On the Determinants of Optimism in Financial Analyst Earnings Forecasts: The Effect of the Market's Ability to Adjust for the Bias

This paper examines whether the documented bias in analyst earnings forecasts is intentional by examining whether it is related to the market's ability to adjust for this bias. For intentional bias to exist it is not enough for analysts to face incentives but rather, analysts should also be willing to respond to these incentives. As the market's ability to adjust for the bias increases, its market effects decrease while analyst reputation costs increase reducing analyst willingness to bias their forecasts. The paper utilizes a firm‐specific design that allows for both the bias component of the forecast error and the market's ability to adjust for the bias to be computed at the firm level. Results suggest that even though forecast error is positive in the latter part of the period under review reflecting overall analyst pessimism, the bias embedded in the forecasts is optimistic throughout the period. More importantly, I find that analyst forecast bias is decreasing in the market's ability to adjust for it. This result provides further evidence that analysts knowingly bias their forecasts and provides support for the existence of reporting bias, in particular. Thus, the evidence provides justification for recent regulatory efforts to increase the objectivity of analyst research reports.     

Additional Evidence on Analysts’ Decision to Issue Disaggregated Earnings Forecasts: Strategic Biasing

This study examines why analysts issue disaggregated earnings forecasts to I/B/E/S. Some recent studies suggest that analysts with superior forecasting ability issue disaggregated earnings forecasts to build reputation in the marketplace and stop forecast disaggregation once their reputation has been established. Based on an analysis of I/B/E/S forecast data for U.S. firms from 1998 to 2008, we find that, in a given year, about 20%–34% of analysts disaggregate for some, but not for all the firms that they follow. This evidence of selective disaggregation by analysts suggests that reputation building alone does not fully explain the decision to disaggregate forecasts. We hypothesize that the decision to disaggregate earnings forecasts is at the firm‐level as well and is systematically related to the analysts’ bias in the issued forecasts. Our findings are that (a) analysts’ overall optimistic bias and forecast errors decrease monotonically with the level of forecast disaggregation, and (b) analysts that selectively disaggregate their forecasts for some firms or who do not persistently disaggregate a given firm's forecasts exhibit more positive bias and larger forecast errors. Our findings are consistent with the notion that the analysts who issue biased forecasts, for example, to curry favour with the management, are less likely to provide disaggregated information as part of the forecast.     

Mutual Fund Manager Forecasting Behavior

I examine publicly released annual earnings forecasts issued in conjunction with stock recommendations by mutual fund managers of actively managed open-end mutual funds. I find that mutual fund manager annual earnings forecasts systematically overestimate the earnings number later disclosed at the annual earnings announcement. In further analyses, I attempt to distinguish between two explanations for this forecast bias: an untruthful reporting bias (market manipulation) and a truthful cognitive bias (optimism). These explanations generate different predictions about the timing of changes in fundholdings of forecasted securities between the forecast release and annual earnings announcement dates. I interpret my findings as more consistent with an optimism explanation for mutual fund manager annual forecast bias and less consistent with a market manipulation explanation for this bias. I am, however, unable to eliminate an unobservable selection bias either in the decision of the mutual fund manager to report a forecast publicly or in the media's decision to publish that forecast as an explanation for my finding that mutual fund manager forecasts are biased.     

Disclosure of internal control material weaknesses and optimism in analyst earnings forecasts

This paper investigates how analyst forecast optimism is associated with disclosures of internal control material weaknesses (ICMWs) and their remediation under Section 404 of the Sarbanes–Oxley Act (SOX). Drawing on agency theory, I hypothesize that analysts are likely to issue earnings forecasts that are more optimistic for firms with ICMW disclosures than for those without ICMW disclosures. Using a sample of 20,875 firm-year observations with 10-K (10-Q) reports from 2004 to 2018, I find a positive association between ICMW disclosures and analyst forecast optimism. This positive association is partially driven by investors’ inability to unravel analyst forecast bias and analysts’ intentions to curry favor with management for private information. In addition, analysts are found to issue less optimistic forecasts for firms with ICMW remediation disclosures compared with those without ICMW remediation disclosures. A series of propensity score matching and regression analyses are conducted to test the robustness of my inferences. Overall, the paper suggests that analysts have incentives to take the opportunity of firms disclosing ICMWs to bias their forecasts upward for self-interest. The findings have the potential to assist regulators in guiding analyst behavior and educating investors to unravel positive bias in analyst forecasts.     

