Do investors recognize biases in securities analysts’ forecasts?

• Author: Philip L. Baird
• DOI: http://doi.org/10.1002/rfe.1094
• Published date: 01 October 2020
• Date: 01 October 2020

Rev Financ Econ. 2020;38:623–634. wileyonlinelibrary.com/journal/rfe

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© 2019 University of New Orleans

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INTRODUCTION

A substantial literature investigating analysts’ earnings forecasts supports the conclusion that they are biased and inefficient. A

more recent and growing body of research asserts that because investors fail to optimally process available information, they

overweight analysts’ forecasts resulting in substantial mispricing of common stock. This assertion is based on evidence pur-

porting to show the existence of profitable trading strategies formed on indicators of bias. However, on the question whether

investors fail to recognize analyst bias, the evidence from realized returns is circumstantial and open to varying interpretation.

By now, analyst biases have been extensively documented. Thus, without a compelling explanation of investors’ inability to

account for them in valuing common stock, the attribution of seemingly profitable trading strategies to deficiencies in investor

judgment must be considered tenuous and needing additional corroborating evidence. The present study takes a new approach

to the question whether investors fail to recognize analyst forecast bias and investigates the determinants of implied return in a

recent cross section of U.S. public companies.

Clearly, from the perspective of financial market efficiency, the inability of investors to recognize analyst bias is troubling.

But, is it true? If investors are able to recognize biases in analysts’ earnings forecasts, then in valuing stocks they will apply

higher discount rates to forecasts they believe are biased upward (i.e., optimistic) vis-à-vis market expectations and lower rates

to those they believe are biased downward (pessimistic). It should be the case, then, that stock price relative to analysts’ consen-

sus earnings forecast is correlated with the indicators of bias. That is, for a given consensus forecast, stock price will be lower

(higher) to the extent investors perceive the forecast to be optimistic (pessimistic). If investors are unable to recognize analyst

bias (or, equivalently, if they believe analysts’ forecasts are unbiased), then stock price relative to the consensus forecast will

be uncorrelated with indicators of bias. In this study, the relation of stock price to consensus forecast is measured by reverse

engineering an equity valuation model to obtain the internal rate of return implied by current stock price and the consensus

Received: 12 August 2019

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Revised: 7 November 2019

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Accepted: 30 November 2019

DOI: 10.1002/rfe.1094

ORIGINAL ARTICLE

Do investors recognize biases in securities analysts’ forecasts?

Philip L.Baird

I wish to thank an anonymous reviewer whose comments resulted in an improved version of the paper. Any remaining errors are my own.

Palumbo-Donahue School of Business,

Duquesne University, Pittsburgh, PA, USA

Correspondence

Palumbo-Donahue School of Business,

Duquesne University, Pittsburgh, PA, USA.

Email: bairdp@duq.edu

Abstract

This study presents direct evidence on the question whether investors recognize the

widely documented biases in securities analysts’ earnings forecasts. The internal rate

of return implied by current stock price and consensus earnings forecast is found to

be correlated with indicators of bias in a manner consistent with investors discount-

ing optimistic earnings forecasts at higher rates of return and less optimistic forecasts

at lower rates of return. In a departure from studies of excess returns, the evidence

in implied returns indicates that investors recognize the biases in analysts’ earnings

forecasts.

KEYWORDS

analysts’ forecast bias, behavioral bias, earnings, market efficiency

JEL CLASSIFICATION

G11; G12; G14; G41