What Drives the Value of Analysts' Recommendations: Earnings Estimates or Discount Rate Estimates?

Abstract:     
An analyst changes his recommendation of a stock to indicate to investors that his valuation of the stock differs from the market's valuation. Explicitly or implicitly, the difference in valuation ultimately arises from disagreement about earnings estimates and/or discount rate estimates. We argue that recommendation changes that are based on changes in earnings estimates are characterized by harder information, greater verifiability, and shorter forecast horizons than recommendation changes that are based on discount rate estimates, so they are less subject to analysts' cognitive and incentive biases. Therefore, earnings-based recommendation changes should be more informative to investors than discount rate-based recommendation changes. We find that both the initial price reaction and the drift after recommendation changes are between 50% to 200% bigger for earnings-based recommendation changes than for discount rate-based recommendation changes. Trading on earnings-based recommendation changes earns average risk-adjusted returns of over 3% per month over the period 1994-2007.

Number of Pages in PDF File: 59

Keywords: analysts, brokers, recommendations, earnings, growth rates, discount rates, information, market efficiency

JEL Classification: G14, G24

working papers series