The effects of social bias against female analysts on markets

I provide evidence for the effects of social bias on markets by studying female analysts. I find that the market reaction to female analysts' forecasts is weaker and slower than that to male analysts' forecasts. I also find that female analysts' forecasts are more accurate and timely than those of male analysts. Taken together, these findings imply that female analysts are underestimated even if they have better forecasting ability than male analysts. This effect decreases when female analysts are attractive, increases when the covered firm's CEO is male and is mediated by analysts' self-confidence. These results emphasize three sources of social bias against female analysts: incompetence bias, immorality bias, and credit bias. I also employ two exogenous shocks to rule out alternative explanations and conduct robustness tests to further support my results. My findings thus highlight that social bias against females remains an issue that significantly affects the capital market.     

Value relevance of analyst earnings forecasts in emerging markets

Even though research in accounting and finance has extensively examined the role of financial analysts in developed economies, this issue has not been thoroughly examined in an emerging market setting. In this paper, I examine whether, following a market opening, analyst forecast accuracy and the market's reliance on analyst forecasts increase with time. Accuracy is expected to increase over time as analysts exert more effort and gain valuable forecasting experience. Results indicate that time is positively related to analyst forecast accuracy after controlling for a number of other firm and country characteristics. Second, I posit that time should also be related to the market's propensity to use analyst forecasts to form earnings expectations. As markets open and investors become more sophisticated, the reliance on analyst forecasts should also increase. Results are consistent with this expectation. In particular, I find that in the first sub-period earnings expectations based on random walk exhibit greater relative information content than earnings expectations based on analyst forecasts. This pattern is reversed in the third sub-period where analyst forecast errors better explain returns. Incremental information content tests produce similar results. Future research should further investigate the relation between financial analysts and other important market characteristics in emerging economies.     

CEO happiness and forecasting

We utilize the IBM Watson Tone Analyzer to measure chief executive officers' (CEOs') levels of joy (happiness) in year-end conference calls, and empirically test how CEOs' happiness affects the properties of their own and analysts' forecasts. We find that joyful CEOs are more likely to issue forecasts, less likely to miss their forecast targets, and exhibit lower optimistic bias in their forecasts. When joyful CEOs issue earnings forecasts, analysts revise their forecasts upwards and produce forecasts that are less dispersed and more accurate. Our results demonstrate that inherent CEO happiness significantly impacts the forecast properties of both managers and analysts, thus supporting upper echelons theory.     

The Effect of Issuing Biased Earnings Forecasts on Analysts' Access to Management and Survival

This study offers evidence on the earnings forecast bias analysts use to please firm management and the associated benefits they obtain from issuing such biased forecasts in the years prior to Regulation Fair Disclosure. Analysts who issue initial optimistic earnings forecasts followed by pessimistic earnings forecasts before the earnings announcement produce more accurate earnings forecasts and are less likely to be fired by their employers. The effect of such biased earnings forecasts on forecast accuracy and firing is stronger for analysts who follow firms with heavy insider selling and hard‐to‐predict earnings. The above results hold regardless of whether a brokerage firm has investment banking business or not. These results are consistent with the hypothesis that analysts use biased earnings forecasts to curry favor with firm management in order to obtain better access to management's private information.     

超预期股本扩张与分析师每股盈余预测

卖方分析师的每股盈余预测在实证文献中被广泛使用。该指标同时依赖于分析师对目标公司未来净利润的预测和对目标公司未来股本数量的预测。因此,如果在分析师发布预测后,目标公司的股本数量发生超出分析师预期的扩张,则每股盈余预测将无法代表分析师对目标公司未来基本面的预测。本文构建了“调整后每股盈余预测”指标,该指标可剔除超预期股本扩张对每股盈余预测的影响,真实反映分析师对目标公司未来基本面的预测。本文应用该指标,在两个具体的实证研究场景中证明了,忽略超预期股本扩张的影响可能得出错误的实证结论。本文还进一步指出了三个忽略超预期股本扩张的影响可能导致错误实证结果的研究场景。     

