Valuation Implications of Unconditional Accounting Conservatism: Evidence from Analysts' Target Prices

Posted: 26 Aug 2018

See all articles by Jae B. Kim

Jae B. Kim

Lehigh University - College of Business & Economics

Alexander Nekrasov

University of Illinois at Chicago

Pervin K. Shroff

University of Minnesota - Twin Cities - Carlson School of Management

Andreas Simon

Pepperdine University - Graziadio Business School

Date Written: July 25, 2018

Abstract

We examine whether financial analysts understand the valuation implications of unconditional accounting conservatism when forecasting target prices. While accounting conservatism affects reported earnings, conservatism per se does not have an effect on the present value of future cash flows. We examine whether analysts adjust for the effect of conservatism included in their earnings forecasts when using these forecasts to estimate target prices. We find that signed target price errors (actual minus forecast) have a significant positive association with the degree of conservatism in forward earnings, suggesting that target prices are biased due to accounting conservatism. Cross-sectional analysis suggests that more sophisticated analysts and superior long-term forecasters adjust for conservatism to a greater extent than other analysts. In additional analyses, we explore the mechanism through which conservatism leads to bias in target prices. We first show that analysts’ earnings forecasts are negatively associated with the degree of conservatism, i.e., analysts include the effect of unconditional conservatism in their earnings forecasts. Based on alternative earnings-based valuation models that analysts may use, our evidence suggests that analysts fail to appropriately adjust their valuation multiple for the effect of conservatism included in their earnings forecasts when using these forecasts to derive target prices. As a consequence, we find that, for extreme changes in conservatism, the bias in analysts’ target prices due to conservatism leads to a distortion of market prices. The evidence highlights the concern that analysts may not appreciate the valuation implications of conservative accounting which could inhibit price discovery.

Keywords: Conservatism, valuation, analyst target price, mispricing

JEL Classification: G12, G14, G41, M41

Suggested Citation

Kim, Jae Bum and Nekrasov, Alexander and Shroff, Pervin K. and Simon, Andreas, Valuation Implications of Unconditional Accounting Conservatism: Evidence from Analysts' Target Prices (July 25, 2018). Contemporary Accounting Research, Forthcoming. Available at SSRN: https://ssrn.com/abstract=3232827

Jae Bum Kim

Lehigh University - College of Business & Economics

621 Taylor Street
Bethlehem, PA 18015
United States

Alexander Nekrasov

University of Illinois at Chicago ( email )

1200 W Harrison St
Chicago, IL 60607
United States

HOME PAGE: http://business.uic.edu/profiles/alexander-nekrasov/

Pervin K. Shroff (Contact Author)

University of Minnesota - Twin Cities - Carlson School of Management ( email )

19th Avenue South
Minneapolis, MN 55455
United States
612-626-1570 (Fax)

Andreas Simon

Pepperdine University - Graziadio Business School ( email )

Malibu, CA
United States

HOME PAGE: http://https://bschool.pepperdine.edu/academics/faculty/andreas-simon/

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