What Value Analysts?

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Abstract
We evaluate the contribution of analysts' earnings forecasts to investors' decisions by comparing the association between annual excess returns and a broad set of information items derived from financial statements with the association between excess returns and that information set plus the present value of five-year ahead analysts' earnings forecasts. We thus bring to a sharp focus the incremental contribution (over financial statement information) of the major product of analysts - near and medium-term earnings forecasts - to investors' decisions as reflected by annual excess returns. Large differences in explanatory power between the regressions with and without analysts' forecasts are evidence in favor of analysts' contribution to investors' decisions. However, in assessing analysts' contribution from associations with stock returns care should be taken to account for the inherent simultaneity - analysts not only contribute (possibly) to investors, they also observe stock price behavior and learn from investors' decisions. We are therefore using a system of simultaneous equations to control for the endogeneity of both excess returns and analysts' forecasts, allowing us to isolate the net contribution of analysts' forecasts to capital markets. Our findings, based on cross-sectional regressions covering the period 1982-1997, indicate that over the sample period, analysts add a hefty 40 percent (in Adj-R2 terms) to the explanatory power of financial information with respect to stock returns. However, when simultaneity (i.e., analysts' learning from returns) is accounted for, their contribution is estimated as a modest 12 percent. This result suggests that analysts' mostly react to changes in market values rather than cause them. Additional findings are: (1) The explanatory power of the broad-based financial statement information set decreased significantly over the examined period, while the explanatory power of the model including analysts' forecasts decreased at a lower rate. Analysts, therefore, mitigate to some extent the decrease in the informativeness of financial statements. (2) The incremental contribution of analysts in firms that report losses is substantially larger than in profitable companies. (3) The incremental contribution of financial analysts is largest in high-tech industries followed by low-tech industries, and regulated firms, suggesting that the contribution of analysts is larger in sectors where the informativeness of financial reports is low. (4) Analysts' contribution to valuation in firms with substantial research and development (R&D) capital is relatively larger than in firms without such R&D capital. (5) The incremental contribution of analysts during economic boom periods is higher than during recessions (e.g., the early 1990s). (6) Based on a firm-specific measure of analysts' incremental contribution, we find that this contribution decreases with firm size, systematic risk, and earnings persistence, and increases with the firm's R&D capital. All in all, we find the direct contribution of analysts' forecasts of earnings to investors' decision to be quite modest. However, this contribution is substantial in firms, sectors and circumstances where the informativeness of financial statements is relatively low.

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