超预期股本扩张与分析师每股盈余预测

卖方分析师的每股盈余预测在实证文献中被广泛使用。该指标同时依赖于分析师对目标公司未来净利润的预测和对目标公司未来股本数量的预测。因此,如果在分析师发布预测后,目标公司的股本数量发生超出分析师预期的扩张,则每股盈余预测将无法代表分析师对目标公司未来基本面的预测。本文构建了“调整后每股盈余预测”指标,该指标可剔除超预期股本扩张对每股盈余预测的影响,真实反映分析师对目标公司未来基本面的预测。本文应用该指标,在两个具体的实证研究场景中证明了,忽略超预期股本扩张的影响可能得出错误的实证结论。本文还进一步指出了三个忽略超预期股本扩张的影响可能导致错误实证结果的研究场景。     

Analysts' Rationality and Forecast Bias: Evidence from Sales Forecasts

When optimistic forecasts can improve access to management, rational analysts have incentives to issue optimistically-biased forecasts (Lim, 2001). This paper proposes that the extent of this optimistic forecast bias will depend on the forecast's importance to management. If management attaches less importance to a forecasted measure, analysts should decrease their forecast bias because the expected benefits of issuing optimistic forecasts are less. We examine analysts' earnings and sales forecasts, and predict that analysts' optimistic bias will be greater for earnings than for sales. Results are consistent with our predictions and contribute to the evidence that analysts' forecast bias is rational and intentional.     

Endogenous entry/exit as an alternative explanation for the disciplining role of independent analysts

Gu and Xue [2008. The superiority and disciplining role of independent analysts. Journal of Accounting and Economics, this issue, doi:10.1016/j.jacceco.2008.02.002] study the disciplining effect of independent analysts on the accuracy and forecast relevance of the forecasts of non-independent analysts. One of the intriguing results is that while independent analysts issue inferior forecasts, their presence appears to reduce the forecast bias, improve the forecast accuracy and increase the forecast relevance of forecasts issued by non-independent analysts. We explore alternative explanations for the Gu–Xue results. Our evidence of endogenous entry and exit of independent analysts provides a more compelling explanation for the reported results.     

The effect of Regulation FD on the properties of management earnings forecasts

We investigate Regulation FD’s (FD) effect on management earnings forecast properties. We posit FD’s prohibition on private manager-analyst communication reduces (increases) optimism (pessimism) in management earnings forecasts. Prior to FD, managers could avoid publicly retracting prior optimistic forecasts by privately communicating with analysts, who could lower investor expectations with a new analyst forecast. After FD, managers with optimistic forecasts must either publicly admit their optimism by issuing a new management forecast or they must negatively surprise investors at the earnings announcement. Further, FD forces managers to use public forecasts instead of private communications to establish beatable expectations. Our evidence suggests FD reduced optimism in management forecasts. This reduction in optimistic bias is not offset by an increase in pessimistic bias. Consistent with this, we further find post-FD improvements in forecast accuracy and informativeness. We find no such changes around several potentially confounding events or for foreign firms surrounding FD. Overall, our evidence suggests FD improved firms’ forecast properties (less bias, greater accuracy, and greater informativeness).     

Analyst reputation and management earnings forecasts

Prior studies show that analysts with high reputation are influential in the market. This paper examines whether managers consider analyst reputation in shaping their voluntary disclosure strategy. Using Institutional Investor magazine’s All-American (AA) rankings as a proxy for analyst reputation, we find that the coverage of AA analysts is positively associated with the likelihood of quarterly management earnings forecasts (MEFs). We also find that AA analysts’ forecast optimism is more positively associated with the likelihood of MEFs than non-AA analysts’ forecast optimism when the firm is covered by AA analysts. Analyses based on AA analyst coverage changes and AA status changes confirm the relation between analyst reputation and MEFs. We further find that analyst reputation influences other MEF properties, such as forecast news, bias, and revisions, and that our results are robust to alternative measures of analyst reputation. Further analyses show that market reactions at quarterly earnings announcements are more positive (negative) when firms meet/beat (miss) AA analysts’ forecasts than when firms meet/beat (miss) non-AA analysts’ forecasts. Collectively, our findings suggest that managers strategically provide voluntary forecasts by taking into account the reputation of individual analysts following their firms.     

A new measure of earnings forecast uncertainty

Relying on the well-established theoretical result that uncertainty has a common and an idiosyncratic component, we propose a new measure of earnings forecast uncertainty as the sum of dispersion among analysts and the variance of mean forecast errors estimated by a GARCH model. The new measure is based on both common and private information available to analysts at the time they make their forecasts. Hence, it alleviates some of the limitations of other commonly used proxies for forecast uncertainty in the literature. Using analysts' earnings forecasts, we find direct evidence of the new measure's superior performance.     

