Analysts’ earnings forecasts serve as an important benchmark for investors in evaluating firm performance (Brown 2001, Brown and Caylor 2005). It is well known that stock returns are significantly related to contemporaneous earnings forecast errors and future forecast revisions. Recent evidence also suggests that the mere act of beating (missing) analyst forecasts evokes a favorable (unfavorable) market response at the time of the earnings announcement after controlling for the magnitude of the forecast error (Lopez and Rees 2002, Bartov, Givoly, and Hayn 2002).
Researchers have now begun to investigate the source and determinants of this market response (Rees and Sivaramakrishnan 2006). In this paper, we contribute to this line of research by examining whether the observed equity premium (penalty) to beating (missing) analyst forecasts is a function of outstanding stock recommendations. In addition, we examine whether analysts’ own response to firms’ beating/missing earnings forecasts in revising their subsequent forecasts is consistent with investors’ response.
If the act of meeting or beating analysts’ expectations evokes a positive response from the market, then managers with equity pricing motives have an incentive to engage in earnings management to meet analysts’ expectations. Indeed, Abarbanell and Lehavy (2003) [hereafter, AL03] posit that managers’ incentives to meet or beat analyst forecasts is more pronounced when their firms’ stock prices exhibit greater sensitivity to earnings news.
Using stock recommendations as a proxy for price sensitivity to earnings news, they show that the proportion of firms meeting/beating analyst forecasts is significantly higher among firms with more favorable recommendations, and that managers of these firms have a greater incentive to measure up to analysts’ expectations. In turn, such an incentive should exist only if the premium (penalty) to beating (missing) analyst forecasts is more pronounced for these firms. We test this price sensitivity hypothesis by examining the differential stock price response to earnings news for different levels of stock recommendations.