This article was originally published in Arab Times

 

GCC stock markets currently suffer from a lack of extensive analyst research. This is primarily due to the closed nature of many markets in the region. However, during the past few years, several of these markets have opened up spurring analysts interest, although by international standards this coverage still continues to be on the lower side.  With the research available,  only 18% of GCC listed stocks receive analysts coverage.  However measured in market capitalization terms, this accounts for only around 70%, indicating the concentrated nature of the GCC markets. Also, trading in GCC markets is currently dominated by retail investors, who do not demand analysts forecasts to base their trading decisions. In future the increased institutionalization of GCC markets will promote the need for more extensive analysts earnings forecasts. Following an earlier article in the Financial Times (FTfm supplement) Mr. Raghu Mandagolathur, President of CFA Kuwait and Stephen M. Horan discuss the usefulness of earnings forecasts in equity analysis. 

Q: Are analyst earnings forecasts important?

Analyst earnings forecasts are a quantifiable part of equity research and a reasonable proxy for the market’s expectations of those earnings.  Although some investors and fund managers emphasize them, many do not.  A quarter of analysts surveyed by CFA Institute rarely or never incorporates quarterly earnings into their analysis, choosing instead to focus on longer-term measures of performance. 

Q: Is a heavy emphasis justified?

Earnings forecasts are only one factor in determining fundamental value.  Ultimately, a company’s value is the present value of its expected future cash flows over the long haul.  Reported earnings can be poor predictors of those future cash flows.  They can also be poor measures of historical cash flows, particularly over short time frames.

 Information such as accounting convention, industry trends, and management quality is critical to interpreting reported earnings figures and developing informed expectations of long-term cash flows.  The entire earnings report, formal filings, and independent information sources provide valuable information to update one’s long-term expectations. 

 Respected analysts use multiple metrics (such as cash flow, book value, and residual income) in addition to earnings to value companies. 

 

Q: How is the quality of an earnings forecast measured?

 Typically, the precision of an analyst’s earnings forecast is measured by the difference between the actual earnings per share reported by the company and the analyst’s estimate, called forecast error.  Accuracy is often measured by the absolute value of the forecast error such that forecasts that are 10 percent above or below actual earnings have the same level of accuracy. 

 But analysts are often charged with being overly optimistic in their forecasts.  This upward bias is sometimes measured by the raw forecast error or by the difference between an analyst’s forecast and the average forecast. 

Q: Are analyst forecasts actually biased?

Studies confirm the suspicion that earnings forecasts tend to be biased upward––that is, higher than actual earnings.  Annual and multi-year earnings forecasts tend to be more optimistic and less accurate than quarterly forecasts.  Optimism among analysts may have intensified over time as the proportion of upwardly biased quarterly forecasts has increased from less than half to more than three quarters over a 22-year period. 

Some of the apparent trend toward optimism can be attributed to a growing inconsistency between forecasted and reported earnings.  Analysts tend to create pro forma earnings forecasts that exclude special charges.  Over time, these charges have become more frequent and more negative, making the analyst’s pro forma forecast appear optimistic compared with reported earnings. 

Q: Are some estimates better than others?

Conventional wisdom suggests that investment banking makes sell-side analysts more susceptible to misaligned incentives than buy-side analysts.  In a recent study published in the Financial Analysts Journal, researchers from Harvard Business School report that sell-side forecasts were actually less biased and more accurate than buy-side estimates issued by a top 10-rated money management firm––a result confirmed by other studies. 

In related research, analysts at the most prestigious banking firms provided less optimistic forecasts than their less prestigious peers. Moreover, retail brokers were more optimistic than institutional brokers. 

Q: What accounts for the difference?

Institutional investors rank sell-side analysts in annual polls based in large part on the accuracy of their earnings forecasts.  Compensation is determined accordingly.  

 Buy-side analysts, in contrast, are typically not compensated based on their earnings forecasts.  In the Harvard study, they were evaluated based on internal rankings and market-adjusted returns. 

Q: Are there other indicators of forecast accuracy?

Yes. Analysts that cover fewer stocks and specialize in the company’s industry tend to produce more-accurate earnings forecasts than generalists.  Experience and resources also seem to play a role.  Forecasts from analysts with more experience and from larger firms tend to be more accurate.  Evidence also suggests that professional credentials improve accuracy. 

Q: Is it proper to focus on short-term earnings estimates?

The desire to hit quarterly or semi-annual earnings targets can prompt companies to use accruals opportunistically or classify expenses capriciously as special non-recurring items, such as restructuring charges.  In the extreme, company executives may knowingly misreport earnings.

A focus on short-term earnings to the exclusion of other factors can also lead to poor decisions by company executives on the quarterly treadmill.  In a survey of 400 executives, 80 percent reported that they would decrease discretionary spending on such areas as research and development, advertising, maintenance, and hiring to meet short-term earnings targets.  

 More than 50 percent of these executives said they would delay new projects, even if it meant sacrificing value creation to meet quarterly earnings expectations.  Focusing on earnings management not only detracts from long-term business management; it sends the wrong message to employees.