Financial Education

It is generally accepted that more accurate earnings forecasts by analysts should result in superior investment performance. In the Winter 2007 Journal of Investing Fortin, Gilkeson and Michelson examine three hypotheses to determine what factors may be advance indicators of superior forecast accuracy.

Hypothesis 1 is that more frequent forecast updates represent greater analyst effort and indicate greater accuracy. No support is found for this hypothesis.

Hypothesis 2 is that (a) greater changes in successive estimates result in more accurate forecasts and (b) given a tendency toward optimism, a decrease in estimates is a stronger indicator than a similar-size increase. Tests of this hypothesis find no support and even that larger changes suggest greater error and may be a signal of higher uncertainty, regardless of direction.

Hypothesis 3 is that (a) the magnitude of the change in earnings relative to last year’s earnings indicates greater accuracy and (b) a decrease is a stronger indicator than a similar magnitude increase. They find that larger changes lead to less accuracy, but that forecast declines lead to greater accuracy.

The authors conclude that investors should avoid following recommendations of analysts who frequently revise estimates and who change forecasts by significant amounts. However, they suggest that analysts forecasting earnings declines are worth noting.

For more information, see all articles on: Fundamental Analysis, Investing in Stocks, Research

See also:

Scaled Earnings Surprise

The Role of Capital Market Expectations in Portfolio Management

Psychological Traps in Investment Analysis

What Works on Wall Street

Earnings Surprise and Future Excess Returns