtoonlyannual)reports.
1987-1994.
Barth,Kasznikand Archival,I/B/E/S, Relative to industry peers, analyst following increases with R&D and advertising
McNichols(2001) 1983-1994. expenditures.
PanelC.ResearchQuestion3.1.3:Whatenvironmental,classificationandreportingqualityfactorsaffectanalysts'forecastsandrecommendations?
Hawetal.(1994) Archival,I/B/E/S, Forecast complexity increases and analyst forecast accuracy deteriorates following
1977-1984. mergers,butafterfouryearsaccuracylevelsreturntopre-mergerlevels.
Hopkins(1996) Experimentwith83 The classification of hybrid instruments as either a liability or an equity causes
buy-sidefinancial analysts to overemphasize the debt (equity) attributes of the instruments in making
analysts. stockrecommendations.
HirstandHopkins Experimentwith96 The clarity of income effects in comprehensive income disclosures affects analysts'
(1998) buy-sideanalysts. abilitytodetectearningsmanagementandmakeeffectivevaluationjudgments.
Hopkinsetal.(2000) Experimentwith113 The method of accounting for a business combination affects analysts' stock price
buy-sideequityanalysts. judgmentsunlesstheincomeeffectofthemethodisclearlydelineated.
DuruandReeb Archival,I/B/E/S, Forecasting complexity increases and accuracy decreases with corporate international
(2002) 1995-1998. diversification.
Plumlee(2003) Archival,ValueLine, Theeffectivetaxrateeffectsofthemorecomplexaspectsofthe1986taxactweremore
1984-1988. difficultforanalyststoforecast.
Hirst,Hopkins, Experimentwith56 Analystsuseinformationaboutinterestrateriskmoreeffectivelywhengainsandlosses
andWahlen(2004) buy-sideanalysts. aremeasuredandreportedinfinancialstatementsthanwhentheyaremerelydisclosedin
financialstatements.
PanelD.ResearchQuestion3.1.4:Howdoanalyststransforminformationintotargetpricesandstockrecommendations?
Bandyopadhyay,Brown, Archivalstudy,Research RESnextyearearningsforecastrevisionsexplainabout30%ofthevariationinRES
andRichardson(1995) EvaluationService(RES), 12-month-ahead price forecast revisions; and revisions in Value Line's 3-5year ahead
ValueLine,1983-1988. earningsforecastsexplainabout60%ofthevariationinrevisionsinValueLine's3-5year
aheadpriceforecasts.
Block(1999) Questionnairesurveyof 46%ofrespondentssaidthatpresentvalueanalysisisnotpartoftheirnormalprocedures.
membersofAIMR. Analystsconsideredearningsandcashflowtobefarmoreimportantthandividendsand
bookvalueinsecurityvaluation.However,analystsrelymoreheavilyonearningsmultiples
versusDCFinvaluation,andgrowthpotentialandearningsqualityarethecrucialfactorsin
evaluatingP/Eratios.
Bradshaw(2002) ContentanalysisInvestext Analyststendtojustifyfavorablestockrecommendationsandtargetpriceswithreference
reports,FirstCall tolowP/Eratiosrelativetogrowthprojections,andanalystsappeartoderivetargetprices
Real-TimeDatabase, usingaPEG-basedmultiplesapproachthatadjustsP/Eratiosforgrowthprospects.
1998-1999.
Bradshaw(2004) Archival,Investext Asimpleheuristicbasedonanalysts'consensuslong-termgrowthrateforecastsexplains
reports,FirstCall 23%ofthevariationinanalysts'consensusstockrecommendations,andthisheuristicis
Real-TimeDatabase, negatively correlated with value-to-price ratios based on earnings-based valuation
1998-1999. models.
S.Ramnathetal./InternationalJournalofForecasting24(2008)34–75 41
Table1(continued)
Reference Method Keyresult
PanelD.ResearchQuestion3.1.4:Howdoanalyststransforminformationintotargetpricesandstockrecommendations?
Demirakos,Strong,and Contentanalysisof AnalystsoverwhelminglyrefertosimpleP/Emultiples(asopposedtoDCForearnings-
Walker(2004) Investextreports, basedvaluationmodels)tosupporttheirstockrecommendations.
1997-2001.
LohandMian(2006) Archival,I/B/E/S, Analystswhoissuemoreaccurateforecastsalsoissuemoreprofitablerecommendations,
1994-2000. implyingthatanalystsusetheirearningsforecaststogeneraterecommendations.
