Analyst Forecasting Ability
Analyst Forecasting Ability
A study by Elton, Gruber, and Gultekin demonstrated the value of accurate forecasts. 12 They found that if an investor was armed with perfect information about the growth of earnings that would occur, an investor could have generated significant abnormal positive returns.
12 Edwin Elton, Martin Gruber, and M. Gultekin, “Expectations and Share Prices,” Management Science (September 1981).
FINANCIAL STATEMENT ANALYSIS
Given the value of good forecasts, let’s look at how well analysts do in forecasting EPS.
There has been extensive research dating back to the late 1960s that has investigated how well analysts do in forecasting earnings. We’ll look at some recent evidence on the subject. Before we discuss the recent evi- dence, we must first define how to measure the forecast error.
A simple procedure is to look at the difference between the actual EPS and the forecasted EPS. The latter is measured by the consensus EPS. The result is a measure of the earnings surprise. The problem with using this measure of earnings surprise is that it does not take into account the severity of the error based on the level of EPS. For example,
a $0.02 difference between the actual and consensus EPS is more signif- icant for a company with actual EPS of $0.20 than it is for a company with actual EPS of $10. Thus, the dollar difference in the error must be deflated or standardized by the level of EPS. Two measures have been used by researchers. Earnings surprise can be standardized by dividing by either actual EPS or consensus EPS. In fact, because researchers want to know the bias of the forecast error (overestimate or underestimate), the practice is to divide by the absolute value of the actual EPS or con- sensus EPS. That is, the forecast error can be measured in either of the following ways:
Actual EPS Consensus EPS –
Forecast error = -------------------------------------------------------------------------------------
Absolute value of the Actual EPS or,
Actual EPS Consensus EPS –
Forecast error = -----------------------------------------------------------------------------------------------
Absolute value of the Consensus EPS The forecast errors as measured above are also referred to as a measure
of “standardized earnings surprise.” Using the Qualcomm example, the two measures of forecast error are:
Actual EPS Consensus EPS –
Forecast error = -------------------------------------------------------------------------------------
Absolute value of the Actual EPS $0.33 $0.26 –
= ------------------------------------ = 21.21%
and
Earnings Analysis
Actual EPS Consensus EPS –
Forecast error = -----------------------------------------------------------------------------------------------
Absolute value of the Consensus EPS $0.33 $0.26 –
= ------------------------------------ = 26.92%
To assess the forecasting ability of analysts, researchers then analyze these forecasting errors by looking at the mean absolute forecasting error and the proportion of the sample of forecasts outside of practical error bands (e.g., the percentage of forecasts that fall outside a plus or minus a 10% interval around the actual earnings).
Recent studies by David Dreman and Michael Berry 13 and by Lawrence Brown 14 have examined the ability of analysts to forecast quarterly EPS and whether or not there is a bias in analyst forecasts. Dreman and Berry found that the average forecast errors are too high— more than 20% when not standardized and double that amount when standardized. They also found that when a 10% forecast band is used, more than half of the forecasts were outside the band. Dreman and Berry used other bands but the 10% figure is what they state is “a level that many Wall Street professionals consider minimally acceptable.” 15 Moreover, they find that forecasts overestimate actual earnings. That is, analysts tend to be optimistic about a firm’s future earnings. In conclud- ing their study, they write:
The observed frequency, size, and increasing trend of all of the error metrics for quarterly estimates bring into ques- tion many important methods of stock valuation, which rely on precise earnings estimates sometimes years into the future. The growth, earnings momentum, discounted cash flow, and earnings yield techniques, for example, require fine-tuned estimates often a decade or more into the future. Thus, a significant portion of current security anal- ysis requires a precision in earnings forecasts that is increasingly difficult for analysts to meet. 16
13 David N. Dreman and Michael A. Berry, “Forecasting Errors and Their Implica- tions for Security Analysis,” Financial Analysts Journal (May/June 1996), pp. 30–41.
14 Lawrence D. Brown, “Analyst Forecasting Errors: Additional Evidence,” Financial Analysts Journal (November/December 1997), pp. 81–88.
