Wall Street analysts routinely inflate stock prices
ANN ARBOR, Mich.Wall Street analysts often
provide biased research in response to investment banking pressures,
according to a new study by a University of Michigan Business School
"Sell-side analysts have long faced allegations
that pressures to generate investment banking business compromise
the soundness of their investment research," said Richard
Sloan, professor of accounting and finance at the U-M Business School.
"Our evidence supports these allegations. We found that analysts
routinely hype the stock of firms raising new financing so that
these firms can issue securities at temporarily inflated prices."
Sloan and two of his former doctoral students,
Mark Bradshaw of Harvard Business School and Scott Richardson of
the Wharton School at the University of Pennsylvania, examined data
from financial statements and stock returns from 1975-2000 for more
than 100,000 firm-year observations.
They found that the degree of overoptimism in
sell-side analysts' earnings forecasts, stock recommendations
and target prices is systematically related to corporate financing
activitiesespecially for firms that are issuing new securities.
"The economic significance of our results
is striking," Sloan said. "For example, we find that
target prices set by analysts are, on average, 80 percent too high
for firms issuing securities versus only 20 percent too high for
firms repurchasing securities."
The researchers say that the predictability of
future stock returnswhich historically have been unusually
low in the three years following securities issuances and unusually
high during the same time-frame for securities repurchasesis
due to temporary mispricing rather than risk.
"The predictable future stock returns are
directly related to predictable biases in analysts' earnings
forecasts," Sloan said. "It appears that investors initially
buy into analysts' biased earnings expectations and are subsequently
surprised by the predictable forecast errors.
"Further, we find that analysts set significantly
higher future target prices for firms issuing securities than for
firms repurchasing securities. If the lower future stock returns
for issuing firms represent a lower risk premium, then we would
expect analysts to set lower target prices for such firms."
The study also shows that analysts tailor their
overoptimism to the type of security being issued. For example,
analysts typically exaggerate short-term earnings prospects of debt
issuers to reduce the perceived credit risk of these securities.
In contrast, they overstate the long-term growth potential of equity
issuers in order to sell securities at higher prices.
Finally, Sloan and colleagues say that the primary
driver of overoptimism is external financing activity, not, like
prior research has shown, whether analysts work for firms that have
investment banking ties to the companies they cover. Analysts with
no ties often enjoy financial incentives to provide overly optimistic
research on issuing firms as well, they add.
"Our analysis shows that the relation between
corporate financing activities and analyst research is pervasive,"
Sloan said. "Sell-side analysts routinely manipulate their
investment advice in response to investment banking pressures in
order to temporarily inflate stock prices around securities issuances."
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Contact: Bernie DeGroat
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