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

Authors


  • The comments of Ashiq Ali, Robert Battalio, Sung Chung, Somnath Das, Gus DeFranco, Ryan Lafond, John Lyon, Hai Lu, Paul Healy, Steve Monahan, Rick Mendenhall, John O'Hanlon, Krishna Palepu, Gord Richardson, Scott Richardson, Steven Rock, Brian Rountree, Cathy Schrand, Margaret Shackell-Dowel, Pervin Shroff, Philip Stocken, Phil Shane, Tom Stober, Rex Thompson, Samir Trabelsi, Jenny Tucker, Arnt Verriest, Kent Womack, Jun Xia, Tzachi Zach, Paul Zarowin, and workshop participants at the 2006 American Accounting Association annual meeting, 2006 Conference on Finance, Economics, and Accounting, 2006 London Business School Accounting Symposium, 2006 Lone Star Accounting Research Conference, Brock University, Dartmouth College, Drexel University, Harvard University, Lancaster University, New York University, Pennsylvania State University, Southern Methodist University, Tilburg University, the University of Colorado, the University of Illinois, the University of Melbourne, the University of Minnesota, the University of Notre Dame, and the University of Toronto are greatly appreciated. The paper reflects many long conversations with Mark Zmijewski. We thank Lorie Marsh for her assistance with the preparation of this paper.

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%. The importance of this bias is illustrated by the fact that several extant studies estimate an equity premium in the vicinity of 3%, 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% and that the unbiased value-weighted estimate of this premium is 4.43%.

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