V. Summary and Conclusions

Using a large database of analyst price targets, stock recommendations, and earnings forecasts, we examine short-term market reactions to target price announcements and long-term comovement of target and market prices. Consistent with our predictions, we ind that target prices are informative both unconditionally and conditional on contemporaneously issued recommendation and earnings forecast revisions. Moreover, revisions in target prices contain information about six-month postevent abnormal returns. Recommendation and earnings forecast revisions are also found to be informative in the presence of target prices. We document a role for the degree of the recommendation change for a given target price change, suggesting that the degree of the stock recommendation revision conveys analysts uncertainty regarding the overall assessment of the irms prospects. We provide additional evidence as to the dynamic properties of analyst price targets by examining their long-term comovement relative to stock prices. Using a cointegration framework, we ind that, on average, one-year-ahead target prices are 28 percent higher than current market prices, an estimate that we refer to as the long-term relation of the price system.This framework allows us to document the dynamics that force the two sets ofprices to converge on the long-term relation. We show that, while market prices react to the information conveyed in analyst reports, once the price system has been shocked away from this long-run relation, any subsequent correction is done primarily by analysts, while market prices alone contribute little to this correction phase. We provide evidence that the market understands the latter relationship.

Target prices and, more generally, inancial analysts have recently received considerable attention. This paper is the irst to explore and document evidence on the informativeness and time-series behavior of analysts target prices, thus contributing to our understanding of price formation in equity markets. First, as Asquith et al. (2002) and others document, target prices are often computed as the product of forecasted earnings and an earnings multiple. Hence, controlling for the revision in the earnings forecast, the announcement of a target price provides researchers with a unique opportunity to observe how investors incorporate information on the reduced form model deemed correct by the analysts in forecasting future price appreciation. Our findings of a monotonic relation between abnormal returns and target price revisions, controlling for earnings forecast revisions, is consistent with the view that market participants view the magnitude of the multiple used by the analyst as informative. Second, the evidence that target price revisions contain information regarding future abnormal returns is important and consistent with either market underreaction due to investor behavioral biases or rational learning in the face of structural uncertainty (Brav and Heaton (2002)). The evidence of such a drift however interpreted, is also relevant to the current debate regarding the objectivity and unbiasedness of analyst reports.

Our indings should serve as a starting point for further research on various related questions. Since the ratio of target-to-market prices can be viewed as a measure of ex ante expected return, it would be interesting to examine whether

these ex ante returns are unbiased and are more accurate relative to forecasts generated from asset pricing models such as the CAPM or intrinsic value measures such as in Lee et al. (1999). These ex ante expectations can also be used in asset pricing tests, such as that in Fama and MacBeth (1973), in lieu of realized returns (see Brav, Lehavy, and Michaely (2002)).

Various other questions warrant further investigation: Are there any cross-sectional diferences in market reaction based on irm and brokerage house characteristics? How do analysts determine their target prices? Are these prices based on valuation models whose inputs include their own earnings forecasts? What governs analyst decisions to issue or withhold target prices? What, if any, are the consequences on analysts reputations of providing incorrect target prices or chasing the stock price? Are any diferences to be found in target prices be-tween affiliated and unaffiliated analysts (Michaely and Womack (1999))? Finally, given that the sample period we study is quite unusual in the history of U.S. capital markets, additional out-of-sample evidence is desired. We leave these intriguing questions for future research.

Appendix: Additional Evidence on the Role of Recommendation Revisions

We report additional tests designed to explore the role of the magnitude of recommendation revisions (e.g., hold-to-buy relative to hold-to-strong buy), controlling for the information in both target price and earnings forecast revisions. We expect the magnitude of a recommendation revision to be informative even in the presence of target prices. For a given target price revision, the magnitude of the associated recommendation revision can provide additional information on an analysts level of conidence in that target price. For example, a positive revision in a target price could be perceived as more credible (or more precise) when accompanied by a revision from a hold to a strong buy rather than a revision from a hold to a buy recommendation. Hence, a target price might relect the mean of the analysts posterior beliefs regarding the irms value, while a recommendation provides additional information regarding the dispersion of these beliefs.

We investigate this view as follows. First, we split the sample into two subsets, depending on the type of the recommendation revisions, namely upgrades and downgrades. Then, within each such classiication, we consider the possible recommendation revisions and regress event-day abnormal returns on an intercept as well as on earnings forecasts and target price revisions.

The results are presented in Table A1. Consider first columns 1-3 in which we focus on recommendation upgrade categories. To ensure a meaningful interpretation of the incremental role of the relative recommendation revision, we focus on recommendations that were revised from and revised to the same recommendation. Thus, we compare among three possible such upgrades: (1) hold to strong buy, (2) buy to strong buy, and (3) hold to buy.

The regression results are consistent with the prediction that, controlling for earnings forecast and target price revisions, more-extreme revisions in stock

Recommendation Upgrades from Recommendation Downgrades from

recommendations are perceived as providing more-informative signals. For example, the coeicient estimate associated with upgrades to strong buy from hold (3.459) is significantly different (p-value = 0.018) from the one associated with upgrades to strong buy from buy (2.479). Similarly, upgrades from hold to strong buy are larger than upgrades from hold to buy, although these diferences are marginally signiicant (p-value = 0.088).

When we consider recommendation downgrades in columns 4-6, we find results consistent with the hypothesis that the magnitude of a recommendation revision conveys independent information to market participants. Speciically, we examine downgrades from: (1) strong buy to hold, (2) strong buy to buy, and (3) buy to hold. We ind that the coeicient estimate associated with downgrades from strong buy to hold (- 3.239) is significantly different (p-value = 0.005) from the one associated with downgrades from strong buy to buy (- 1.960). Similarly, revisions from strong buy to hold are associated with a larger negative abnormal return than revisions from buy to hold (- 3.239 vs. - 2.655). These results support an informative role for the magnitude of recommendation revisions, consistent with the interpretation that analysts employ the degree of the recommendation revision to convey their conidence in their target price estimate.

References

Asquith, Paul, Michael M. Mikhail, and Andrea Au, 2002, Equity analyst reports, Working paper, Duke University, Fuqua School of Business.

Bandyopadhyay, Sati P., Lawrence D. Brown, and Gordon D. Richardson, 1995, Analysts use of earnings forecasts in predicting stock returns: Forecast horizon effects, InternationalJournal of Forecasting 11,429-445.

Barber, Brad, Reuven Lehavy, Maureen McNichols, and Brett Trueman, 2001, Can investors profit from the prophets? Security analyst recommendations and stock returns, Journal of Finance 56, 531-565.

TableAl

The Role of Recommendation Revisions