The Accuracy and Bias of Equity Values Inferred from Analysts’ Earnings Forecasts

Theodore Sougiannis, Takashi Yaekura

Research output: Contribution to journalReview article

26 Citations (Scopus)

Abstract

We evaluate the extent to which unbiased and accurate estimates of equity value can be derived from three multiperiod accounting-based valuation models using consensus analysts’ earnings forecasts over a four-year horizon. The models are (1) the earnings capitalization model, (2) the residual income model without a terminal value, and (3) the residual income model with a terminal value that assumes residual income will grow beyond the horizon at a constant rate determined from the expected residual income growth rate over the forecast horizon. Our analysis is based on valuation errors that are calculated by comparing estimated prices to actual prices. We find that, on average, analysts’ earnings forecasts convey information about value beyond that conveyed by current earnings, book values, and dividends. Each of the models that we used has valuation errors that decline monotonically as the horizon increases, implying that earnings forecasts at each horizon convey new value relevant information. We cannot find a clear advantage to using firm specific growth rates instead of a constant rate of 4 percent across all sample firms. In addition, only 17 percent of the imputed growth rates could be used in terminal value calculations. The residual income model with a terminal value shows the best performance on average, but it values more accurately only 48 percent of our sample firms. The earnings capitalization model and the residual income model without a terminal calculation value more accurately 18 percent and 13 percent of the sample firms, respectively. The remaining 21 percent of firms are more accurately valued using only reported current earnings and book values of equity. Thus, different models are appropriate for different firms. The conditions under which given models work best relate to ex-ante growth indicators such as the current book-to-market, earnings-to-price, the present value of the expected residual income over the forecast horizon, the growth rate in expected earnings, and firm size, but not to industry membership. In all models estimated prices are, on average, downward biased and inaccurate and they explain at best 70 percent of the variation in market prices. We examined the quality of the earnings forecasts and the quality of the GAAP earnings as two possible reasons for the biased and inaccurate results. Our tests provide evidence consistent with both of these reasons. Thus, we conclude that the poor model performance is due to information missing from the forecasts and to the practice of conservative accounting.

Original languageEnglish
Pages (from-to)331-362
Number of pages32
JournalJournal of Accounting, Auditing and Finance
Volume16
Issue number4
DOIs
Publication statusPublished - 2001
Externally publishedYes

Fingerprint

Equity
Analysts' earnings forecasts
Residual income model
Residual income
Book value
Earnings forecasts
Capitalization
Forecast horizon
Conservative accounting
Market price
Book-to-market
Firm size
IT value
Missing information
Industry
Dividends
Valuation model
Information value
Present value
Income growth

ASJC Scopus subject areas

  • Accounting
  • Finance
  • Economics, Econometrics and Finance (miscellaneous)

Cite this

The Accuracy and Bias of Equity Values Inferred from Analysts’ Earnings Forecasts. / Sougiannis, Theodore; Yaekura, Takashi.

In: Journal of Accounting, Auditing and Finance, Vol. 16, No. 4, 2001, p. 331-362.

Research output: Contribution to journalReview article

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