Analysts’ Incentives and the Dispersion Effect
Chuan-Yang Hwang
Yuan Li
1
• Puzzle (Diether, Malloy and Scherbina (2002) )
• A negative cross-sectional relationship between
dispersion in analysts’ earnings forecasts and
future stock return (the dispersion effect).
2
• Explanations in the Literature
• DMS: (Miller 1977) difference of opinion
• Johnson (2004): information risk
• Sadka and Scherbina (2007):analyst disagreement
and information asymmetry
• Commonalities:
• Dispersion is viewed as an exogenous variable
• Measure as information uncertainty, cause of lower
stock return
3
• Our explanation: Analysts’ incentive of not fully
downward revising their forecasts when they possess
bad news would simultaneously increase forecast
dispersion and induce an upward bias in consensus
forecasts, and stock price.
4
• Analysts’ Incentive to issue optimistic opinions
• Investment banking business (Dugar et al. (1995), Lin and
McNichols (1998,2005), Dechow et al. (2000), Michaely
and Womack (1999) )
• Trading Volume ( Cowen et al. (2006) , P.J.Irvine (2001))
• Access to managers’ information (Francis and Philbrick
(1993), Das, Levine, Sivararnarkrishnan (1998), Lim
(2001))
• Career Concern ( Hong and Kubik (2003) )
5
• Incentives are more pervasive among firms
have bad yet publicly unknown information:
• Non-incentive driven analysts—downward
revise forecasts promptly
• Incentive driven analysts-reluctant to
downward revise
• --dispersion increase and an upward bias in
consensus forecast
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3.0
2.5
3.0
2.0
2.5
Bad
News
-0.5
1.5
2.0
Dispersion Increase
Upward Bias:0.5/3
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Supporting Result (1)
The dispersion effect exists only among bad news
firms.
8
• Supporting Result (2)
• Analysts’ incentive, change in dispersion, and upward
bias in consensus forecasts increase with level of
dispersion among bad news firms.
9
Supporting Result (3)
After controlling for incentive-induced upward bias
embedded in consensus earnings forecasts, the
dispersion effect disappears.
10
Supporting Result (4)
Firms with low information uncertainty exhibits stronger dispersion
effects as high forecast dispersion is more likely to be generated by
analysts’ incentive.
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