How do analysts forecast earnings?

Publication Type:
Conference Proceeding
2009 AFAANZ Conference, 2009, pp. 1 - 56
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This paper examines the question of how analysts forecast earnings. We examine the determinants of analysts forecasts of both short and long run earnings. The paper is motivated by the importance of analyst forecasts as proxies for expected earnings, which is accompanied by a large literature on the properties of analysts forecast errors but limited evidence on the first order effecthow analysts produce the earnings forecasts. There is an implicit assumption permeating the analyst forecast literature that analysts use the fundamental analysis based forecasting frameworks laid out in the leading business valuation texts. These forecasting frameworks evaluate a firms future prospects in terms of sets of factors relating to the firms industry, strategy, and financial information. Prior studies generally assume the analysts use this business analysis framework for forecasting. The contribution of this study is to explicitly test this proposition. For 28,261, 21,051 and 25,053 US firm-year observations for analysts 1 and 2 year ahead forecasts and long run EPS forecasts, our key findings suggest that analysts anchor on historical EPS to forecast short and long run EPS consistent with the recommendations in the business analysis frameworks. However, inconsistent with the recommended fundamental analysis frameworks, our results suggest that analysts use the forecasting framework only in the long run, to obtain a long-run growth rate to apply to the historical EPS reported by management. Overall, the results suggest that analysts believe their best EPS forecast is the current historical EPS reported by management.
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