PanelE.ResearchQuestion3.1.5:Whatistheroleofearningscomponentsinanalysts'decisionprocesses?
Chandra,Procassini, Archival,ValueLine, Analysts' firm-specific sales forecast revisions reflect information in industry trade
andWaymire 1986-1993. association industry-wide orders-to-sales ratio reports. This information is useful in
(1999) assessingthepersistenceofunexpectedfirm-specificquarterlysalesannouncements.
MestandPlummer Archival,ValueLine, The proportion of transitory earnings components reflected in earnings forecasts
(1999) 1982-1988. decreasesasforecasthorizonsincrease,suggestingthatshort-termforecastsaredirected
at GAAP earnings, whereas long-term forecasts reflect expectations about persistent
earnings.
Brownand Archival,I/B/E/S, EarningschangesbasedonactualquarterlyearningsreportedontheI/B/E/Sdatabase
Sivakumar(2003) 1989-1997. exhibitmorepersistencethanearningschangescomputedusingEPSfromoperationsper
Compustat.I/B/E/S-reportedactualearningsarealsomorecloselyassociatedwithmarket
measuresthanCompustat'sEPSfromoperations.
GuandChen(2004) Archival,FirstCall, Non-recurringitemsthat analystsforecastand include intheir actualearningsreports
1990-2003. havegreaterpersistenceandhighervaluationmultiplesthanthoseexcluded.
A,showsthatanalysts'earningsforecastsrelyheavily Some research, which is summarized in Table 1,
ondisaggregatedandqualitativeinformation.Thetwo Panel B, examines the firm characteristics that in-
most commonly used sources of information, other fluence analyst decisions to follow firms. Assuming
than reported earnings, are management communica- thatagreateranalystfollowingleadstomoreefficient
tions (Previts et al., 1994; Lang & Lundholm, 1996; information transmission and lower cost of capital,
Bowen et al., 2002) and segment reports (Bouwman firmsbenefitbyattracting moreanalysts.Studiesfind
et al., 1995; Healy et al., 1999). For example, in an that the firm disclosure quality is the most impor-
experimental setting, Maines, McDaniel, and Harris tant factor that drives the analyst following (Lang &
(1997) find that analyst confidence in segment Lundholm, 1996; Botosan & Harris, 2000). Interest-
reporting quality depends on consistency with the ingly,Previtsetal.(1994)observethatanalystsprefer
definitions of segments used by the company for to follow firms with effective earnings management
internal decision-making. The nature of the disag- tools“whichprovideanalystswithalow-riskearnings
gregated information that is most important to platformformakingstockpriceforecastsandbuy/sell/
analysts, and their preferred methods of disaggrega- hold recommendations… (p. 63).” Future research
tion are questions that remain open to further might evaluate whether analysts tend to follow firms
research. that manage earnings towards expectations, and if so,
Analysts consistently point to the quality of firm whetherinvestorshavemoreorlessinformationabout
reporting as an important factor in determining the firms that donot orcannot manageearnings.
usefulness of financial information (Williams, 1996; Anumberofarchivalstudies,beginningwithBrown,
Healyetal.,1999).Interestingly,LangandLundholm Richardson,andSchwager(1987),havesuggestedthat
(1996) report that the source of information that in- complexity affects analyst forecast accuracy. More
creasesforecastaccuracyoftendoesnotreduceanalyst recentresearch,whichissummarizedinTable1,Panel
disagreement. Future research might help us to better C,addressesthequestionoftheeffectsofcomplexityon
understandtherelationshipbetweenforecastaccuracy analyst forecasting quality. If providing unambiguous
andconsensusasoutcomesoftheinformationusedby informationistheobjectiveoffinancialreporting,thenit
analysts. is important to understand the potential for the
42 S.Ramnathetal./InternationalJournalofForecasting24(2008)34–75
misinterpretationofinformationbyusers.Someexperi- forecasts into valuation and recommendation judg-
mentalstudiesfindthatanalysts'judgmentsareaffected mentsremainsanelusivetopicforfurtherresearch.