Rational Expectations and Security Analysts' Earnings Forecasts

This paper investigates the rationality of security analysts' forecasts. The forecasts of analysts participating in Lynch, Jones, and Ryan's Institutional Brokers Estimate System (I/BE/S) data base are evaluated relative to past values of their own forecast errors, past values of forecasted earnings per share, and quarterly percentage changes in publicly available macroeconomic and financial time series. The publicly available series include the consumer price index, unemployment rate, oil prices, stock prices, gross national product, and corporate profits. The authors conduct a generalized orthogonality test and include only information available to analysts at the time the forecasts are made. The empirical results reject analyst forecast rationality, but not without exception.     

Analysts’ earnings forecast errors and cost of equity capital estimates

This study investigates the relation between analysts’ forecast errors and cost of equity capital estimates implied from analysts’ earnings forecasts and price. My analysis predicts and removes forecast errors from analysts’ earnings forecasts on an out-of-sample basis and then uses these adjusted analysts’ forecasts to reverse-engineer cost of equity capital estimates. While the correction for predictable analysts’ forecast errors meaningfully lowers each of three firm-level implied COEC estimates employed in this study and commonly used in the literature, I do not find that this correction improves their association with realized returns.     

Analyst reputation and the issuance of disaggregated earnings forecasts to I/B/E/S

Although sell-side analysts privately forecast revenues and expenses when producing earnings forecasts, not all analysts choose to provide I/B/E/S with earnings forecasts disaggregated into revenues and expenses. We investigate the role of reputation in explaining this decision. We find that analysts without established reputations are more likely than reputable analysts to issue disaggregated earnings forecasts to I/B/E/S, consistent with I/B/E/S exposure benefits accruing to analysts seeking to establish a reputation. Among less reputable analysts, those with high ability are more likely to disaggregate, consistent with this group reaping greater benefits from the exposure I/B/E/S provides. Additional tests support our primary hypotheses. Among less reputable analysts, those who disaggregate are more (less) likely to be promoted (demoted or terminated). The stock market responds similarly, with more weight assigned to earnings forecast revisions provided by analysts who disaggregate their earnings forecasts.     

The association between quarter length,forecast errors,and firms’ voluntary disclosures

Approximately 60 percent of adjacent fiscal quarters contain a different number of calendar days. In preliminary analyses, we find the change in quarter length is significantly associated with the changes in sales and earnings and that analysts condition on the prior quarter's results when making their forecasts. These results indicate that it is important for analysts to adjust for changes in quarter length when making forecasts. However, we find the quarterly change in days is positively associated with analysts’ sales and earnings forecasts errors, where forecast error equals the actual earnings minus the forecasted earnings. These results indicate that analysts systematically underestimate (overestimate) performance when quarter length increases (decreases). We find evidence indicating investors make similar errors as returns around earnings announcements are positively associated with the change in quarter length, but only when changes in firm performance is more sensitive to changes in quarter length. Corroborating these findings, managers are more (less) likely to discuss quarter length during conference calls when quarter length decreases (increases). These results are consistent with managers’ strategic disclosure incentives. In summary, our evidence suggests analysts and investors fail to fully take account of the quasi-mechanical effect that quarter length has on firm performance and managers strategically alter their voluntary disclosures to take advantage of these failures.     

Analysts' forecasts of Japanese firms' earnings: additional evidence

This article examines analysts' forecasts of Japanese firms' earnings during Japan's economic burst period in the 1990s. Using the evidence of analyst earnings forecasts in the United States as a benchmark, the article documents the following three findings. First, whereas the forecast accuracy of U.S. analysts following U.S. firms improves over time, the forecast accuracy of U.S. and Japanese analysts following Japanese firms does not. Second, whereas decreases in forecast errors of U.S. analysts following U.S. firms are best explained by decreases in forecast bias of the analysts, increases in forecast errors of U.S. and Japanese analysts following Japanese firms are best explained by increases in the frequency of losses experienced by Japanese firms. Third, Japanese analysts forecast earnings less accurately than do U.S. analysts. These findings reflect the difficulty of producing accurate earnings forecasts during economic downturns. They also suggest that Japanese analysts are more bound than their U.S. counterparts by cultural ties that impede forecast accuracy.