Understanding the Determinants of Analyst Target Price Forecasts

Abstract

We investigate the determinants of analysts’ target price forecasts and evaluate their relative importance for explaining the cross-sectional variation in target price implied returns. We identify four broad determinants: the informational component predictive of future stock returns, errors in forecasting fundamentals, errors in forecasting the expected return to risk, and biases relating to analysts’ incentives. Our findings indicate that analysts have a limited ability to predict short-term future returns, and incorrect fundamental forecasts marginally impact target price valuations. Errors in forecasting the expected return to empirical risk proxies such as beta and idiosyncratic volatility have the greatest impact and induce significant noise and optimism into target prices. Job-related incentives induce incremental optimism in target prices. We use our target price determinants model to predict the optimistic bias in target price forecasts and evaluate whether investors correctly ignore the predictable bias. The results suggest that investors make similar valuation errors to analysts and/or do not perfectly back out the predicted bias in target prices.

Keywords: target price forecasts, risk, growth, forecast errors, stock volatility, predictable bias, financial analysts, incentives, implied return, future return, market efficiency

JEL Classification: M40, M41, G14