15 Dreman and Berry, “Forecasting Errors and Their Implications for Security Anal- ysis,” p. 39
16 Dreman and Berry, “Forecasting Errors and Their Implications for Security Anal- ysis,” p. 39.
FINANCIAL STATEMENT ANALYSIS
The database used in the Dreman-Berry study was the Abel-Noser database. This database uses information from Value Line, I/B/E/S, Zacks Investment Research, and First Call. The potential problem with such a database is that providers define actual earnings and forecasted earnings differently and as a result this could make the forecast errors
larger than they actually are. 17 In a study published a year after the Dreman-Berry study, Brown reexamined the ability of analysts to fore- cast earnings relying only on the I/B/E/S database. He also reported results using the Abel-Noser database used in the Dreman-Berry study. Brown found that for the two databases, the results supported the posi- tion that analyst forecasting errors are large. In addition, he finds that there is an optimistic bias in the forecasts.
Brown extended his investigation to determine whether the types of firms that analysts follow have an effect on their forecasting ability. Brown examined this question by looking at analyst forecasts based on the following firm-specific factors: whether a firm is included in the S&P 500, market capitalization, the absolute value of earnings forecast, and analyst following. He found that for firms in the S&P 500, the forecast- ing errors are smaller compared to firms not in the S&P 500. For firms with comparatively large capitalization, absolute value of earnings fore- cast, and analyst following, the forecasting error was relatively small. He continued to observe an optimistic bias. When Brown investigated analyst forecast errors for 14 industries, he found that the forecasting errors for some are substantially greater than for others.
There are other findings reported in the Brown study that warrant noting because they shed some light on other questions we raised earlier in this chapter regarding earnings management. Brown, as well as Dreman and Berry, found that the median and modial value of earnings surprise was zero, suggesting that analysts forecasts tended to be on tar- get (although the average forecast was too large relative to actual earn- ings). Brown found that the number of small positive errors was greater than the number of small negative errors. Based on this finding, Brown suggested that corporate managers may manage earnings so as to not fall below the consensus estimate. Moreover, Brown also found that the number of large negative errors was greater than the number of large positive errors. This finding sheds some light on the “big bath” observa- tion that we discussed earlier, whereby managers create large negative earnings surprises relative to the number of large positive earnings sur- prises.
17 D.R. Philbrick and W.E. Ricks, “Using Value Line and I/B/E/S Analysts Forecasts in Accounting Research,” Journal of Accounting Research (Autumn 1991), pp. 397–
Earnings Analysis
Parts
» Financial Management and Analysis
» SECURITIES MARKETS The primary function of a securities market—whether or not it has a
» Stock Exchanges Stock exchanges are formal organizations, approved and regulated by
» Stock Market Indicators Stock market indicators have come to perform a variety of functions,
» Efficient Markets Investors do not like risk and they must be compensated for taking on
» THE FEDERAL RESERVE SYSTEM The United States has a central monetary authority known as the Fed-
» The Fed and the Money Supply Financial managers and investors are interested in the supply and
» Deposit Institutions Traditionally, the United States has had several types of deposit institu-
» Investment Banking The primary market involves the distribution to investors of newly
» Interest Rates and Yields Because bonds are traded in the secondary market, the price of the bond
» The Risk Premium Market participants talk of interest rates on non-Treasury securities as
» OPTIONS An option is a contract in which the writer of the option grants the
» Buying Call Options The purchase of a call option creates a position referred to as a long call
» Buying Put Options The buying of a put option creates a financial position referred to as a
» CAP AND FLOOR AGREEMENTS There are agreements available in the financial market whereby one
» I n assessing a company’s current and future cash flows, the financial
