Effect of Analysts' Optimism on Estimates of the Expected Rate of Return Implied By Earnings Forecasts

34 Pages Posted: 23 Mar 2007 Last revised: 3 Jan 2008

See all articles by Peter D. Easton

Peter D. Easton

University of Notre Dame - Department of Accountancy

Gregory A. Sommers

Southern Methodist University (SMU) - Accounting Department

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Abstract

Recent literature has used analysts' earnings forecasts, which are known to be optimistic, to estimate implied expected rates of return; yielding upwardly biased estimates. We estimate that the bias, computed as the difference between the estimates of the implied expected rate of return based on analysts' earnings forecasts and estimates based on current earnings realizations, is 2.84 percent. The importance of this bias is illustrated by the fact that several extant studies estimate an equity premium in the vicinity of 3 percent, which would be eliminated by the removal of the bias. We illustrate the point that cross-sample differences in the bias may lead to the erroneous conclusion that cost of capital differs across these samples by showing that analysts' optimism and, hence, bias in the implied estimates of the expected rate of return, differs with firm size and with analysts' recommendation. As an important aside, we show that the bias in a value-weighted estimate of the implied equity premium is 1.60 percent and that the unbiased value-weighted estimate of this premium is 4.43 percent.

Keywords: earnings forecasts, biased estimates, implied expected rates of return

Suggested Citation

Easton, Peter D. and Sommers, Gregory A., Effect of Analysts' Optimism on Estimates of the Expected Rate of Return Implied By Earnings Forecasts. Journal of Accounting Research, Vol. 45, No. 5, pp. 983-1016, December 2007. Available at SSRN: https://ssrn.com/abstract=971027

Peter D. Easton (Contact Author)

University of Notre Dame - Department of Accountancy ( email )

Mendoza College of Business
Notre Dame, IN 46556-5646
United States
574-631-6096 (Phone)
574-631-5127 (Fax)

Gregory A. Sommers

Southern Methodist University (SMU) - Accounting Department ( email )

United States
214-768-1188 (Phone)
214-768-4099 (Fax)

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