Blog - Investing Notes

February 21, 2008 - Comprehensive Overview of Research on Equity Analyst Forecasting

What is the state of research on the forecasting methods and outputs of equity analysts? In their 2008 paper entitled "The Financial Analyst Forecasting Literature: A Taxonomy with Suggestions for Further Research", Sundaresh Ramnath, Steve Rock and Philip Shane catalog and organize past research on the forecasting of equity analysts with focus on the period since 1992. Using results from approximately 250 post-1992 papers related to equity analysts from eleven major research journals, they summarize findings related to the following questions:

• Decision process:
  1. What information affects the development of analysts' earnings forecasts and recommendations?
  2. What information affects analyst following and portfolio decisions?
  3. What environmental, classification and reporting quality factors affect analysts' forecasts and recommendations?
  4. How do analysts transform information into target prices and stock recommendations?
  5. What is the role of earnings components in analysts' decision processes?
• Nature of expertise:
  1. What is the nature of analyst expertise?
  2. What characteristics make forecasts useful?
  3. Do analysts herd?
  4. What attributes of analyst and investor information are associated with dispersion in analysts' earnings forecasts?
• Information content:
  1. How informative are analysts' short-term earnings forecasts?
  2. How informative are analysts' annual earnings growth forecasts?
  3. Do forecasts of earnings components provide information incremental to forecasts of earnings?
  4. How informative are the various components of analyst research reports?
• Market efficiency:
  1. Do analysts' forecasts and recommendations efficiently reflect the information in earnings?
  2. Do analysts' forecasts and recommendations efficiently reflect information from sources other than earnings?
  3. Do stock prices efficiently reflect the information in analysts' forecasts and recommendations, and other information in analyst research reports?
  4. Do analysts' earnings forecasts explain inefficiencies in stock prices with respect to publicly available information?
• Incentives and behavioral biases:
  1. How do incentives impact analysts' effort and decisions to follow firms?
  2. Do incentives create systematic optimism/pessimism in analysts' forecasts and recommendations?
  3. How do management incentives impact communications with analysts, analysts' forecasts, and analysts' recommendations?
  4. How does the market consider analysts' incentives in setting prices?
  5. Do economic incentives or behavioral (psychological) biases create an underreaction in analysts' forecasts?
• Regulatory environment:
  1. How do new regulations affect the information environment and the characteristics of analysts' forecasts?
  2. How do differences in regulations across countries affect the information environment and the characteristics of analysts' forecasts?
• Validity of research on analysts:
  1. How might statistical validity issues threaten inferences about the behavior of analysts' forecasts and recommendations?
  2. How might construct or internal validity issues threaten inferences about the behavior of analysts' forecasts and recommendations?

The authors conclude that: "Discovering the information and valuation models that determine equity security prices in capital markets is a daunting task. ...[T]he key lies in the way the market derives a consensus from the distribution of extant individual analysts' forecasts of a company's future earnings, the characteristics of the information impounded in that consensus, and the additional information the market incorporates into its model for valuing a company's equity securities."

In summary, this paper provides a comprehensive and organized overview of past research on equity analyst inputs, processing and outputs.

For related research, see Blog Synthesis: The Wisdom of Analysts, Experts and Gurus. See also the forecast aspects of Earnings Trends to see equity analysts in action.