Effect of Analysts' Optimism on Estimates of the Expected Rate of Return Implied By Earnings Forecasts
Peter D. Easton
University of Notre Dame - Department of Accountancy
Gregory A. Sommers
Southern Methodist University (SMU) - Edwin L. Cox School of Business
Journal of Accounting Research, Vol. 45, No. 5, pp. 983-1015, December 2007
Recent literature has used analysts' earnings forecasts, which are known to be optimistic, to estimate implied expected rates of return, yielding upwardly biased estimates. We estimate that the bias, computed as the difference between the estimates of the implied expected rate of return based on analysts' earnings forecasts and estimates based on current earnings realizations, is 2.84%. The importance of this bias is illustrated by the fact that several extant studies estimate an equity premium in the vicinity of 3%, which would be eliminated by the removal of the bias. We illustrate the point that cross-sample differences in the bias may lead to the erroneous conclusion that cost of capital differs across these samples by showing that analysts' optimism, and hence, bias in the implied estimates of the expected rate of return, differs with firm size and with analysts' recommendation. As an important aside, we show that the bias in a value-weighted estimate of the implied equity premium is 1.60% and that the unbiased value-weighted estimate of this premium is 4.43%.
Number of Pages in PDF File: 33
JEL Classification: G29, M41, G12Accepted Paper Series
Date posted: December 11, 2007
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