Valuation Model Use and the Price Target Performance of Sell-Side Equity Analysts

59 Pages Posted: 15 Sep 2006 Last revised: 19 Dec 2011

See all articles by Cristi A. Gleason

Cristi A. Gleason

University of Iowa - Department of Accounting

W. Bruce Johnson

University of Iowa - Department of Accounting

Haidan Li

Santa Clara University - Leavey School of Business

Date Written: August 28, 2011

Abstract

This study investigates the influence of inferred valuation model use on the investment performance of sell-side equity analysts’ published price target opinions. There is limited and inconclusive evidence on how analysts’ price targets are determined and on their value for investment decisions. Using a broad sample of 45,693 price targets provided to First Call by sell-side analysts during 1997 through 2003, we first show that price targets have investment value because they predict future stock returns. Next, we develop and implement an innovative large-sample procedure for inferring valuation model use from the observed correlation between analysts’ price targets and two researcher-constructed stock valuation estimates that differ in simplicity and rigor. Reliance on a less rigorous valuation model may diminish the investment advantage associated with an analyst’s more accurate earnings forecasts but it may also mitigate the disadvantage of less accurate forecasts. We test whether the apparent use of a more rigorous valuation technique yields higher quality price targets as measured by realized investment returns over a 12-month horizon, controlling for possible differences in earnings forecast accuracy. The central message from our data is that price targets exhibit superior investment performance when analysts appear to be using a fundamental residual income (RIM) stock valuation technique rather than a simple price-earnings-growth (PEG) valuation heuristic. This investment advantage is reduced when analysts’ earnings forecasts are inaccurate. Our results underscore the importance of valuation model choice to analyst’s stock investment evaluation process.

Keywords: security analysts, price targets, earnings forecasts, earnings-based valuation models

JEL Classification: G10, G14. G24

Suggested Citation

Gleason, Cristi A. and Johnson, W. Bruce and Li, Haidan, Valuation Model Use and the Price Target Performance of Sell-Side Equity Analysts (August 28, 2011). Contemporary Accounting Research, Forthcoming, Available at SSRN: https://ssrn.com/abstract=930720 or http://dx.doi.org/10.2139/ssrn.930720

Cristi A. Gleason

University of Iowa - Department of Accounting ( email )

108 Pappajohn Business Building
Iowa City, IA 52242-1000
United States

W. Bruce Johnson

University of Iowa - Department of Accounting ( email )

108 Pappajohn Business Building
Iowa City, IA 52242-1000
United States
319-335-1048 (Phone)
319-335-1956 (Fax)

Haidan Li (Contact Author)

Santa Clara University - Leavey School of Business ( email )

500 El Camino Real
Santa Clara, CA California 95053
United States
408-554-5181 (Phone)

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