by the accounting method choice, the classification of Table 1, Panel E, lists some recent research on the
financial statement items, and whether items are rec- role of earnings components in analysts' forecasting
ognizedinfinancialstatementsordisclosedinfootnotes decisions. The analyst's challenge is to separate the
(Hopkinsetal.,2000;Hopkins,1996;Hirstetal.,2004). transitory from the more permanent components of
Anumberofarchivalstudiesalsosuggestthatcomplex- earnings surprise, and evaluate the persistence over
ity affects analyst forecastaccuracy (Haw etal., 1994; short-andlonger-termforecasthorizons(e.g.,Mest&
Duru&Reeb,2002).Plumlee(2003)providesperhaps Plummer, 1999). We expect to see more research that
themostdirecttestofthisproposition,findingthatthe assessesanalysts' abilitytodetectandadjust for tran-
magnitude of errors in forecasting effective tax rates sitory earnings components. Following Gu and Chen
increases withthe complexityoftax law changes.She (2004),wealsoexpecttoseemoreresearchevaluating
interpretsherresultsasindicatingthatgreaterinforma- the degree to which differences between actual earn-
tioncomplexityreducesanalystuseoftheinformation, ings, as reported in forecast databases (e.g., I/B/E/S),
duetoeitherprocessinglimitationsortimeconstraints. and the GAAP-based earnings reported in financial
Sincetheresearchdesigndidnotpredictthedirectionof statements reflect truly non-recurring items. Finally,
the forecast errors, an alternative explanation is that we expect researchers to develop approaches to
analystsobtainedandefficientlyprocessedallpossible evaluating analyst forecast accuracy with respect to
information regarding the effects of the morecomplex components of earnings not specifically disclosed on
taxlawchanges,butbecausethoseeffectswerehighly I/B/E/S or other analyst databases.
uncertain,theforecasterrorswerelargeinabsolutevalue
forthefirmsmostaffected.Furtherresearchisneededto 3.2. The nature of analyst expertise and the distri-
distinguishbetweentheseexplanations. butionalcharacteristicsofanalysts'earningsforecasts
Questions regarding the algorithms or models an-
alystsusetoconverttheirearningsforecastsintostock 3.2.1. Questions addressed since 1992
recommendations offer fertile ground for further The studies described in Table 2 focus on the
research.Anumberofstudies,whicharesummarized followingresearch questions:
in Table 1, Panel D, find correlations between ac-
counting variables and analysts' price forecasts and 1. What isthenature ofanalystexpertise? (Panel A);
recommendations (e.g., Bandyopadhyay, Brown, & 2. Whatcharacteristicsmakeforecastsuseful?(PanelB);
Richardson, 1995). However, the evidence in Brad- 3. Do analystsherd? (Panel C);and
shaw (2002, 2004) suggests that simple algorithms 4. Whatattributesofanalystandinvestorinformation
based on P/E ratios and long-term growth forecasts areassociatedwithdispersioninanalysts'earnings
explain analysts' recommendations better than more forecasts? (Panel D).
sophisticated valuation models.9 Bradshaw's sample
period corresponds to a time when the market was If accuracy and value relevance are related, then
overheating,perhapsduetoanalystspushinglong-term identifyingexpertforecastersmaybeaprofitablestrat-
growth forecasts of growth-oriented firms. It will be egy for investors. The research since 1992 suggests
interesting to examine whether the heuristics used by thatforecastaccuracyleadstomediarecognition,and
analysts to generate recommendations, as well as the accuracy increases with employer size (proxying for
stock price effects of these recommendations, change research resources), the number of forecasts made in
overtime.Themodelsanalystsusetotranslateearnings a forecasting interval (proxying for effort), and both
firm-specificandgeneralexperience.Forecastaccuracy
appearstobenegativelyrelatedtothenumberofindus-
9 Also see Demirakos et al., (2004), who use content triesandfirmsthatagivenanalystfollows(proxyingfor
analysis of Investext reports and find that analysts over-
specialization). Some evidence indicates that superior
whelmingly refer to simple P/E multiples (as opposed to DCF
analysts in the forecasting dimension also exert a
or earnings-based valuation models) to support their stock
recommendations. greaterinfluenceonprices,supportingBrown's(1993)
S.Ramnathetal./InternationalJournalofForecasting24(2008)34–75 43
Table2
SelectedPapersAddressingQuestionsRelatedtotheNatureofAnalystExpertiseandtheDistributionalCharacteristicsofAnalysts'Earnings
Forecasts(Section3.2)
Reference Method Keyresults
PanelA.ResearchQuestion3.2.1:Whatisthenatureofanalystexpertise?
Mainesetal.(1997) Experimentswith56 ExperiencedanalystsusesegmentreportsmoreeffectivelythanMBAstudents.
professionalanalysts
and60MBAstudents.
