Academics, practitioners, and individual investors have long been interested in understanding the value and usefulness of sell-side analysts equity reports. In recent years, security analysts have been increasingly disclosing target prices in these reports, along with their stock recommendations and earnings forecasts. These target prices provide market participants with analysts most concise and explicit statement on the magnitude of the irms expected value. Despite the increasing prominence of target prices, their role in conveying information to market participants and their contribution to the formation of equity prices have remained largely unexplored.1 This paper provides new evidence on these issues.
*Brav is at Duke University and Lehavy is at University of Michigan. We thank Jeff Abar-banell, Ravi Bansal, Tim Bollerslev, Jennifer Francis, Joel Hasbrouck, David Hsieh, Jack Hughes, S. P. Kothari, Charles Lee, Roni Michaely, Michael Roberts, seminar participants at University of California-Irvine, University of Illinois-Champaign, University of North Carolina at Chapel Hill, University of Minnesota, Tel-Aviv University, The Interdisciplinary Center Herzlyia, Israel, University of Toronto, and Purdue University for their comments, and we thank Mark Carhart and Ken French for providing the factor time series. We also thank the following individuals for their insights: Stan Levine from First Call, Jennifer Lyons from Lend Lease Rosen Real Estate securities, LLC, Jim Wicklund from Dain Rauscher, Inc., Ralph Goldsticker from Mellon Capital Management, Len Yaffe from Bank of America Securities, and Peter Algert from Barclays Global Investors. We owe special thanks to John Graham, Campbell Harvey, Brett Trueman, and Richard Willis for many invaluable insights and comments. All remaining errors are ours.
1 Bradshaw (2002) studies a sample of 103 analysts reports and documents the frequency with which analysts employ target prices to justify their choice of recommendations. Using a sample of 114 Canadian firms, Bandyopadhyay, Brown, and Richardson (1995) also find that forecasted earnings explain a large proportion of the variation in price forecasts.
Understanding the role of target prices in capital markets is important for several reasons. First, because target prices are often computed as the product of forecasted earnings and a financial ratio such as an earnings yield (Fernandez (2001) and Asquith, Mikhail, and Au (2002)), evidence that target prices are informative in the presence of earnings forecasts supports the argument that market participants consider price formation via multiples to be useful. Second, evidence that market participants react to the information conveyed in analyst target prices is relevant for the recent controversy regarding the value of analyst research reports (see U.S. House of Representatives (2001)). Such evidence should therefore be considered when assessing the implications of potential biases in analystsopinions on the informativeness of their reports. Third, if target prices are incrementally informative, that would suggest that results in prior research on analysts stock recommendations and earnings forecasts might be partially attributed to the value that investors assign to price targets. Finally, an investigation into the role of target prices enables us to evaluate the view that target prices provide little or no value to market participants.2 Speciically, it may be argued that recommendations and earnings forecasts may completely subsume the information in target prices, since the latter are determined after the stock recommendation and earnings forecast have been set. It may also be argued that target prices are uninformative and serve as a mere vehicle to enhance an individual analysts stature, or that they may not be easily interpreted by investors as they are not necessarily associated with an end date. The view that target prices provide little or no value to market participants provides for a natural null hypothesis in this paper.
We begin our analysis with an examination of stock price reactions both associated with and subsequent to target price revisions. If capital market participants perceive analyst price targets as valuable, we should observe signiicant price reactions around their announcements. If larger upward (downward) revisions in target prices represent more (less) favorable news, we expect market reactions around target price revisions to increase in the favorableness of the revision. Since target prices are generally issued in conjunction with stock recommendations and earnings forecasts, we also ask whether target prices are incrementally informative. Given the discreteness of stock recommendations, we expect target prices to be informative in the presence of stock recommendations.
Using a large database ofanalyst target prices, we document signiicant abnormal returns around target price revisions and show that the abnormal returns are increasing in the favorableness of the target price revision. We also show that
OBrien (2001) reflects on the controversy regarding the value of price targets: Price targets, at their worst, can be used to exploit unsophisticated investors Now that some of the
dust has settled, market professionals are seeing some marginal value in price targets, if only in interpreting the vernacular of Wall Street. Vickers and Weiss (2000) assert that .analysts are increasingly lobbing absurdly extreme calls that attract big-media attention and encourage momentum investing.
target prices are incrementally informative, conditional on contemporaneously issued stock recommendations and earnings forecast revisions. Motivated by evidence in prior research of a price drift subsequent to recommendation and earnings forecast revisions (e.g., Stickel (1995), Womack (1996)), we examine postevent abnormal returns.We ind that target price revisions contain information regarding future abnormal returns above and beyond that which is conveyed in stock recommendations. This inding reinforces the view that target prices do contain valuable information.
Further evidence on the properties of analyst price targets is provided by an analysis of the long-term comovement of both stock and target prices. Because target prices are forward looking, we argue that, much like stock prices, they ought to be linked to the underlying fundamental value of the irm. Therefore, using a cointegration framework, we examine the long-term dynamics that link target and market prices. The ratio of target price to the underlying stock price provides a measure of analysts beliefs regarding the irms expected return. The cointegration analysis allows us to estimate the mean of this ratio, which we interpret as the long-term relation of the two price series.
The long-term analysis also enables us both to provide evidence on how the system oftarget and stock prices reacts to deviations from this long-term relation and to quantify the speed and magnitude of adjustment of each price series back toward this long-term relation. We ask whether analysts react to deviations from the long-term relation by adjusting their target prices, or whether stock prices contribute towards most of the long-term adjustments. Given our inding of postevent excess returns, the long-term analysis is of particular interest because it provides evidence as to the relative magnitude by which analysts (investors) adjust target (stock) prices toward the long-run target-to-stock price ratio. The long-term analysis, conducted on a subset of 900 irms with a continuous target price record, reveals that, on average, target prices are 28 percent higher than concurrent market prices and, moreover, this ratio is inversely related to irm size. We also ind that once the ratio of target-to-market price is higher (lower) than the estimated long-run ratio, it is primarily analysts who revise their targets down (up) such that the ratio reverts back to its long-run value. Market prices, in contrast, barely contribute to this correction phase.
In our inal analysis we combine the short- and long-term analyses by examining whether investors understand the properties of the long-term dynamics that we document. Specifically, for each target price revision, we construct an estimate of the expected and unexpected component of the revision, and examine investors reactions to each component. We ind that average abnormal returns are signiicantly associated with the proxy for the unexpected revision in the target price but not for the expected component. This inding supports the view that investors understand the long-term dynamics that we document.
Our examination of the informativeness of analysts target prices contributes to extant research on the information content of analysts two other signals: stock recommendations and earnings forecasts. This research generally inds sig-niicant positive (negative) price reaction to recommendation upgrades (downgrades; e.g., Elton, Gruber, and Grossman (1986), Stickel (1995), Womack (1996)).
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