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Analyst Forecasts, Errors-in-expectations, and the Value Premium

Chu Zhang, Hong Kong University of Science and Technology

31st Aug 2012  11:30 am - 12:30 pm Room 214/215, H69 - Economics and Business Building

Investors' extrapolative errors-in-expectations about future corporate earnings have been hypothesized in the literature as an explanation for the value premium. The extant literature uses analysts' earnings forecasts as a proxy for investors' expectations and has found certain evidence consistent with the hypothesis. But researchers have not reached consensus on whether the value premium is indeed caused by extrapolative errors-in-expectations. In this paper, we examine analysts' long-term earnings growth forecasts, compare them with the earnings growth predicted by an empirical model, and use the difference between the analyst forecast and the model forecast as a measure of the errors-in-expectations. We find evidence that analysts extrapolate in their earnings forecasts, although not for all types of stocks, but we conclude that the errors-in-expectations are not the cause of the value premium because the errors-in-expectations measure we construct does not have strong predictive power for future returns and does not subsume the market-to-book ratio in generating the value premium.