Mikhailetal.(1997) Archival,Zacks, Forecastaccuracyincreaseswithfirm-specificexperience,andmarketreactionsaremore
1980-1995. closelyrelatedtotheforecasterrorsofanalystswithfirm-specificexperience.However,
firm-specific experience is not related to abnormal returns following analyst stock
recommendationrevisions.
Clement(1999) Archival,I/B/E/S, Forecastaccuracyispositivelyrelatedtoexperienceandemployersizeandnegatively
1983-1994. associatedwiththenumberofindustriesandfirmsfollowed,providingevidenceabout
thecharacteristicsofsuccessfulanalysts.
Jacobetal.(1999) Archival,Zacks, Forecastaccuracyimproveswithanalystaptitude(analyst-targetalignments),brokerage
1981-1992. size,andindustryspecialization,butnotwithgeneralexperience.Forecastaccuracyalso
improves as a function of the number of forecasts made in a forecasting interval,
providingevidenceaboutthecharacteristicsofsuperioranalysts.
Dechowetal.(2000) Archival,I/B/E/S, Analystevaluationsaremoreoftenbasedonstockrecommendationsandtheaccuracyof
1981-1990. annualearningsforecaststhanontheaccuracyoflong-termgrowthforecasts.
Brown(2001b) Archival,I/B/E/S, Asimplemodelusingpastaccuracytopredictcurrentandfutureaccuracyperformsas
1986-1998. wellasamodelusingcurrentanalystcharacteristicstoidentifysuperioranalysts.
Hirstetal.(2004) Experimentwith56 Analystsfollowinglessthanthesamplemediannumberoffirmsmakebetterdecisions
buy-sideanalysts. thananalystsfollowingmorethanthemediannumberoffirms.
Clarke,Ferris, Archival,I/B/E/S, Stock recommendations reflect more pessimism for firms that subsequently file for
Jayaraman,and 1993-2001. bankruptcy. All-Star analysts downgrade earlier and more strongly than other analysts.
Lee(2006) Significantdifferencesexistinrecommendationsbetweenaffiliatedandunaffiliatedanalysts.
PanelB.ResearchQuestion3.2.2:Whatcharacteristicsmakeforecastsuseful?
Sinha,Brown,and Archival,I/B/E/S, Controllingforforecasttiming,superioranalystsmaintainforecastaccuracysuperiority
Das(1997) 1984-1993. inholdoutperiods,butinferioranalystsdonotcontinuetobeinferiorinholdoutperiods.
Cooper,Day,and Archival,I/B/E/S, Market responses to forecast revisions are higher for forecast timeliness leaders.
Lewis(2001) 1993-1995. Performance rankings basedon timelinessare moreinformative than thosebasedon
tradingvolumeandaccuracy,suggestingthattimelyforecastsarevaluedbythemarket.
GleasonandLee Archival,I/B/E/S, Pricing offorecastrevisions is greaterfor forecaststhat diverge fromthe consensus.
(2003) 1993-1998. Priceadjustmentisfasterandmorecompleteforcelebrityanalysts.
Mozes(2003) Archival,FirstCall, Forecastimmediacy(proximitytothebeginningofaforecastcluster)isnegativelyrelatedto
1990-1994. forecastaccuracy,andpositivelyrelatedtoforecastdispersionandimprovedaccuracyrelative
tooutstandingforecasts,suggestingthatforecasttimelinessisimportantinpricediscovery.
ClementandTse Archival,I/B/E/S, Boldforecastshavelargerpricingimplicationsbecausetheyoffergreaterimprovements
(2005) 1989-1998. in forecast accuracy as compared to herding forecasts, implying that bold forecasts
reflectmoreusefulprivateinformation.
Cheng,Liu,and Archival,Thomson Fundmanagersweighbuy-sideresearchmorewhensell-sidereportsarebiasedorwhen
Qian(2006) Financial/Nelson theuncertaintyaboutthebiasinsell-sidereportsisincreasing.
Information'sDirectoryof
FundManagers,2000-2002.
PanelC.ResearchQuestion3.2.3:Doanalystsherd?
Trueman(1994) MathematicalModel To enhance investor assessment of their forecasting ability, analysts tend to release
forecastsclosertopriorexpectationsthaniswarrantedgiventheirprivateinformation,
andanalystswithlessabilityaremorelikelytoherd.
Graham(1999) MathematicalModeland Analysts with high reputations or of low ability tend to herd; herding also occurs if
Archival,Newsletters, strong public information is inconsistent with an analyst's private information,
1981-1992. suggestingthatanalystsareconservativeinforecasting.
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