Target price optimism, investor sentiment, and the informativeness of analysts' target prices

Abstract

If target prices are reflective of the true value of a stock, they should correctly reflect the market’s over- and underpricing, that is, be negatively associated with investor sentiment. However, empirical evidence of Clarkson et al. (2020) finds the opposite. Prior research offers two competing explanations for why target prices may not be informative: (1) analysts’ optimism, and (2) analysts’ use of less sophisticated valuation methods. We examine the effect of the interrelation between investor sentiment, target price optimism, and the analyst’s inferred use of sophisticated valuation methods on the informativeness of target prices. Contrary to conventional wisdom that believes target price optimism would always weaken the informativeness of target prices, we find that when investor sentiment is low, target price optimism has a positive effect on the informativeness of target prices. Analysts’ continuous target price optimism drives target prices away from fundamentals in high sentiment, while optimistic target prices are closer to intrinsic values in low sentiment. Target price informativeness is highest for target prices that are inferred to be based on more sophisticated valuation methods during periods of low sentiment. In high sentiment, however, the informativeness of target prices is close to zero, irrespective of the valuation methods used. This suggests that analysts’ optimism works in favor of the informativeness in low sentiment but is distortive in high sentiment. Further, market reactions to target price revisions do not reflect the higher informativeness in low sentiment. Rather, investors overreact to target price revisions in high sentiment, potentially fueling bubbles.

Keywords: Analysts' Forecasts, Target Prices, Valuation Models