» Depreciation for Tax Purposes For accounting purposes, a firm can select a method of depreciation
» Capital Gains We tend to use the term “capital gain” loosely to mean an increase in the
» Current assets (also referred to as circulating capital and working
» Noncurrent Assets Noncurrent assets are assets that are not current assets; that is, it is not
» Deferred Taxes Along with long-term liabilities, the analyst may encounter another
» THE INCOME STATEMENT An income statement is a summary of the revenues and expenses of a
» THE STATEMENT OF CASH FLOWS The statement of cash flows is a summary over a period of time of a
» T he notion that money has a time value is one of the most basic con-
» DETERMINING THE PRESENT VALUE Now that we understand how to compute future values, let’s work the
» Shortcuts: Annuities There are valuation problems that require us to evaluate a series of level
» THE CALCULATION OF INTEREST RATES
» T here are a number of factors that affect a stock’s price and its value to
» Dividend Valuation Model If dividends are constant forever, the value of a share of stock is the
» Returns on Common Stock As we saw in the preceding section, the value of a stock is the present
» Straight Coupon Bond Suppose you are considering investing in a straight coupon bond that:
» Returns on Bonds If you invest in a bond, you realize a return from the interest it pays (if
» Coupon Bonds The present value of a bond is its current market price, which is the dis-
» Callable Bonds Some bonds have a feature, referred to as a call feature, that allows the
» RISK Whenever you make a financing or investment decision, there is some
» Financial Risk When we refer to the cash flow risk of a security, we expand our con-
» Reinvestment Rate Risk Another type of risk is the uncertainty associated with reinvesting cash
» Interest Rate Risk Interest rate risk is the sensitivity of the change in an asset’s value to
» Currency Risk In assessing the attractiveness of an investment, we estimated future cash
» 5 (Continued) Portfolio of Investment C and Investment D
» Portfolio Size and Risk What we have seen for a portfolio with two assets can be extended to
» I n Chapters 8 through 10, we discussed and practiced techniques for
» The Cost of Debt Because Congress allows you to deduct from your taxable income the
» The Cost of Common Stock The cost of common stock is the cost of raising one more dollar of com-
» INTEGRATIVE EXAMPLE: ESTIMATING THE COST OF CAPITAL FOR DUPONT
» CAPITAL BUDGETING Because a firm must continually evaluate possible investments, capital
» Investment Cash Flows When we consider the cash flows of an investment we must also consider
» Asset Disposition At the end of the useful life of an asset, the firm may be able to sell it or
» Change in Expenses When a firm takes on a new project, the costs associated with it will
» Putting It All Together Here’s what we need to put together to calculate the change in the firm’s
» The Analysis To determine the relevant cash flows to evaluate this expansion, let’s
» The Problem The new equipment costs $300,000 and is expected to have a useful life of
» T he value of a firm today is the present value of all its future cash
» Payback Period The payback period for a project is the length of time it takes to get your
» Discounted Payback Period The discounted payback period is the time needed to pay back the origi-
» Net Present Value If offered an investment that costs $5,000 today and promises to pay
» Net Present Value Decision Rule
» Profitability Index The profitability index (PI) is the ratio of the present value of change in
» Stand-Alone versus Market Risk If we have some idea of the uncertainty associated with a project’s
» Sensitivity Analysis Estimates of cash flows are based on assumptions about the economy,
» Simulation Analysis Sensitivity analysis becomes unmanageable if we change several factors
» Options on Real Assets The valuation of stock options is rather complex, but with the assis-
» OVERVIEW OF DEBT OBLIGATIONS In a debt obligation, the borrower receives money in exchange for a
» Repayment Schedule Term loans are usually repaid in installments either monthly, quarterly,
» Interest In the United States, interest is typically paid twice a year at six month
» Debt Retirement By the maturity date of the bond, the issuer must pay off the entire par
» Rating Systems In all systems the term high grade means low default risk, or conversely,
» S uppose you buy a new car that costs $20,000 and you pay cash for it.
