Horizon-Dependent Underreaction in Financial Analysts' Earnings Forecasts

33 Pages Posted: 3 Oct 2003 Last revised: 20 Sep 2012

See all articles by Jana Smith Raedy

Jana Smith Raedy

University of North Carolina at Chapel Hill

Philip B. Shane

College of William & Mary; Monash University; Monash University - Department of Accounting

Yanhua Sunny Sunny Yang

University of Connecticut - School of Business; University of Connecticut - School of Business

Date Written: November 7, 2005

Abstract

This paper provides empirical evidence that underreaction in financial analysts' earnings forecasts increases with the forecast horizon, and the paper offers a rational economic explanation for this result. The empirical portion of the paper evaluates analysts' responses to earnings-surprise and other earnings-related information. Our empirical evidence suggests that analysts' earnings forecasts underreact to both types of information, and the underreaction increases with the forecast horizon. The paper also develops a theoretical model that explains this horizon-dependent analyst underreaction as a rational response to an asymmetric loss function. The model assumes that, for a given level of inaccuracy, analysts' reputations suffer more (less) when subsequent information causes a revision in investor expectations in the opposite (same) direction as the analyst's prior earnings forecast revision. Given this asymmetric loss function, underreaction increases with the risk of subsequent disconfirming information and with the disproportionate cost associated with revision reversal. Assuming that market frictions prevent prices from immediately unraveling these analyst underreaction tactics, investors buying (selling) stock based on analysts' positive (negative) earnings forecast revisions also benefit from analyst underreaction. Therefore, the asymmetric cost of forecast inaccuracy could arise from rational investor incentives consistent with a preference for analyst underreaction. Our incentives-based explanation for underreaction provides an alternative to psychology-based explanations and suggests avenues for further research.

Note: Previously titled "Horizon-Dependent Conservatism Bias in Financial Analysts' Earnings Forecasts"

Keywords: Earnings forecasts, security analysts, underreaction, forecast rationality

JEL Classification: M41, G14, G29

Suggested Citation

Smith Raedy, Jana and Shane, Philip B. and Yang, Yanhua Sunny, Horizon-Dependent Underreaction in Financial Analysts' Earnings Forecasts (November 7, 2005). Contemporary Accounting Research, Vol. 23, No. 1, Spring 2006; McCombs Research Paper Series No. ACC-04-05. Available at SSRN: https://ssrn.com/abstract=445140 or http://dx.doi.org/10.2139/ssrn.445140

Jana Smith Raedy

University of North Carolina at Chapel Hill ( email )

McColl Building
Chapel Hill, NC 27599-3490
United States
919-962-7475 (Phone)
919-962-4727 (Fax)

Philip B. Shane (Contact Author)

College of William & Mary ( email )

P.O. Box 8795
Williamsburg, VA 23185
United States

Monash University ( email )

23 Innovation Walk
Wellington Road
Clayton, Victoria 3800
Australia

Monash University - Department of Accounting ( email )

H3.43, Building H, Level 3
Monash University Caulfiled
Melbourne, VIC 3145
Australia

Yanhua Sunny Yang

University of Connecticut - School of Business ( email )

2100 Hillside Road
Storrs, CT 06269-1041
United States
8604864696 (Phone)
8604864838 (Fax)

HOME PAGE: http://www.business.uconn.edu/person/yanhua-sunny-yang/

University of Connecticut - School of Business ( email )

2100 Hillside Rd, Unti 1041A
Storrs, CT 06238
United States
8604864696 (Phone)

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