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February 15, 2019

In revising their forecasts of companies’ current earnings, analysts accentuate the negative, new research finds

Widely available earnings forecasts not as informative as many think

It may be the most persistent criticism leveled against stock analysts – excessive optimism, what is widely perceived to be a tendency to be more upbeat about the companies they cover than the facts justify. Now a new study finds that, when it comes to what may be analysts' most closely followed work product – namely, forecasts of current-quarter company earnings – a quite different tendency prevails. An enduring hit song may advise that in life one should "accentuate the positive, eliminate the negative"; but, in forecasting current quarterly earnings, analysts are inclined to do just the opposite, according to the new research.

In the words of the paper in the March issue of The Accounting Review, a journal of the American Accounting Association, "analysts revise current earnings more often for bad than for good news, consistent with not incorporating good news into short-horizon earnings forecasts...The analyst tends to omit positive news from current quarterly earnings forecasts while revising such forecasts [downward] in response to negative news."

This is not, by any means, to suggest that positive developments get discarded. The fate of good news, according to the study's authors, Zachary R. Kaplan and Charles G. Ham of Washington University of St. Louis and Philip G. Berger of the University of Chicago, is that analysts often convey it in other ways than by raising their estimates of current earnings. One alternate way is by revising stock-price targets upward for a firm. Another is by raising estimates of company earnings in future quarters. A third is simply through expressions of optimism about earnings without an outright earnings revision (for example, an analyst's prediction, cited in the study, that a manufacturer would "report significant upside to our expectations for revenue, margins, and EPS, given the tremendous growth in the [firm’s] market and strong results from its closest rival").

Based on data covering the activity of about 9,000 analysts in 71 quarters, the researchers report the likelihood of an upward revision of current earnings estimates to be about 13% and that of a downward revision to be about 19.5%, a 50% greater probability on the down side. But when it came to revisions of stock-price targets and of future-earnings estimates, the prevalence was the reverse, with the likelihood of downward revisions for the two items together being 9.3% and that of upward revisions 11.2%, a 20% greater probability on the up side. In addition, a separate survey of brokerages’ reports to clients found that, without changing their forecasts, analysts did not refrain from explicitly predicting firms would miss or beat them, and that “beat” predictions outnumbered “miss” predictions by about 30%.

What accounts for these patterns? The professors surmise that, in large part, analysts’ reluctance to revise earnings forecasts upwards – and, instead, to convey alternate upbeat predictions separately – stems from a desire to please top managers at the companies they cover. As the professors observe, in keeping earnings forecasts low by not incorporating  positive developments of which they are aware, analysts "cater to managers' preferences for a walked-down forecast pattern...The pattern we document, however, includes avoidance of walking up rather than only a walk-down...Non-earnings forecast signals are more prevalent for positive news than negative news, consistent with analysts responding to incentives to issue forecasts managers will meet or beat."

In this regard, the study's findings complement earlier research by other academics in which analysts were surveyed about their interactions with the firms they covered and reported feeling more pressure to lower earnings forecasts than to boost them. The new paper’s findings suggest how very effective such downward pressures from corporate managers can be.

The practice of reporting positive news without incorporating it into more-widely-circulated earnings forecasts, the study suggests, can provide a significant advantage to brokerage clients over investors who don’t have access to analysts’ reports. For example, on average an upwardly revised stock-price target by an analyst boosts by as much as 4.2% (depending on how it is calculated) the likelihood that a firm will beat the analyst’s on-the-record forecast of current quarterly earnings. This can provide a significant edge to the recipient of the optimistic price-target revision over an investor who only knows the unaltered earnings forecasts.

Why bother with this complex channeling of information? Why not simply raise earnings forecasts when there is good news as frequently as forecasts are lowered when there is bad news? Or, if good news does not justify raising the earnings forecast, why disseminate it at all?

“In analysts’ role as financial intermediaries,” the professors write, “they serve multiple stakeholders who can have possibly conflicting demands for bias and precision (for instance, managers prefer beatable forecasts while investors demand accurate information). Our analysis suggests one channel through which analysts may manage these conflicting demands is by varying the forecasts into which they incorporate news.”

Prof. Kaplan comments: “Analysts convey optimism about current earnings in alternate ways that enable them to be of service to clients, whom they care about, and to avoid displeasing corporate managers, whom they also care about. True, providing information in these ways excludes a broader public of non-clients, but, given the complexity of analysts’ work and the general acceptance that brokerage is a business and not a public service, this would seem to be inevitable.”

He adds that, hopefully, the new study does offer a lesson of potential importance to that broader public – namely, widely circulated earnings forecasts, notwithstanding their value, may not be as informative as many people think.

The research draws on information from the Institutional Brokerage Data System (I/B/E/S), a major source of corporate and brokerage financial data, which the professors supplemented with reports issued by 142 randomly selected analysts. In all, the study comprised 8,860 unique analysts who interacted with 7,933 unique companies over 71 quarters, the whole amounting to 847,471 analyst-firm-quarters’ worth of data.

The study, entitled "Do Analysts Say Anything About Earnings Without Revising Their Earnings Forecasts?" is in the “March issue of The Accounting Review, a peer-reviewed journal published six times yearly by the American Accounting Association, a worldwide organization devoted to excellence in accounting education, research, and practice. Other journals published by the AAA and its specialty sections include Auditing: A Journal of Practice and Theory, Accounting Horizons, Issues in Accounting Education, Behavioral Research in Accounting, Journal of Management Accounting Research, Journal of Information Systems, Journal of Financial Reporting, The Journal of the American Taxation Association, and Journal of Forensic Accounting Research

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