In a perfect world, when more stock market analysts follow a company’s fortunes, individual investors benefit. The additional analysts keep a watchful eye on management and earnings, make investors better informed, and expand the pool of people interested in buying the company’s stock.
In the real world, however, there is a dark side to the interactions between analysts and a company’s managers. In the constant game of what analysts forecast for a company’s quarterly earnings and what managers later report as earnings, it turns out that having more analysts makes it more likely that a company’s earnings will beat expectations — and even more likely that the company will hit the earnings target exactly or by a mere penny per share.
New research by Associate Professor of Accountancy Shawn Huang and colleagues at the University of Missouri-Columbia and the University of Cincinnati shows that greater coverage puts pressure on company managers to manipulate quarterly earnings so the numbers just so happen to meet the analysts’ forecasts.
What causes so many companies to strive to meet short-term expectations? Huang’s team found that when more analysts cover a company, investors react more strongly to bad earnings news. Now pressured to deliver good news, managers whose compensation and careers depend on meeting forecasts are more likely to manage the financial reports accordingly and even guide analysts’ forecasts downward — in effect, making the earnings bar easier for the company to clear.
The research is important, Huang says, because individual investors rely on knowledgeable analysts to provide unbiased information.
“If the financial reports didn’t reflect the firm’s true economic picture, the investors are making decisions based on the wrong information,” Huang says. “Maybe they will make some bad investment decisions, and that will hurt.”
What role do analysts really play?
Other researchers have proposed varying views of the relationship between analysts’ coverage and company earnings. To proponents of the monitoring view, having additional analysts means there are more trained and knowledgeable people following companies more intensely, which constrains managers’ ability to tweak earnings numbers. To proponents of the competition view, having additional analysts adds diverse viewpoints, reduces bias, and heightens the competition among analysts to forecast accurately instead of too optimistically.
A newer take on the analyst-manager relationship, called the pressure view, says additional coverage means information circulates to investors more quickly and more widely, magnifying the negative reactions that occur when a company misses forecasts. Managers aware of those consequences feel pressured to meet forecasts, even if by just a penny per share.
“If a manager couldn’t meet the analysts’ benchmark, the stock market reaction will be negative,” Huang says. “That is why there are huge incentives for managers to meet that benchmark.”
Huang’s team wanted to help determine which view is most valid. If analysts truly monitor companies, then being followed by more analysts would make firms less able to meet or beat forecasts. If analysts compete to forecast accurately, then being followed by more analysts would make firms as likely to beat forecasts as to meet them. If analysts pressure managers, then being followed by more analysts would make firms put a priority on meeting forecasts.
The researchers collected more than 52,000 quarterly earnings numbers from more than 4,100 firms over the period 1996 through 2011, and compared them to the numbers that analysts had forecast. They sorted the data into three categories: firms that missed the forecasts, firms that met the forecasts exactly or by one cent a share, and firms that beat the forecasts by two cents a share or more.
Not surprising to regular market followers, the majority of public companies met or beat forecasts. Companies missed forecasts in just 27 percent of the cases. Nearly 19 percent of the time, companies met the analysts’ forecasts by no more than a penny a share, and nearly 54 percent of the time they beat forecasts by more than one cent a share.
The researchers then factored in the varying levels of analyst coverage. Rather than lowering managers’ ability to manipulate earnings, Huang’s team showed greater coverage raised the odds that firms would meet or beat forecasts. The view that analysts monitor companies, therefore, didn’t dominate the relation between analyst coverage and whether a firm met or beat its analyst earnings forecasts.
The next question to answer was whether analysts compete to deliver accurate forecasts or whether their forecasts pressure managers to meet analysts’ expectations.
The team had expected the competition view to prevail, Huang says. But instead of finding little difference between the odds of companies meeting analysts’ forecasts and the odds of them beating forecasts — meaning analysts were forecasting accurately — the results showed that having more analysts raised the odds of meeting forecasts but not the odds of beating forecasts. That meant the effect of the view that analysts compete to forecast accurately didn’t dominate that of the pressure view, either.
The results suggest that additional analyst coverage pressures managers of companies to smooth earnings so they can continue to meet forecasts. Firms that beat expectations probably are performing well and don’t need to manage earnings to meet analysts’ benchmarks, Huang says.
More evidence of analyst pressure
Further bolstering the pressure view, the research also found that among companies with the same amount of earnings surprises, companies covered by more analysts experienced greater negative stock-market reactions to surprises than those covered by fewer analysts. That finding is one of the best arguments for the view that more analyst coverage pressures managers to prevent negative surprises because bad news spreads quickly to more investors, Huang says.
The team also looked at the 25 percent of cases in which managers issued information to guide analysts’ forecasts. The research found companies were more likely to issue downward guidance when more analysts covered the firm, prompting analysts to lower their forecasts. The team also found that firms that end up meeting forecasts use downward guidance much more often than firms that end up beating forecasts. That suggests that managers under pressure to clear the bar simply use downward guidance to prompt analysts to lower the bar.
It was possible that forces having nothing to do with earnings were raising the odds of firms meeting forecasts, Huang’s team acknowledged. They looked at cases in which brokerage houses closed or merged, resulting in fewer analysts covering a stock. They found that as the number of analysts following a stock fell, so did the odds that a stock would meet expectations — reinforcing their view that pressure to meet expectations rose and fell with the number of analysts following a company.
They also looked at cases in which specialized business units were spun off from larger, multi-segment companies. The spinoffs attracted greater analyst coverage, and the team found they also were more likely to meet forecasts but not beat them — again reinforcing the view that managers feel pressured to meet forecasts.
Having provided additional support for the view that greater analyst coverage puts more pressure on managers to meet expectations, Huang thinks there are further avenues to explore. He wonders whether increased coverage and pressure will affect firms’ willingness to take risks or affect the odds of managers’ misbehavior.
There is still a bright side to analyst-manager relationships, Huang says. The market still needs sophisticated people to process company information, because most individual investors don’t have the time to dig into companies’ financial statements. Greater analyst coverage also means the company stock is more liquid and more investors pay attention to the firm.
But the bright-side benefits that analysts bring to the market also come with a dark-side cost: the pressure managers feel to meet expectations.
“Having greater analyst coverage is a good thing, but there is one cost,” Huang says. “We want to make sure everybody understands that cost.”
The bottom line
Stakeholders in the stock market can learn these lessons from the research, Huang says:
- For investors: When a firm attracts more coverage from analysts, it can mean greater liquidity, which is good for your investment. But more coverage also puts pressure on a company’s managers, and their financial reports might not give the most objective picture of a firm’s performance — especially if earnings happen to meet expectations by no more than a penny per share.
- For analysts: As more of your peers cover a company, expect managers to have more incentive to meet forecasts. Understand that the extra coverage puts pressure on managers. So, consider that the company’s financial results may have been subject to some manipulation.
- For managers: Realize that besides the benefits, there is a cost to having more analysts cover your company. You will feel greater pressure to meet forecasts because any bad news will spread quickly, possibly reducing your compensation and career opportunities.