» Limited Liability The corporate form of doing business is attractive to owners of a busi-
» Stock Ownership We can classify a corporation according to whether its shares of stock
» Voting Rights Common shareholders are generally granted rights to
» Corporate Democracy Corporate democracy gives owners of the corporation a say in how to
» Methods of Repurchasing Stock
» Dividends Although a firm’s board of directors declares a dividend on its preferred
» Sinking Funds Because there is no legal obligation to pay the preferred dividend and
» DEBT VERSUS EQUITY The combination of debt and equity used to finance a firm’s projects is
» CAPITAL STRUCTURE AND TAXES We’ve seen how the use of debt financing increases the risk to owners;
» Interest Tax Shield An interesting element introduced into the capital structure decision is
» Unused Tax Shields The value of a tax shield depends on whether the firm can use an interest
» PUTTING IT ALL TOGETHER As a firm increases the relative use of debt in the capital structure, its
» A s we saw in Part Three, managers base decisions about investing in
» CASH MANAGEMENT Cash flows out of a firm as it pays for the goods and services it pur-
» The Baumol Model The Baumol Model is based on the Economic Order Quantity (EOQ)
» The Miller-Orr Model The Baumol Model assumes that cash is used uniformly throughout the
» The Check Clearing Process The process of receiving cash from customers involves several time-
» RECEIVABLES MANAGEMENT When a firm allows customers to pay for goods and services at a later
» Captive Finance Subsidiaries Some firms choose to form a wholly-owned subsidiary—a corporation
» The Economic Order Quantity Model The Economic Order Quantity (EOQ) model helps us determine what
» Just-in-Time Inventory The goal of the just-in-time (JIT) inventory model is to cut down on the
» Monitoring Inventory Management We can monitor inventory by looking at financial ratios in much the
» Add-on-interest Another way of stating interest is with add-on interest, where the total
» Trade Credit Trade credit is granted by a supplier to a customer purchasing goods or
» Commercial Paper Commercial paper is an unsecured promissory note with a fixed matu-
» Types of Inventory Financing There are several different types of loan arrangements that involve
» SPECIALIZED COLLATERALIZED BORROWING ARRANGEMENT FOR FINANCIAL INSTITUTIONS
» RATIOS AND THEIR CLASSIFICATION
» RETURN-ON-INVESTMENT RATIOS Return-on-investment ratios compare measures of benefits, such as earn-
» The Du Pont System The returns on investment ratios give us a “bottom line” on the perfor-
» LIQUIDITY Liquidity reflects the ability of a firm to meet its short-term obligations
» PROFITABILITY RATIOS We have seen that liquidity ratios tell us about a firm’s ability to meet its
» Using a Benchmark To interpret a firm’s financial ratios we need to compare them with the
» INTEGRATIVE EXAMPLE: FINANCIAL ANALYSIS OF WAL-MART STORES 6
» Dilutive Securities For a company having securities that are dilutive—meaning they could
» ANALYSTS’ FORECASTS There are many financial services firms offering projections on different
» PRICE-EARNINGS RATIO Many investors are interested in how the earnings are valued by the mar-
» FREE CASH FLOW Cash flows without any adjustment may be misleading because they do
» NET FREE CASH FLOW There are many variations in the calculation of cash flows that are used
» Using Cash Flow Information The analysis of cash flows provides information that can be used along
» THE GLOBAL ECONOMY Many countries export a substantial portion of the goods and services
» FOREIGN CURRENCY Doing business outside of one’s own country requires dealing with the cur-
» The Euro The European Union consists of 15 European member countries that
» Global Equity Market In 1985, Euromoney surveyed several firms that either listed stock on a
» Currency Swaps When issuing bonds in another country where the bonds are not denom-
» Currency Option Contracts In contrast to a forward or futures contract, an option gives the option
» A s an alternative to the issuance of a corporate bond, a corporation
» WHAT RATING AGENCIES LOOK AT IN RATING ASSET-BACKED SECURITIES
» Third-Party Guarantees Perhaps the easiest form of credit enhancement to understand is insur-
» EXAMPLE OF AN ACTUAL STRUCTURED FINANCE TRANSACTION
» Accounting for Capital Leases
» FEDERAL INCOME TAX REQUIREMENTS FOR TRUE LEASE TRANSACTIONS
» Direct Cash Flow from Leasing When a firm elects to lease an asset rather than borrow money to pur-
» S tructured financing is a debt obligation that is backed by the value of
» CREDIT IMPACT OBJECTIVE While the sponsor or sponsors of a project financing ideally would pre-
» A business that maximizes its owners’ wealth allocates its resources
» Budgeting In budgeting, we bring together analyses of cash flows, projected income
» Taxes and Transaction Costs The Black-Scholes option pricing model ignores taxes and transaction
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